“Don’t put all your eggs in one basket” is an expression often used by an investment manager to highlight the importance of diversification and having a Portfolio Strategy that considers the overall value of all your investments combined rather than the solo performance of individual investments. This approach recognizes that there will be winners and losers, and it means your investments are not overly dependent on one sector or one company. This spreads your risk, balances your portfolio, and increases your chances of building steady and sustainable future returns.
Potential investors should make note of how the J curve effect can be used to their advantage when managing a private equity fund. Alternative investments broadly refer to any investments that are not publicly traded, meaning they sit outside of the traditional markets of stocks, bonds, and cash. Types of alternative investments include private equity, where people invest in private companies that are not publicly traded.
This can be done by direct investment, through a Venture Capital fund, or by Angel Investing through platforms such as Propel(x). Adopting a portfolio strategy for private equity investing improves your chances of building a successful portfolio. This is where the J curve comes in.
Understanding J Curve Private Equity
J curves are a way of describing the value of a private equity portfolio over time because it often follows a shape similar to the capital letter “J”. Looking at the letter ‘J’ from left to right, the letter traces a dip, bottoms out and then rises. The value of a private equity portfolio often follows a similar trajectory – it first declines in value, then starts to rise slowly and then rises rapidly.
The most important message here is that investors must recognize that their private equity portfolio may decline in value and even go underwater in its early years before it starts to recover and potentially generates high returns. The J curve phenomenon is well established and is a growth strategy that a fund manager may utilize for their clients.
The J Curve & Private Equity Funds
In regards to a private equity fund, a J curve shows how invested capital tends to produce negative returns in the first few years, and in the later years returns can potentially increase as investments mature. A private equity fund typically produces negative investment returns in the early stages of investment due to investment costs, management fees, an investment portfolio that needs to mature, and portfolios that are underperforming in their earlier days but are later written off. Working on the example of investing in startup companies, the stages of a J curve can be broadly described as follows:
- An initial investment stage where capital is allocated or invested in a fund but has not yet been deployed – this is the very beginning of the upturned tail of the J on the left.
- As private equity funds are progressively deployed in different startups, the portfolio is no longer liquid, and the private equity funds are committed for potentially long periods of time, so the redeemable value of the portfolio goes down, following the downward trend of the tail of the J.
- Startup investing is a risky undertaking, and many startups fail. In fact, data from investment industry analyst CB Insights shows that 67% of startups fail to provide a return for their investors and that this typically happens within the first 20 months of them first raising capital. This means that in the first year or two of startup investing, it is expected that there will be failures. This represents the trough or the bottom of the tail of the J. During this time the investment is not liquid meaning you may not be able to sell it.
- As time moves on, the J curve theory is that the strong companies in a private equity portfolio will find their feet and begin to provide positive performance for their investors. This is where the pendulum swings and the portfolio value hopefully moves up into positive territory as it tracks the long line of the J and trends upwards — leading to a net gain in cash flow.
Factors that Influence the J Curve Effect
When investing in startups, it is important to understand that it requires a long-term commitment and to accept that there will be failures along the way. Poor performers often shut down quite quickly, typically in the first one or two years. So, for example, during the investment period, if you invested $10k into each of 10 startup companies at the end of the first year, you might have experienced three shutdowns, which would mean your portfolio value would be down by $30k. That is why it is so important to have a Portfolio Strategy where you look at all your investments together in totality and to have a high tolerance for risk.
When you consider investing in a startup during the investment period, it is also important to understand and accept that a good company needs time to shine. Many star performers that are household names today took many years before they returned funds and positive cash flow to investors. For example, there was an eight-year gap between Facebook’s first Series Seed funding in 2004 and its IPO in 2012. Startup failures and the time required for companies to build success are two big variables that impact the shape of the J curve. Another is time – faster deployment of capital means a steeper J curve. The selection of companies to include in your portfolio is another obvious factor – the better the choice of who to invest in, the better are your chances of receiving a return from those companies. If it takes longer to generate returns, the shape of the J curve will be flatter and potentially deeper (which is not a good thing).
The overall state of the wider financial market and economy can have an effect on the value of your portfolio investments if the companies you have invested in are impacted by those factors in the wider market. Costs in the form of fees and charges associated with managing your portfolio or making the investments also have an impact on returns and, therefore, the shape of the J curve. In summary, key factors influencing the J curve include:
- Startup failures
- The strength of startup successes
- Fees and charges
- The state of the wider market
How to Mitigate The J Curve & Reduce Risk For Private Equity Investments
The first step to mitigating the impact of the J curve is to really understand it. Do your research and learn about the factors that have a strong influence on the returns, and develop your strategy around portfolio company selection and timing accordingly.
Accessing curated deal flow and getting sound advice from angel investing platforms like Propel(x) can assist with selecting your investments. The strategic timing of your investments is also key. Learning more about how to start angel investing could be a good place to start. Most important of all is the adoption of a Portfolio Strategy and risk tolerance for your private equity investments. This will help you accept the failures that will likely happen early on in your investment journey before the solid performers start to bear fruit and build overall value in your portfolio. Diversification is very important to reduce risk and create balance in your investment portfolio and influence the shape of the J curve.
Hypothetical J Curve example
A hypothetical example of a J curve in private equity is shown below for illustrative purposes only to show the general shape and principles of what a J curve could potentially look like. Note the impact of the initial investments, the early failures, and the positive trends in the long term. Over the course of the fund’s life, an investor should anticipate an initial decline in value, but trust that their committed capital will trend positive and begin to yield strong performance figures.
The Bottom Line on the J Curve Phenomenon
Investment priorities vary for each individual, but the bottom line is generally quite fundamental for most investors, and that means identifying the potential financial return that can be achieved on their investments balanced by the risks of the investment. Recognizing the role of the J curve and the effect it has on returns over time is an important piece of the investment puzzle.
This article was originally published on November 5, 2021 and was updated on March 25, 2022.