Private Debt

CHAPTER 16Direct Lending and J‐curve Mitigation

Building a private equity portfolio, or increasing current allocations, can frustrate investors due to negative or low returns in the early years of investment. This is known as the J‐curve, attributable to upfront loading of organizational costs, management fees paid on undrawn fund commitments, and a lag in profit generation associated with growth‐oriented equity strategies. As a result, investors in private equity often feel they are taking one step back before taking two steps forward. The J‐curve is also frustrating because cash flow is significantly negative for several years when investing in private equity because there is no cash interest to distribute to investors and it takes five to eight years before companies are eventually sold and proceeds distributed to investors.

The J‐curve effect elevated liquidity problems for many of the largest private equity investors during the 2008 global financial crisis (GFC). Commitments to private equity funds reached peak levels during 2006 and 2007, creating large unfunded liabilities in the form of contingent capital calls, just before the GFC. When the GFC hit, not only did these funds see their asset values go to distressed levels, squeezing the availability of liquid assets to meet benefit or spending payouts, but their private equity, unfunded commitments became a big concern, particularly given the drying up of private equity distributions. Many of the largest institutional ...