Summary
Investor interest and participation in private markets continues to grow.
In this post, we’ll discuss strategies that can be used to potentially eliminate the J-curve in a private markets investment program, resulting in improved investment outcomes.
The secondary market involves the buying and selling of pre-existing investor commitments to private markets funds.
ra2studio/iStock via Getty Images Investor interest and participation in private markets continues to grow. Investors are attracted to private markets for different reasons, including access to the significant investable opportunity set that exists across the universe of private companies along with the potential for greater returns and lower volatility relative to the public markets .
Implementing a successful private markets program as part of a total portfolio is not without some implementation challenges, however, and perhaps the most pressing issue investors face which needs to be solved for is managing the J-curve . What is the J-curve?
In private markets, the J-curve is the term commonly used to describe the tendency for investors in closed-end funds to experience negative returns in the early years of a fund’s life, particularly with primary (newly formed) fund investments.
This occurs because capital commitments take several years to be called, yet fees are charged (on committed capital) prior to the realization of returns, such as distributions or the sale of portfolio company investments. And while the J-curve reverses over time as investments are made, the fund’s net asset value grows and investments are realized, investors are nonetheless exposed to negative returns in those early years.
In this post, we’ll discuss strategies that can be used to potentially eliminate the J-curve in a private markets investment program, resulting in improved investment outcomes.
As investors implement their desired strategic asset allocation targets to private markets, a key component of their portfolio construction toolkit is the use of secondary (purchase of existing interests in private markets funds) and co-investment strategies (investments directly into portfolio companies).
By allocating a meaningful component of portfolios to secondaries and co-investments, investors’ capital commitments can be called more quickly and returned faster, ultimately allowing their private markets portfolios to enjoy positive performance very early on. What is the secondary market?
The secondary market involves the buying and selling of pre-existing investor commitments to private markets funds. Secondary funds, in turn, can buy either from the investment managers (general partners or GPs) or those investing into their funds (limited partners or LPs).
As secondary interests are comprised of existing portfolio company investments, they are more mature in their lifecycle when compared to primary fund investments. How secondary funds can help diminish the J-curve – and return cash to investors quicker
The more developed nature of the underlying investments offers a host of additional benefits to the investors in secondary funds. As noted earlier, when the typical private markets fund begins to invest, early cash outflows typically lead to a J-curve, or initial negative performance early in the fund’s life.
This can be particularly daunting for newer entrants building out their first private markets portfolio. Without distributions from longer-tenured funds, years of negative and/or low returns would face the new private markets investor.
Including secondary funds in the mix can optimize portfolio construction. By entering later in an investment lifecycle, and therefore closer to or during achievement of value accretion, such an initial dip is lessened in secondaries funds.
In other words, by shortening the length and/or lowering the depth of the outflows and hastening inflows, secondary funds can diminish the initial J-curve of a private markets portfolio and offer cash back more quickly to the private markets investor.
The more advanced stages of investments within a secondary fund can also translate to shorter timelines to exit for the underlying assets, and therefore shorter tenures for the secondary funds relative to a primary allocation. Secondary funds can therefore offer entrance into otherwise longer-dated strategies for investors with timeline constraints. What are other potential benefits of secondaries?
Other potential benefits of secondaries include reducing blind pool risk and the potential to purchase assets at discounts to net asset value.Another key benefit of secondaries investing is reducing blind pool risk. When investors commit to primary funds, they don’t know in advance what investments the GP will make.In contrast, secondary funds invest in existing commitments and are able to conduct due diligence on these assets prior to investing. With this greater transparency into the underlying assets comes greater visibility into potential future performance, including near-term exits, pending asset write-ups and positive inflection points. These all contribute to improving near-term […]
source Flattening The J-Curve: Private Equity Strategies To Improve Investment Outcomes