J-Curve: Why Investments Follow a Familiar "J" Shape

By Markets Fool.com

The J-curve has been observed in everything from economics to statistics. In investing, it typically describes the graphical shape of performance and cash flows for private equity investments and private equity funds.

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If you chart the performance and cash flow received from a private equity investment over time, it will typically follow the shape of a J, as the blue line in the example below shows.

J-Curves in cash flows
J-curves in a chart of a fund's cash flows to and from investors exist for two primary reasons.

First, private equity funds do not typically take possession of their investors' capital until they have identified investments to make in the fund. Investors merely "commit" to investing in the fund, giving the cash to the manager upon request on an as-needed basis. Thus, in the early years, cash flows are negative because the manager will call on capital from its investors to make new investments.

Second, most private equity investments generate little or no routine cash flow to the investor in the early years. Typically, private equity firms use huge amounts of debt and a small amount of their investors' capital to buy out whole companies. The lenders in the deal reduce their risks by negotiating for a "cash flow sweep," which requires that some or all excess cash flow produced by the target company be used to pay down debt.

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So the earnings from a leveraged buyout will typically flow first to the lenders to reduce the company's leverage. Years later, when debt has been paid down and the business has grown, excess cash will start flowing to the equity investors.

The J-Curve in fund performance
In charting the performance of a private equity fund, you'll find it also follows a J-curve pattern. It isn't uncommon for a fund to show losses early before turning positive years after its launch.

One of the biggest reasons the J-curve exists in fund performance is simply because private equity investments take time to perform, yet many funds pay routine management fees regardless of performance. Thus, in the early years, fees take a slice of the assets before the assets have time to appreciate in value.

Second, the fund manager is responsible for determining the value of the investments in the fund at a given point in time. Many funds mark their investments at a reasonable market value or at the investment's original cost, whichever is lower. That means strongly performing companies will be marked at their original cost (no gain), while weak performers will be marked down.

Since not every investment is a winner, a single early loser results in negative performance in the initial years. However, when the rising values of the winning investments are realized through a sale years later, the performance of the fund will take on the familiar J-curve shape.

Using J-curves to compare investment performance
The whole point of a J-curve is to quickly and graphically compare investments to one another by comparing the steepness of the J-curve. The incline is determined by the returns, and by how quickly those returns make it back into the hands of the investors.

The best investments generate the highest returns in the shortest amount of time, thus resulting in a steep J-curve shape. The J-curve of a poorly performing investment will exhibit very little steepness, because the returns are low, take a long time to be realized, or both.

The J-curve simply makes it possible to quickly and graphically compare the performance of two funds with no heavy mathematical thinking required.

The article J-Curve: Why Investments Follow a Familiar "J" Shape originally appeared on Fool.com.