In essence, the J-Curve is just a J-shaped curve that shows how a fund will perform below cost before recovering over time. In my view though, the J-Curve looks more like a leaning “S” but I digress. This is driven by the high fee nature of the VC. Typically, a fund's performance experiences an initial decline below its cost due to the capital allocated for management fees. However, the fund tends to rebound as the assets within its portfolio mature and appreciate in value.
This occurs primarily during the initial stages of the fund's existence when investments are typically maintained at cost, and management fees are incurred. As the portfolio matures and companies generate value over time, the NAV (and distributions if any) exceed the cost of the management fees.
The J-Curve is particularly pronounced for pre-seed/seed stage funds given two additional considerations versus their later stage counterparts:
Portfolio companies may be written off before meaningful value creation occurs in the rest of the portfolio creating further distance between the capital called and the NAV
Management fees may sometimes be higher as a percentage of the fund given the size of early-stage funds, mathematically pushing down TVPI.
Can a Fund Avoid the J-Curve?
The J-Curve is structurally built into the mechanics of a fund and as such, is very difficult to avoid. What I mean by that is that the management fees charged by a fund will create a drag on returns when initial investments are made and held at cost. Remember that the J-Curve is based on a fund’s TVPI (you would also see it in terms of IRR too), which mathematically is calculated as the Capital Called over the Net Asset Value + Distributions Paid. That mathematical fact is what creates a J-Curve.
Some managers may proactively tailor their strategy to make the J-Curve less pronounced than otherwise. They can do this by: 1) either lowering management fees and minimizing fund expenses (which is often counter to their best interest); 2) generating early write-ups/ exits that would offset the cost of the fees. For example, an early-stage GP (Series A & B), may at the very start of the fund, write a few Series C & D cheques with the goal of having another round of financing at a higher valuation/ company quickly acquired by someone else. That said, at the end of the day, the J-Curve is venture capital reality. There’s not many reasons to absolutely avoid it. Early distributions will probably get recycled and write-ups are paper only anyway.
Expect a J-Curve
It’s a little jarring to see the J-Curve if you’ve never invested in venture before. However, it’s perfectly normal for the first few years of a fund. I would expect a normal fund to get out of it sometime towards the end of the typical investment period (~4 years into the fund life). Sometimes it takes a little longer— that’s normal. However, if a GP is still saying that 7+ years in (even for a pre-seed/seed fund) that they are in the J-Curve, I’d be weary. In those instances, the majority of the time, it’s not a J-Curve thing, it’s a bad fund thing.
A Practical Example: J-Curve by Phases of a Fund
By no means is this Excel the rule, but it does illustrate the J-Curve over different periods of a typical venture fund.
Investment Period
A typical fund will see its TVPI drop over the course of its investment period before recovering sometime around year 4.
Table 1, 1 year in:
You’ll notice that the cost of investments is $30K and that investments are held at cost. Because of the ~$6K in management fees, the TVPI is at 0.83x despite the MOIC for all the investments being at 1x.
Table 2, 2 years in:
The fund TVPI drops further to 0.78x due to the 12K in management fees that have been called and paid. This creates a greater drag versus year 1 (Table 1) since investments are still held at cost, but more capital has been called.
Table 3, 4 years in:
Value creation finally occurs as some companies are written up. However, the fund is still below 1x TVPI as management fees called until now (25K) are still worth more than the value that has been created (17.5K) by the write-ups.
Value Creation:
Table 4, 7 years in:
The value that has been created has clearly exceeded the fees that have been charged by the fund. The difference between the MOIC of 2.65x and the TVPI of 2.11x is the fees that were charged by the fund.
Harvest:
Table 5: 10 years in:
The value of the fund has fallen a little bit (hence my earlier reference to an leaning S curve rather than a straight J-Curve). From what I have seen, this is relatively typical of funds since a fund is unlikely to realize its NAV at the absolute peak of the curve. Instead, the TVPI drops slightly as monetization occurs.
If you have comments, questions or criticism, message me on Twitter @Lawrence_Ou and I’m happy to chat and discuss!
Follow us on Twitter @LP_Perspectives. None of the above should be considered fund advice, financial advice or even legal advice. The views and writings above are strictly that of the author(s) and do not in any way represent the view of past or present employers.