J-curves: Looking for the next exit window

Historically, the (pooled average) cash flow J-Curve of private equity funds had an average length of six to seven years until the capital was paid back, with shorter durations – and portfolio company holding periods – in the boom years and longer ones in economic recessions.

We analysed a data set from Preqin containing detailed cash flow and valuation information of 1,416 private equity funds (buyout and venture capital) from 1983 through to 2012. These were split by vintage year into five groups: the ‘Golden 80s’ (1983 to 1989), the ‘Roaring 90s’ (1990 to 1998), ‘Tech Bubble’ (1999 / 2000), ‘Aftermath’ (2001 to 2004) and ‘Debt Bubble’ (2005 to 2008). For these five different groups, we calculated the pooled ratio of distributions to paid-in capital or capital calls (DPI) of all funds for each year and performed a comparison (the results are comparable whether you use averages or medians of DPI). The analysis shows very different cash flow patterns for the various groups (Chart 1, below).

Chart 1

In comparison to the other groups, the ‘Roaring 90s’ were substantially above average: these funds had relatively consistent capital calls and early distributions with a break-even (DPI=1) after fewer than 6 years. So on average, funds returned the invested capital before this point. Some of the funds in our data set even returned capital after just three years. This period was characterised by a buoyant M&A market and continuously increasing stock market prices; volatility was relatively low, and there was an IPO boom at the end of the 1990s, which opened the exit channel for private equity- (and particularly venture-) financed companies. As a result, the holding periods of these companies shortened substantially, especially in the second half of the 1990s.

A similar situation can be observed in the ‘Aftermath’ group. While they were much slower in deploying capital, given the situation in the period between 2001 and 2003, they had still returned more than 50 percent after six years. Again, some funds (especially those with later vintages) returned their entire capital after three to four years, because they were able to use the boom years 2006 and 2007 to exit their companies, mostly to strategic buyers and other financial investors. In addition, many portfolio companies’ equity investment was refinanced at a very early stage, as debt was easily available. While views differ as to whether these can be considered exits, the replacement of equity with debt resulted in very early cash flows for investors, with many benefitting from these dividend recaps. However, it can also be clearly observed that capital repayment slowed down after the refinancing window closed in 2008.

The chart demonstrates that the ‘Golden 80s’, the ‘Tech Bubble’ years and the ‘Debt Bubble’ years behaved relatively similar over the first five years of their fund lifetime. The ‘Tech Bubble’ and ‘Debt Bubble’ funds were all raised and started in recessionary years, which resulted in slower investment activity due to an elevated level of market uncertainty. The fact that some fund managers have asked or are currently asking investors for an extension of their investment period is an example of this, because they did not succeed in investing the capital within the agreed investment period. The ‘Golden 80s’ funds also fit into this picture, because the first private equity funds were characterised by longer investment periods and lifetimes (some were even structured as evergreen).

We then compared the DPIs during the lifetime of the funds after six years, in order to compare the ‘Debt Bubble’ funds, which are not fully realised, to the other fund groups (Chart 2, below).

Chart 2

On the left side of the second chart, the pooled DPI of different vintage years is shown while on the right the averages for our groups can be found. While the funds in the ‘Roaring 90s’ would have returned more than their invested capital after six years, the “Tech Bubble” funds had returned just above a third of invested capital to investors. Due to the turmoil in financial markets, the ‘Debt Bubble’ funds were slower in returning capital, with only a quarter of invested capital being paid back.

Hence, in addition to the difficult investment environment, exit timings were and continue to be very difficult for the ‘Tech Bubble’ and ‘Debt Bubble’ funds: the typical holding period would end in times when public equity markets were depressed, which obviously affects exit proceeds. While the ‘Golden 80s’ fund managers managed to exit their companies very quickly at the end of the decade and the beginning of the 1990s, the main question for the ‘Debt Bubble’ funds remains unanswered: can we expect another benign exit window for the current portfolio companies? And if not, what is our plan B?

Don’t write off Debt Bubble funds

The answers to these questions depend on both the quality and substance of the underlying investments, and the overall equity and debt market environment, including the level of M&A activity. The quality of the underlying portfolio companies can be reviewed by analysing their financials: mainly revenue streams, profitability and debts. Although a higher default rate at a portfolio company level cannot be observed currently, the level of debt still in some of the (mainly) larger companies raises question marks about future refinancing or sale processes.

However, higher debt ratios would need to be reflected in lower equity valuations of the portfolio companies, assuming stable enterprise values. Adding the latest available net asset values to our analysis, it can be shown that cash flows combined with the valuations (TVPI) of the ‘Debt Bubble’ funds are no longer very different from the historic patterns of the other groups. This might be an indication that the current situation merely reflects a time lag – that underlying investments might be realised at attractive valuations if the exit environment becomes more benign.

Chart 3

Chart 3 (left) shows that ‘Debt Bubble’ funds are more like the other groups in terms of realised and unrealised value than one would have expected – the big difference, obviously, being the larger amount of capital in the unrealised part of the portfolio. Therefore, it is too early to state definitively that the overall returns of these investments will necessarily be low. Even if the IRR is likely to be lower, due to the longer holding periods, the multiples still seem to be comparable with other vintage years.

That said, a lower level of realisations – and relatively full valuations for unrealised assets – obviously increase the risk profile of these investments for investors (this is partly driven by mark-to-market valuations, which were introduced in the post-tech bubble funds). Hence, fund managers need to demonstrate that they are able to realise the investments at or above their current valuations.

Admittedly, the J-Curve does not look very appealing at this stage. But previous periods – e.g. the Golden 80s – showed a similar return profile initially, only to benefit from an attractive exit window after some years.

And from a comparative point of view, other asset classes such as stocks have also failed to satisfy investors over this ‘Debt bubble’ period. While it is good to be critical given the situation (both in terms of the J-Curve and overall macro-economic developments), the opportunity for attractive returns has not been lost – yet.

In summary: while ‘Debt bubble’-era funds are lagging behind the cash flow profile of our other groups, and still have to demonstrate satisfactory realisations to investors, from a value perspective these funds have actually developed in line with our other groups. So the jury is still out as to whether investors will generate attractive returns with these funds; it all depends on whether there’s another exit window in the coming years.

How investors can protect themselves

The obvious consequence for investors is that they currently have to plan for a decreased amount of incoming distributions relative to past years, at least as long as exit opportunities remain limited. However, given the higher expected volatility in cash flow behaviour, and the fast-changing market conditions we have seen recently, active investors can also benefit from the current situation by adjusting their strategies accordingly – since there are ways to improve the cash flow characteristics of private equity portfolios. Here are four of them:

•   Manage liquidity: It is of utmost importance for investors to fully understand the potential cash flow pattern and the situation of their underlying investments. Based on the expected future market environment and by monitoring their cash inflows, investors with a more active approach to commitment management can benefit from such a situation by adjusting their investment behaviour accordingly.

•   Commit to funds directly: A more active and accurate management of the portfolio is only possible with more control over investment activity. Therefore – and due to the fact that the J-curves of funds of funds are even longer than those discussed above – many investors have started moving away from fund of funds and committing to funds directly instead, especially in local markets. An analysis of the break-even point (DPI=1) of more than 50 Fund-of-Funds included in the Preqin data set shows that it takes significantly longer to get the capital back – 13 years, on average. So while single funds have returned around 50 percent of their invested capital after six years, on average, the equivalent figure for funds of funds is only around 22 percent.

•   Add products with current yield: Adding investments with a running yield, such as mezzanine or infrastructure, provides investors with consistent and early distributions over the life time of an investment. This is especially true for the kind of investments in infrastructure and mezzanine that focus on current yield, compared to those that rely more on realisations at exit. Products with current yield can also include interest-generating tranches of a securitisation of private equity portfolios; this was used as a portfolio management tool in the early to mid 2000s and seems to be returning to the market (see also Diller/ Wulff, PEI May 2011).

•   Invest in secondaries: Instruments with a shorter J-Curve have earlier distributions than traditional private equity investments and usually pay back capital quicker. Due to the later entry point of secondaries – usually three to six years into the fund’s life – investors get into a fund later, saving significant time during the investment period and hence part of the J- Curve. In addition, the investment period of the secondary fund plays also an important role. While many traditional funds offer investment periods over many years, the cash flow profile of an investor can be optimised further through a shorter (e.g. one year) investment period, as seen in some innovative structures. In this case, expected pay-back of invested capital would come after a maximum of three years.



Our analysis of the cash flow profiles of these five different groups shows that the patterns vary significantly. While the ‘Roaring 90s’ and the ‘Aftermath’ funds show relatively attractive cash flow profiles with quicker repayment periods, the ‘Tech Bubble’ funds show a very long J-Curve, resulting in DPIs well below one after a period of six years.

The ‘Debt Bubble’ funds seem to mimic this cash flow behaviour, and after the first couple of years show lower distributions than the ‘Roaring 90s’ and ‘Aftermath’ funds. However, cash flow behaviour in the “Golden 80s” funds was similar over the first years, and they showed that they were able to deliver satisfactory returns despite this slow start.

These analyses confirm the feelings investors have about the development of the J-Curve in peak periods, but also in economically more difficult times.

However, it’s also true that the J-Curve can be reduced (both in general and under current conditions), without giving up much of the advantages of private equity as an asset class. Ultimately, the final decision to structure a portfolio with the desired characteristics remains the responsibility of investors – as does any decision about their appetite for illiquidity, and how (and to what extent) this illiquidity can be reduced. n

Christian Diller
and Marco Wulff are partners and co-founders at Montana Capital Partners, a Switzerland-based asset manager offering private equity investors innovative liquidity solutions through its annual secondary fund characterised by a short J-Curve and structured transactions/ securitisations.