The J-Curve Reversal: How Private Equity is Leveraging the S-Curve

Key Points:

• The traditional J-curve narrative in private equity investments is becoming obsolete.
• The S-curve provides a more accurate representation of the performance of private market transactions over time.
• Understanding and managing the S-curve is crucial for investors looking to measure and manage their private market allocations.
• The S-curve offers actionable and quantifiable insights for benchmarking and returns analysis.
• Time-weighted returns computed using modified Dietz methods can deliver misleading performance information.
• Incorporating the de-risking effect of durations is critical for accurate benchmarking and effective portfolio management.

The J-curve narrative has long been used to describe the performance of private equity (PE) funds. It refers to the initial downward plunge of the internal rate of return (IRR) due to the high expenses and fees incurred in the early stages of the fund’s lifecycle. However, this narrative oversimplifies the underlying sigmoid pattern, known as the S-curve.

The S-curve takes into account the impact of decreasing marginal returns over time in private market transactions. As distributions become more distant, their financial relevance decreases, leading to marginally decreasing returns. Understanding and managing the S-curve requires a duration-based and time-weighted performance calculation strategy.

Investors in private markets are increasingly interested in understanding the risk and return outlook of their allocations compared to other asset classes. Ex post comparisons based on the J-curve narrative have limited practical application. On the other hand, analyzing the S-curves provides actionable insights for benchmarking and returns analysis.

Private market investments pose unique challenges in portfolio management compared to more liquid asset classes. The J-curve narrative, along with current PE indices and metrics, assumes annualized and chained IRRs. However, this approach delivers misleading performance information by neglecting the de-risking effect of distributions.

Incorporating the de-risking effect of durations, where the S-curves twist, is crucial for accurate benchmarking and effective portfolio management. It provides a more realistic understanding of the performance and risk-adjusted contribution of private market investments.

The J-Curve Effect vs. the S-Curve in Private Equity

A visual representation of the J-curve and S-curve in private equity demonstrates the difference between the two concepts. The J-curve line represents capital growth if IRR returns were applicable to the entire commitment and reinvestment was instant. On the other hand, the S-curve models the true dollar creation of the private fund portfolio, taking into account the context of time and a realistic investment pacing and overcommitment framework.

Data supports the thesis that the S-curve provides a more accurate representation of private equity performance. Long-term median IRRs for private equity funds are around 13.3%, but US pension funds have reported long-term PE returns of 9.3%. This suggests that a steady-state overcommitment strategy of 1.4x would align with the S-curve approach.

However, performance numbers alone do not tell the whole story. Risk-adjusted contribution is crucial, and this can only be estimated accurately with S-curves and duration-adjusted return on capital (DARC) weighted returns. Incorporating the de-risking effect of durations is critical for both accurate benchmarking and effective portfolio management.

Overall, private equity investors can benefit from a shift in perspective from the J-curve narrative to the S-curve paradigm. Understanding the S-curve and incorporating its insights into portfolio management strategies will lead to more accurate performance analysis and better risk management.