Is the J-curve really an S-curve in disguise?

As private market assets mature, investors can find themselves unaware of their investment's current status. This late stage of the private market cycle can come with a lack of transparency on holdings, alongside uncertain timeframes for receiving capital back. Without true understanding and oversight, this could leave investors in a worse position than they thought with an extended time period to meet their investment objectives.

Monitoring of a private market asset post deployment is often overlooked. In my experience, investors undertake lots of due diligence to find a suitable investment. But these assets aren’t set and forget, monitoring them is very important during deployment, harvesting and exit.

Not monitoring your investments is like never getting a health checkup. Just as a doctor provides preventive care and identifies potential health issues early, regular portfolio reviews serve as preventive financial care to catch potential problems before they escalate.

You may think you don’t have options, but you do - factoring in realistic expectations into your forecasts allows you to take informed decisions on other elements of your portfolio. The secondary market is also available to sell assets outside of the “normal” liquidity schedule.

Expected Returns - Are you assuming the right level?

Investors may be familiar with the J-curve when investing in private equity. This relates to the expectation that in a primary private market investment, the value of your investment is expected to initially fall. This is because of initial costs incurred which outweigh the minimal or non-existent returns generated at that point, after which value begins to be realised and a subsequent upward trend in performance emerges. This pattern in returns resembles the shape of the letter J. Often this performance curve is depicted finishing with that upward trajectory up to the end of the investment’s life.

I would argue that a more realistic picture would be a complete flattening of the curve to reflect that in the final period of a fund’s life returns are commonly muted. Commonly there is little extra value gained as the manager exits the final positions in the portfolio.  There can even be a significant risk of write downs in values at this time. This doesn’t get much airtime because when a small portion of assets are remaining, the impact on return multiples of a fund is negligible. However, impact on forward looking expected return of current holdings can be significant.

This revised return expectation leads the J-curve to become more of an extended S, but I’m not convinced the term S-curve will send the J-curve out of fashion.

Why does this matter?

Investors can often be largely unconcerned with the precise exit valuations on the last few holdings on a well performing fund. This is understandable, however, for pension schemes, particularly those in deficit, this causes problems for expected return estimations and journey planning. Private assets, particularly private equity, can have very high return expectations, as high as gilts + 6% and beyond. These assets may produce this return on average, but as they approach the end of their life, returns typically level off. Depending on the exact vehicle you’re invested in, it may be appropriate to assume no further return in the last 18 months to 2 years as capital is returned. But the higher private equity return is likely still assumed as part of your recovery plan and journey planning. In this scenario it is important to reflect reasonable expectations.

This issue was much less important when overall expected returns for schemes were higher and when high returning private assets were being replaced with similar allocations as capital is returned, but this is something we’re not seeing as often today.

Liquidity - Will you receive your capital back when you expect?

Illiquidity in private markets is expected, it allows managers to appropriately plan and generate returns without the risk of unexpected outflows. It also breathes life to the so-called illiquidity premium that investors demand from allocating to these assets. That being said, pension schemes’ end game planning is increasingly being materially influenced by residual illiquid positions. This has bred opportunity for other less liquidity-strained investors to take advantage of sizeable discounts on assets traded on the secondary market. If you are not looking at a secondary market sale route, understanding the precise liquidity provisions in your private market investment is key to mapping your exit plan. Often investors either aren’t explicitly given dates for expected return of capital or if they are provided, small details in the initial agreement for things such as extension provisions or maximum deferral periods aren’t common knowledge.

What am I suggesting schemes do?

Private market assets offer a great opportunity for pension schemes either in helping to repair deficits or for surplus generation, both through primary and secondary market investment.

However, investors do need to have a detailed understanding of the stage of life that their private markets asset or portfolio is in to assess expected future return, as well as the expected liquidity timeline for their holdings. I advise trustees with private market allocations to ask their advisor or manager for additional oversight and support in assessing holdings in terms of valuation, prospects and time remaining. This will help avoid unwanted nasty surprises or delays to a scheme’s journey plan.