A discussion on the J-Curve in private equity

These are the questions Fort Washington Investment Advisors address in this feature.

What Causes the J-Curve?

Two things fundamentally cause the J-Curve. The principal driver is that management fees in a fund are charged based on a fund’s entire committed capital and the capital called in the early years is only a portion of the fund’s committed capital. Thus, in the early years, management fees and organizational expenses represent an unusually large portion of contributed capital. For example, in a $100 million fund with a 2% management fee, annual management fees would be $2 million per year. If the fund also has $300,000 of organizational expenses, the legal and travel expenses associated with forming the fund, then the fund would have $2.3 million of expenses in its first year. If the fund made five investments of $3 million each, was valuing them at cost and had called 20% of committed capital after its first year, then the fund’s interim value would look as follows:



The fund would be considered below par on an interim valuation basis because of the $20 million of investments. The fund’s interim value would be $17.7 million or 0.89x the capital contributed.

The second major driver of the J-Curve is best explained in the following way: the lemons ripen early, particularly with venture capital funds. Troubled companies tend to be written down or written off much more quickly than successful companies develop. A successful company usually will take longer to reach a positive return such as an Initial Public Offering (IPO) or an acquisition. Most general partners expect that successful companies take four to seven years to reach their positive outcome. Troubled companies, on the other hand, will surface more quickly as it becomes apparent that their business models or management teams are not working. Using the first example cited above, we will add some more investments to show what happens. If we carry on to the second year with another 20% of committed capital being called, five investments being made and two of the original five investments having trouble, with one being written- off and one written down to half its value, the value would look as follows:



In this scenario, investors evaluating the interim performance of the fund may become uncomfortable since they have contributed 40% of their capital commitment and the interim valuation was at 78% of their contributions. The investor must remember, at all times, that private equity is an illiquid and long-term asset class. What may not be reflected in the interim valuation is that there could be a “Google” emerging in the portfolio of investments and this investment could be held at cost. Most private equity fund general partners typically take a conservative approach. In fact, the private equity industry has historically required conservative valuation guidelines and has been inconsistent in the treatment of interim valuations between buyout and venture capital deals. Buyout deals are frequently written up to reflect a multiple of earnings after a year, whereas venture capital deals are often held at cost until there is a financing or exit event. Companies that do well and do not need additional financing, the very companies that have increased in value, are held at cost until they are acquired or go public many years later.

The companies that are performing well, but are held at cost, understate the value in the portfolio. Over the subsequent three to four years, these companies may be sold for 3-10x or more invested capital. These ultimate realized values often are not reflected in the interim valuations. The chart below illustrates how total value (unrealized valuation of the fund (NAV) plus cumulative distributions) may track over time relative to contributed capital.



A Look at Interim Valuations

Nobody likes to see the value of their investment decline shortly after they make an investment. Investors in private equity should expect a return greater than the public equity market as compensation for its illiquidity, long-term commitment and risk. At Fort Washington, we believe that investors should expect 5% to 10% (500 to 1000 basis points) per year above the public equity markets as measured by the S&P 500 Index. In evaluating interim performance, investors should expect negative interim returns and expect that their return should become positive in years four through seven depending on a variety of factors including the pace of investment, the presence of early winners in the portfolio, and the market environment over the duration of the investment period. The primary focus for investors should be the timing and size of cash distributions to the limited partners and the ultimate returns based on distributions. The private equity industry uses a ratio of the distributions to capital paid in or “DPI” to measure the level of distributions. As the portfolio matures, investors will see the DPI ratio cross 1.0x (or par) as an important milestone toward the ultimate return of the portfolio.

In evaluating an unrealized portfolio, the unrealized interim valuations (referred to as the accounting value) are often deceiving in reflecting the true economic value of the portfolio. As a result, investors should focus on four factors in the portfolio: 1) the realized value, 2) the ratio of capital invested that has been written off, 3) the ratio of companies held above and below cost and 4) the portion of the portfolio that is valued by the public markets but not yet distributed. Doing this can give the investor a better indication of the quality of the portfolio. At Fort Washington, when we meet with fund general partners to evaluate an unrealized portfolio, we discuss the potential value creation in the portfolio such as companies’ revenue rates over the last few years, penetration in new markets, and, for technology companies, design partnerships with industry leaders.

The most important thing is that investors have proper expectations and recognize that interim valuations are often quite different and disconnected from the ultimate return of the portfolio.

For example, in two of Fort Washington’s funds of funds, we held a partnership at an interim valuation of 0.53x the contributed capital. Many investors would be concerned with the accounting value and the potential of this portfolio. However, in our numerous discussions with the fund’s general partner, we were aware of a number of companies that were progressing very well and building significant value, though they were held at cost. In one quarter, two of these companies achieved liquidity, one went public and one was acquired, both yielding a return greater than thirty times capital invested. The fund’s valuation went from 0.53x to 1.75x in one quarter as the accounting value moved toward the economic value.

Reducing the J-Curve

Since the J-Curve is generally due to fees charged on the fund’s committed capital and those early “lemons”, there are ways to reduce the effects of these events. These include: 1) effectively managing fees, 2) purchasing secondary interests in private equity funds at a discount, and 3) managing the portfolio between buyout and venture capital such that there are likely to be some winners ahead of or consistent with some of the “lemons” in the early years. Due to the nature of this investment class and the higher risk profile of private equity, particularly in venture capital, we have to accept some “lemons” for taking the appropriate risk to achieve some of the high returns generally associated with private equity investing.

At Fort Washington, we build diversified portfolios with leading venture capital and buyout funds focused on delivering strong returns relative to the public markets.

We should mention that some fund managers take steps to reduce the J-Curve that, in our opinion, are inefficient and reduce the portfolio’s expected returns. What they do is invest in lower returning investments such as auctioned secondary purchases, mezzanine funds, and other funds aimed to create current income or bet on stages in the economic cycle. We believe it is important to manage the portfolio to achieve the best economic returns, not to manage interim accounting valuations.

Summary

To summarize, we do not believe that investors should be so concerned with the J-Curve that they accept lower risk-adjusted returns. Investors in private equity have the opportunity to realize substantial returns in their portfolios over the long term. Focusing on short-term measures in a long-term asset class can distract investors from achieving their objectives. We hope this discussion will help investors put interim returns in perspective and enable them to feel more comfortable by focusing on the long-term opportunities that a private equity investment presents.

About Fort Washington Capital Partners Group

Fort Washington Capital Partners Group (FW Capital) is the private equity division of Fort Washington Investment Advisors, Inc., a registered investment adviser under the Investment Advisers Act of 1940, as amended from time to time. FW Capital manages more than $1 billion in private equity assets and commitments for private sector and government institutions and high-net-worth individuals utilizing, among other things, private equity funds of funds, direct co-investments funds and customized investment programs. FW Capital and its affiliates have made investments in more than 90 private equity funds and maintain relationships with more than 60 private equity firms. FW Capital currently manages five private equity fund of funds vehicles, two direct co-investment funds, and five customized geographically targeted programs in Kentucky, New Mexico, Ohio and Utah.

About Fort Washington Investment Advisors, Inc.

Fort Washington Investment Advisors, Inc. (Fort Washington), a registered investment adviser under the Investment Advisers Act of 1940, as amended from time to time, provides professional and comprehensive investment management services for institutions, corporations, insurance companies, mutual funds, foundations, associations and high-net-worth individuals. Founded in 1990, Fort Washington manages more than $26.5 billion in assets*, offering a broad array of investment styles from equity and fixed income to private equity limited partnerships. Fort Washington is a member of Western & Southern Financial Group. For more information, visit www.fortwashington.com.

* As of 12/31/05 does not include Todd Investment Advisors, Inc., a wholly owned subsidiary, with $3.5 billion in assets; or Fort Washington Capital Partners Group, a division for Fort Washington Investment Advisors, Inc., with more than $1 billion in commitments and assets under management.