Carried Interest: Weekly Private Equity Buzz Phrase

This week's buzz phrase is the J-Curve Effect.

In the early years of a private equity fund, investment returns are virtually always negative. The fund manager is making capital draw-downs to cover his fees (generally 1.75% - 2.5% per annum), but the investment portfolio has not yet matured enough to build value and offset these costs.

The J-Curve Effect is particularly pronounced in the US, where most private equity firms hold their investments at the lower of cost or market value. In this approach the carrying value of any under-performing investment must be written down immediately, but the value being created by star portfolio companies is only recognised at the time of exit.

In Australia mark-to-market carrying values are the norm, so the impact of the J-Curve is less dramatic. Nonetheless, the J-Curve Effect is still often cited by institutional investors as a reason why it's hard to enter the private equity asset class. A new investor must be willing to weather 3 - 7 years of negative returns . . . a hard sell for the trustees of a conservative pension fund.

CalPERS includes a great illustration of the J-Curve Effect on their website (notice that the investor finally achieves a positive return in year 5):

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