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J Curve

A period of initial decline followed by a rise to a point higher than the starting point

What is a J Curve?

A J Curve is a chart where the line plotted falls at the beginning and rises gradually to a point higher than the starting point, forming the shape of the letter J. It is a phenomenon in which a period of unfavorable returns is followed by a period of gradual recovery that rises to a higher point than the starting point. The phenomenon applies in a variety of fields such as private equity funds, economics, medicine and political science.

 

J Curve chart
Source: Wikimedia Commons

 

For example, if you plot the performance and cash flows of private equity funds, the chart will follow the shape of a “J.” Private equity funds focus on the premise that the internal rate of return of an investment drops at the beginning until a level of stability is attained, after which the business can enter a profitable state.

 

J Curve in Private Equity

In private equity, the J Curve represents the tendency of private equity funds to post negative returns in the initial years and post increasing returns in later years when the investments mature. The negative returns at the onset of investments may result from investment costs, management fees, an investment portfolio that is yet to mature, and underperforming portfolios that are written off in their early days.

Typically, private equity funds do not take possession of their investor’s funds until they’ve identified profitable investments. The investors just commit to providing funds to the fund manager as needed or upon request. After the fund’s identified possible investments and started investing, it uses large amounts of debt and a small portion of the investor’s funds to kick off the investment. Banks that lend to private equity funds negotiate for a ‘cash flow sweep‘ that requires the fund to pay down its debt with some or all of the excess cash flow generated. In the initial years, the private equity fund generates little or no cash flow for the investors and the initial funds generated are used to reduce the company’s leverage.  This concept requires extensive financial modeling and a financial analyst at a PE fund will have to build an LBO model for the deal.

If the fund is well managed, it will begin experiencing unrealized gains followed by events in which the gains are realized. Leveraged IPOs, mergers and acquisitions, IPOs and buyouts result in increased returns to the fund, and this will take on the J Curve shape. With the excess cash and the after the debts are paid, the extra cash will go to the equity investors. The J Curve incline is determined by the returns generated, and how quickly these returns get back to the investors. A steep curve represents a fund that generated the highest returns in the shortest time possible, while a curve with little steepness represents a poorly managed private equity fund that took too long to realize returns and only generated low returns.

The J Curve for American private equity funds is usually more pronounced. These funds usually carry investments at a lower market value. Additionally, American funds are prone to writing up the carrying value of performing investments less than writing down underperforming investments. The value of the profitable investments is only recognized when there is an event like IPO and M&A that forces the company to mark up the investment.

 

J Curve in Economics

In economics, a J Curve refers to a change in the country’s balance of trade, following a currency devaluation or depreciation. A weak currency means that the imports will be costly, while it will be less valuable to export commodities. The imbalance leads to a fall in the current accounts, hence a smaller surplus or a bigger deficit. The high cost of imports will reduce the import volume, and this will cause the volume of exports to rise due to the more competitive prices of foreign buyers. Foreign buyers will be attracted to lower-priced local products. Since domestic consumers will buy less of the imported goods, they will purchase comparable local products that are more affordable than the foreign-originated goods.

Immediately after the devaluation of a currency, the immediate reaction is that exports will remain unchanged while imports will increase. Traders with preexisting contracts with foreign producers and manufacturers will honor their agreements. In the short run, there will be a lag in changing the consumption habits of imports, and there will be an immediate jump followed by a lag until traders stop importing expensive products. The demand for expensive imports and the demand for cheaper exports will be unchanged in the short run, as consumers look for cheaper alternatives.

The long-term implication of currency devaluation or depreciation is that local consumers will switch to comparable locally-produced products. Also, foreign traders will purchase more products that are being exported to their country than they will buy their country’s products. The products exported to their country are relatively cheaper due to the weakened currency value. At this stage, the country experiences the desired outcome of improving the current account balance. The J Curve forms when the country’s currency appreciates and the value of exports become more expensive than the value of imports.

 

Other Resources

  • Analysis of Financial Statements
  • Market Economy
  • Pigou Effect
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