Measuring Returns of Private Equity Funds

The J Curve Effect

Early in the life of a private equity fund, the total value of the fund may be less than the fair market value of its investments because of the fees and expenses associated with identifying and acquiring the initial investments. Gains in the fund’s investments are typically generated in the later years as the portfolio companies mature and increase in value. The effect of this initial decline in value and subsequent increase in value of the fund is known as the J curve effect. Mitigation of the J-curve effect involves the active involvement of the manager in identifying investment opportunities that generate earlier distributions, and involve more rapid deployment of capital. Secondary fund investments, co-investments and certain mezzanine fund investments can achieve the objective of mitigating the J-curve effect in a private equity portfolio.

Performance Measures

In the first year of a private equity fund, investments are typically carried at cost. In subsequent years, the sale of portfolio companies (including through public offerings of their securities) results in cash distributions to the limited partners. Over time, an increasing proportion of a fund’s performance reflects actual cash distributions received, rather than valuation estimates. The most widely used measure of performance is the IRR. The calculation of the IRR takes into consideration the timing of cash contributions from the limited partners, distributions to and from the fund and the length of time an investment has been held. Another widely accepted measure of performance is the multiple of invested capital that is realized by the limited partners. This measures the proceeds received from a fund plus the valuation of the remaining investments divided by the capital contributed to the fund.

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