Strategic Research

December 2006

Understanding the J-Curve: A Primer on

Interim Performance of Private Equity Investments
DANIEL MURPHY
Vice President
Executive Summary
Private Equity Group Private equity provides a number of benefits to investors, such as access to the private economy,
daniel.murphy@gs.com attractive potential returns and diversification. But investing in private equity also exposes
(212) 855-0462
investors to the so-called J-Curve, a less attractive aspect of the asset class.

The J-Curve is an industry term that derives from the graphical pattern exhibited by some key
metrics used to gauge the performance of private equity investments. Specifically, the J-Curve
commonly refers to attributes such as negative cash flows for several years after commitments
are made, poor apparent performance early in the life of an investment, and valuations held at,
or near, cost for investments that may be several years old.

In this paper, we outline the main factors driving the J-Curve, and provide a framework for
investors to assess its impact on apparent fund performance. It is important to keep in mind that
the J-Curve Effect is not an indicator of the overall performance of a private equity
investment, but rather an attribute of the investment at a certain point in its life cycle. In our
view, understanding the mechanics behind the J-Curve allows investors to better manage their
expectations regarding private equity investments.

We begin our analysis by modeling J-Curves for three commonly tracked private equity investment
measures: Cumulative Net Cash Flow (CNCF), Interim Internal Rate of Return (IRR) and
Interim Return on Investment (ROI).1 While the specific attributes of the J-Curve (e.g., minimums,
curvature, etc.) differ for each metric, they often share many similar traits, providing enough
consistency to validate our efforts. Our model of a typical private equity fund projects that:
CNCF reaches a minimum around year five of the fund. In other words, total contributions
are expected to be greater than total distributions until the fifth year of the investment.
The Interim IRR may be between -5% and +16% three years into the investment, even for a
fund that will eventually have a 15% net annual return.
The ROI is expected to be between 90% and 130% after three years, even for a fund that
will eventually have a total return of twice the overall contributed capital.

At first glance, these statistics may surprise many investors, given that most private equity
investments are likely to be profitable at the end of their lifecycle. The discrepancies between
final and interim return numbers are due to the combined effects of management fee structures,
the cash flow pattern of private equity investments and the valuation practices of the General
Partners (GP) of private equity partnerships.

Although the J-Curve Effect can not be completely eliminated, our research suggests that it can
be mitigated. We discuss how investors concerned about the interim performance of their
portfolios can utilize several methods to minimize the negative impact of the J-Curve, such as
adopting steady annual commitment programs and investing in specialized funds that experience
shorter investment cycles, such as secondary, mezzanine and distressed funds.

1 CNCF is the sum of all cash flows to and from an investment. The Interim IRR and ROI are the performance metrics calculated
part-way into a funds life, and are the performance measures most often associated with private equity investments. See Appendix A
for detailed definitions of these measures.
Understanding the J-Curve: A Primer on Interim Performance of Private Equity Investments

What is the J-Curve?

Investments in private equity boast a wide range of features that set them apart from their public
counterparts relatively limited liquidity, negative cash flows in the early years of the investment,
valuation constraints and management fees based on committed capital, among others. These
features inherent to the asset class impact the management of investors cash flows as well as the
timing of when the potential returns in private equity funds can be harvested. These impacts are
usually measured by the J-Curve, an industry term that derives from the graphical pattern exhibited
by key metrics used to gauge the performance of private equity investments.

In our research, we modeled a typical private equity fund and studied the J-Curves for three
commonly tracked private equity investment metrics: Cumulative Net Cash Flow (CNCF), Interim
Internal Rate of Return (IRR) and Interim Return on Investment (ROI). The result of this analysis is
shown in Exhibit 1.2

The chart of CNCF is the one that most closely follows the shape of the letter J, declining in the
early years of the fund before increasing and turning positive. Although not as visually clear as the
CNCF chart, the IRR and ROI charts are also often referred to as J-Curves.

Exhibit 1 Private equity investments show specific cash flow and return attributes known as the J-Curve

Cumulative Net Cash Flow Internal Rate of Return Return on Investment

150 20 220
10 200
100

% of contributed capital
% of committed capital

180
0
50 160
Percent

-10
0 140
-20
120
-50 -30 100
-100 -40 80
2 4 6 8 10 2 4 6 8 10 2 4 6 8 10
Year Year Year
For illustrative purposes only.
Simulated performance results do not reflect actual trading and have inherent limitations. Please see additional disclosures.
Source: Goldman Sachs Asset Management (GSAM)

Since private equity funds draw down capital over the course of several years and make investments
that often last four years or longer, most cash flows are negative in the first few years after a
commitment is made, causing the initial decline in the CNCF curve.

In addition, it is not unusual for GPs to take several years to find a sufficient number of attractive
opportunities in which to invest all of their capital. Also, GPs will often make subsequent
investments in the companies in their portfolio to help them expand.

2 In order to adjust for the fact that contributions to private equity investments are conducted in a staggered fashion, the ROI charts in
this paper show the evolution over time of return on investment as a percentage of the contributed capital.

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Understanding the J-Curve: A Primer on Interim Performance of Private Equity Investments

Furthermore, private equity investments do not typically have a significant current income
component. Thus, most cash received from an investment comes only when the investment is sold.
Since the duration of private equity investments is typically between three and seven years, it may
be six or seven years before a fund experiences significant distributions. This slow rate of
distributions, combined with the time it takes GPs to fully invest their funds, means that investors
will often be called upon to fund their capital commitments for several years before any eventual
profits are returned to them.

However, as the fund becomes fully invested, and early investments mature and are realized,
positive cash flows begin to dominate, shifting the curve upward around year six. Eventually, if the
fund is profitable, CNCF becomes positive (in other words, all of the capital contributions have
been returned to investors), and by year 10 the fund has been fully liquidated.

The J-Curves for IRR and ROI, as illustrated in Exhibit 1, have somewhat different shapes. They
both start out quite low and gradually increase to their final value over several years. In the early
stages of the funds life, performance appears poor, even though the returns on the underlying
investments may be quite attractive. Thats because the IRR and ROI curves are largely determined
by the valuation practices of the GPs as well as the management fee structure typically seen in private
equity partnerships (the CNCF curve, on the other hand, is determined by the investment activity
and the time it takes to liquidate the funds investments). Thus, while the ultimate values of IRR
and ROI at the end of a funds life represent the performance of the funds underlying investments,
the IRR and ROI curves are actually more representative of and more influenced by the funds
management structure.

For example, in the first few years of a funds life, only a fraction of the total commitment is drawn
down and invested in portfolio companies. Management fees, however, are typically charged
annually as a percentage of the total commitment amount. Thus, the capital drawn for
management fees in the first few years of the funds life is a larger fraction of the total capital
drawn than in the later years of the fund. This translates into a larger impact of management fees
on the performance of the fund in the early years than in the later years.

Additionally, private equity investments are often held at cost for some time after their initial
purchase, regardless of whether real changes in value have taken place. This is because private
equity investments, by definition, do not have a public price. Without the price discovery that a
public market affords, it is difficult to assess how much a third party would pay for a given
company at a particular point in time.

Many GPs choose to hold their investments at cost until a significant third-party transaction has
occurred.3 In venture capital funds, for example, this transaction may be a new round of funding,
in which case an accurate or at least market-based value may be obtained on a somewhat
regular basis. However, for many leveraged buyout investments, the only transaction that takes
place following the initial acquisition is the final sale of the company. This can mean that the GP
valuation may significantly under/overstate the true economic value of the investment in the period
between the acquisition and the sale of the investment.

3 In September 2006, the US Financial Accounting Standards Board (FASB) through its Statement of Financial Accounting Standards
(SFAS) No. 157 updated and clarified existing rules on the use of fair market value (FMV) in generally accepted accounting principles.
It also provided additional guidance on how to calculate FMV. While its impact on the overall industry remains unclear, we believe that
the SFAS No. 157 will likely change the valuation practices of some GPs.

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Understanding the J-Curve: A Primer on Interim Performance of Private Equity Investments

What Influences the Shape of the J-Curve?

Many factors contribute to the shape of the J-Curves of a private equity investment. For the purposes
of this paper, we will highlight four of the most important issues affecting J-Curves. They are:
returns, accounting methodology, drawdown rate and duration. We will also examine the J-Curves
for funds of funds. Due to their nature and structure, funds of funds which are designed to provide
diversified exposure to private equity tend to exhibit a unique set of J-Curves.

Returns
The returns on the underlying investments in a private equity fund are often assumed to have a
strong impact on the shape of the J-Curve in the first few years of the fund. However, as shown in
Exhibit 2, different returns do not actually lead to significantly different J-Curves until four or five years
into a fund.

This is because the CNCF is only affected by drawdowns in the early years of a funds life, and the
IRR is dominated by the effect of management fees. Differences in return are only observable when
enough time has elapsed for investments to be held at some value other than cost, which may not
occur until the first realization or later. This illustrates a point that most long-time investors in
private equity have come to realize: Apparent returns in the early years of a private equity fund are
often a poor indicator of the actual performance of the underlying investments.

Exhibit 2 Different returns do not meaningfully alter the J-Curve in the early stages of the fund

Cumulative Net Cash Flow Internal Rate of Return

200 30% Gross IRR 30
30% Gross IRR
150 20
% of committed capital

20% Gross IRR

20% Gross IRR 10
100 10% Gross IRR
Percent

0 0% Gross IRR
50
10% Gross IRR -10
0
0% Gross IRR -20
-50 -30
-100 -40
2 4 6 8 10 2 4 6 8 10
Year Year
For illustrative purposes only.
Simulated performance results do not reflect actual trading and have inherent limitations. Please see additional disclosures.
Source: GSAM

Accounting Methodology
The GPs valuation methodology is a factor that affects the IRR and ROI curves, but not the CNCF curve.
Exhibit 3 illustrates the modeled difference in IRR and ROI between two hypothetical GPs, one who
holds investments at cost until realized, and another who marks the portfolio to market on a quarterly
basis. We also modeled a hybrid view, in which we approximate the funds net asset value (NAV) by
assuming that some investments are held at cost and some are marked to their fair market value (FMV).4

These differences in accounting may make it difficult to compare the performance of two funds until
late in their life cycle, as they may have identical economic performance early on (while their
investments are mostly unrealized) and yet report vastly different NAVs.

4 This uncertainty in the valuation of private equity investments is both boon and bane to private equity. Boon because the inefficiencies
caused by the difficulty in assigning values to private unlisted investments allows talented managers to generate excess returns; and bane
because investors are often forced to accept (and report) poor returns for several years after making a commitment. It is an unfortunate
fact of investing in private equity that investors typically appear to lose money in the early years of a commitment before reaping gains.

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Understanding the J-Curve: A Primer on Interim Performance of Private Equity Investments

It is also worth noting that the FMV line decreases in the last few years of the fund this is due to
the fact that we have assumed that while the GP marks investments to FMV, he or she does not make
an allowance for carried interest on the unrealized investments. This practice also varies by fund, and
a GP that does include an allowance for carried interest will not show this decline.

Exhibit 3 A GPs valuation methodology plays a key role in determining the IRR and ROI curves

Internal Rate of Return Return on Investment

20 Held at FMV 220 Held at FMV

10 200

% of contributed capital
NAV*
180
0
Percent

160
-10 Held at Cost Held at Cost
140
-20
120
NAV*
-30 100
-40 80
2 4 6 8 10 2 4 6 8 10
Year Year
*Approximate
For illustrative purposes only.
Simulated performance results do not reflect actual trading and have inherent limitations. Please see additional disclosures.
Source: GSAM

Drawdown Rate
The drawdown rate of a private equity fund (or how quickly capital is called by a GP) will influence
the behavior of all of the analyzed J-Curves. Exhibit 4, for example, shows the effects of different
drawdown rates on the CNCF and IRR curves. Assuming the funds underlying investments have the
same return and duration characteristics, a faster drawdown rate will make the CNCF curve steeper
and deeper, but it will also reduce the time until all capital is returned, and thus shorten the J-Curve.

The IRR J-Curve, however, will rise more quickly, since the additional invested capital lessens the impact
of management fees early in the life of the fund, and, as a result, helps the fund move into positive
territory more quickly. The opposite effects are true for slower drawdown rates the CNCF curve is
longer and the IRR curve is deeper. As expected, all lines converge at the end of the funds life.

Exhibit 4 The drawdown rate influences the behavior of the J-Curve

Cumulative Net Cash Flow Internal Rate of Return

100 20

10
% of ccommitted capital

40% Drawdown Rate

50
40% Drawdown Rate 0
30% Drawdown Rate
Percent

0 -10 30% Drawdown Rate

20% Drawdown Rate
-20 20% Drawdown Rate
-50
-30

-100 -40
2 4 6 8 10 2 4 6 8 10
Year Year
For illustrative purposes only.
Simulated performance results do not reflect actual trading and have inherent limitations. Please see additional disclosures.
Source: GSAM

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Understanding the J-Curve: A Primer on Interim Performance of Private Equity Investments

Duration
Duration, or the length of time an investment is held by the GP, is a parameter that has a significant
effect on all of the J-Curves of a private equity fund. As a rule of thumb, assuming investments are
sold for the same amount of money, the longer the duration, the lengthier the CNCF curve and the
flatter the IRR curve. We illustrate this effect in Exhibit 5.

Exhibit 5 Duration is another important factor affecting private equity J-Curves

Cumulative Net Cash Flow Internal Rate of Return

100 30
3-Year Duration 3-Year Duration
20
5-Year
% of committed capital

50 5-Year 10 Duration
Duration 7-Year Duration
0

Percent
0
7-Year -10
Duration -20
-50
-30
-100 -40
2 4 6 8 10 2 4 6 8 10
Year Year
For illustrative purposes only.
Simulated performance results do not reflect actual trading and have inherent limitations. Please see additional disclosures.
Source: GSAM

Since the IRR of an investment combines both its ROI and its duration, a fund whose underlying
investments are realized quickly may be mistakenly identified as a better performer than a fund with
longer-duration investments. Exhibit 6 illustrates this phenomenon.

In our example, Fund A holds its investments for an average of two years and generates 15%
annual returns before fees and carry, while Fund B holds its investments for seven years on average
and generates 20% annual returns before fees and carry. In the first three years of the funds lives,
their J-Curves are nearly identical. However, after four years have elapsed, Fund A appears to be
outperforming, since it has realized most of its investments while Fund B is still mostly unrealized
(and largely held at cost). But after year five, Fund Bs IRR curve improves, and the fund ultimately
returns much more capital, and has a higher final IRR, than Fund A. This example illustrates one of
the reasons why it is important not to put too much weight on the early performance of a private
equity fund.

Exhibit 6 Investors should not put much weight on the early performance of a private equity fund
Cumulative Net Cash Flow Internal Rate of Return
200 30
20 Fund B
150
Fund A
% of committed capital

10
100
0
Percent

50 Fund A
-10
0
-20
-50 Fund B -30
-100 -40
2 4 6 8 10 2 4 6 8 10
Year Year
For illustrative purposes only.
Simulated performance results do not reflect actual trading and have inherent limitations. Please see additional disclosures.
Source: GSAM

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Understanding the J-Curve: A Primer on Interim Performance of Private Equity Investments

Funds of Funds
Funds of funds select and invest in a portfolio of private equity funds on behalf of their investors.
Since a fund of funds invests in multiple underlying funds over a period of time, it will have a unique
J-Curve that is different from the J-Curves of its underlying investments.

Exhibit 7 shows an example of this curve for a fund of funds that commits an equal amount of
capital to 20 different partnerships over the course of 15 months. The CNCF curve for a fund of
funds has a wider spread, and is slightly shallower than that of a single partnership.

A fund of funds also has a longer lifespan than a single partnership since it must remain active until
its last underlying partnership is fully liquidated. The IRR curve is also more spread out, and it
remains negative longer, partially due to the timing spread of the underlying commitments, and
partially due to the additional layer of management fees charged by the fund of funds. The J-Curve
for a fund of funds is typically more predictable and stable than that of a single fund investment
since differences in returns, drawdown rates and durations are averaged out across several
partnerships. The number of underlying funds, and their diversified nature, smoothes out the J-Curve.

Exhibit 7 Funds of funds tend to have a unique set of J-Curves

Cumulative Net Cash Flow Internal Rate of Return Return on Investment

100 20 220

% of contributed capital
Single Fund
% of committed capital

Single Fund 10 200

50 0 180
Percent

Single Fund
160
0 -10
Fund of Funds 140 Fund of Funds
Fund of Funds -20
120
-50 -30 100
-100 -40 80
2 4 6 8 10 12 2 4 6 8 10 12 2 4 6 8 10 12
Year Year Year
For illustrative purposes only.
Simulated performance results do not reflect actual trading and have inherent limitations. Please see additional disclosures.
Source: GSAM

How to Mitigate the J-Curve

Many investors concerned about the interim performance of their portfolios wonder about mitigating
the private equity J-Curve. Unfortunately, there is no guaranteed way to lessen the drawdown of
capital or to improve the seemingly low returns in the early years of a private equity commitment.
But there are strategies that often help to improve the profile of the curves in the early years.

One method that may reduce the volatility of the J-Curve, and thus its likely extreme values, is to
follow a disciplined approach to making annual commitments to private equity. Steady annual
commitments will create a portfolio that is diversified in vintage years and will, over time,
incorporate funds at all stages of the private equity life cycle.

As an illustration, Exhibit 8 (next page) compares two private equity investment programs for a
hypothetical investor targeting $100 million of invested capital. The fast commitment program
seeks large initial commitments of capital early in the life of the investment. The steady
commitment program, however, seeks a more balanced disbursement of capital over time.

To further illustrate the point, we also charted the evolution of the J-Curve for just the amount of
capital committed in the first year of each program in our example, $80 million (fast) and $23
million (steady).

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Understanding the J-Curve: A Primer on Interim Performance of Private Equity Investments

Exhibit 8 Steady commitments can mitigate the J-Curve of a private equity program

120
Cumulative Net Cash Flow

80 Capital Committed in the

First Year of Fast Program Capital Committed in the
40 First Year of Steady Program Fast Commitment Program
$ Millions
0
Steady Commitment Program
-40

-80

-120
2 4 6 8 10 12
Year
For illustrative purposes only.
Simulated performance results do not reflect actual trading and have inherent limitations. Please see additional disclosures.
Source: GSAM

While the J-Curve still exists in the early years of either program, its magnitude is mitigated under
the steady commitment program. More importantly, the fraction of the J-Curve that is attributable
to the first-year commitments is significantly reduced in the steady plan. In our illustration, we
assumed that the monies committed in the first year of the fast program performed well, thus
allowing for the fast plan to outperform the steady program in the long run. However, had the
performance of the first-year commitments turned out to be poor, this situation could have easily
been reversed.

In this light, we believe that adopting a steady program moderates the investors exposure to a large
commitment of funds made in a single year, thereby lessening the potential damage to the portfolio
and to the final performance of the private equity investment if those funds turn out to
underperform or to have a particularly deep J-Curve.

Another method that may help mitigate the J-Curve is to make commitments to specialized funds
that experience shorter investment life cycles or that are able to mark their commitments to market
more easily. Secondary private equity funds, mezzanine funds and distressed funds are good
examples of such strategies.

Secondary private equity funds purchase partnership interests from other Limited Partners (LP) in
funds that are typically several years old. Since the secondary fund is purchasing the LPs interest
well into the funds J-Curve, it experiences a higher velocity of cash flows (capital is drawn down
more quickly to acquire these mature assets and then distributed more quickly as these assets are
generally held for a shorter period of time before being sold). The pattern often leads to shorter
J-Curves than primary partnerships.

Mezzanine funds invest in securities that are junior to a companys senior debt, but sit above the
equity, thus being somewhat safer than a pure equity investment while offering higher returns than
the debt (sometimes through equity-conversion features). Mezzanine investments typically pay
regular cash coupons, which can help provide additional positive cash flow early in the funds life
cycle and lessen the impact of CNCF J-Curve. The IRR and ROI J-Curves are also mitigated by these
coupons, as they provide a guaranteed return stream even in the absence of re-valuation of the
underlying securities.

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Understanding the J-Curve: A Primer on Interim Performance of Private Equity Investments

Meanwhile, distressed funds may incorporate trading strategies that involve purchasing the public
debt and equity of companies considered to be in financial distress. Since they are associated with
public companies, these securities tend to be more easily valued as the investment matures.

Additionally, our research has shown that distressed funds tend to put a significant amount of their
capital to work quickly when the economy enters a distressed cycle, thereby reducing the ratio of
management fees to invested capital and raising the IRR and ROI J-Curves. Distressed managers also
will often target holding periods somewhat shorter than typical leveraged buyout or venture capital
managers, thus providing earlier distribution of proceeds to investors.

Conclusion
Private equity is a long-term investment whose performance is difficult to assess in the early years of
a funds life. Due to the asset classs specific attributes such as negative cash flows in the early
years of the investment, valuation constraints and limited liquidity investors are forced to cope
with the J-Curve.

Our research shows that private equity investors should expect to contribute capital to a fund for a
period of five to six years before receiving significant distributions, and they should expect to see
potentially negative interim IRRs and ROIs below cost for several years following the funds close.
Its important to note, however, that these values do not necessarily indicate poor performance of the
funds underlying investments.

Our research also illustrates that many factors influence the profile of the J-Curves, including the
private equity funds strategy, the economic environment and the pace at which capital is committed
to a private equity program, among others. Investors should be aware of these different factors when
they are comparing the performance of funds, particularly a funds early performance.

In addition, our studies indicate that investors may be able to mitigate the impact of the J-Curve on
their investments by using some specific investment strategies, such as setting up steady diversified
annual commitments to private equity, and/or investing in funds with abbreviated J-Curves, such as
secondary, mezzanine and distressed funds.

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Understanding the J-Curve: A Primer on Interim Performance of Private Equity Investments

Appendix A
Below are the definitions and assumptions used to build the illustrative examples in this white paper.
Let:
Ct be the contributions made by an investor at time t
Dt be the distributions received by an investor at time t
Vt be the reported valuation of remaining investments at time t

The Cumulative Net Cash Flow CNCF of a private equity investment at time is defined to be:

(1)

This is simply the sum total of all cash flows experienced by the investor through time , with
contributions defined to be negative and distributions positive.

The Interim Internal Rate of Return IRR of a private equity investment is the discount rate that sets
the net present value of the investment to zero. For an investment at time , this is mathematically
defined as the solution to the equation:

(2)

The Interim Return on Investment ROI is another measure of the performance of an investment
that divides the total proceeds and value of the investment by its cost. This metric is calculated as:

(3)

As can be seen from equations 2 and 3 above, both the Interim IRR and ROI incorporate the
reported valuation V . Since this value is dependent on the valuation practices of GPs and may not
reflect the true market value of investments, and since in the early years of a fund the unrealized
valuation may be a significant fraction of the total value of the investment, both the Interim IRR and
ROI may not reflect the actual performance of a private equity investment.

For a fund that has been fully realized at or before time T, the final IRR IRRT and final ROI ROIT
are similarly defined as solving:

(4)

(5)

These values represent the true performance of the fund, but are only available after the fund has
liquidated all investments.

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Understanding the J-Curve: A Primer on Interim Performance of Private Equity Investments

Appendix B
The projected cash flows and values used to create the examples in this paper are calculated using an
implementation of the cash-flow model described in the paper Illiquid Alternative Asset Fund
Modeling by Dean Takahashi and Seth Alexander of the Yale University Investments Office, published
in the Journal of Portfolio Management (Winter 2002).

This model has parameters for the rate at which cash is drawn down, the rate of distribution
(bow) and the gross internal rate of return (IRR) of the fund. We have augmented this model to
include projections of invested value, management fees, and carried interest; and we utilize a
formulation that calibrates the bow parameter described in the article to yield a desired average
duration of investments.

For our base case projection in Exhibit 1, we project quarterly cash flows and values for a fund with a
lifespan of 10 years, meaning that all investments are fully liquidated 10 years after the close of the
fund. We assume that 30% of investable commitments are drawn in the first two years, followed by
annual drawdowns of 60% of remaining investable capital. The bow parameter is calculated such
that the cash flows generated imply an average investment duration of five years, and gross returns
(before management fees and carried interest) are 20% annually. Management fees are assumed to be
1.75% of commitments per year for five years, then 75% of the previous years fees thereafter. Carried
interest is assumed to be 20% of profits after investors have received a return of capital.

To estimate NAV, we use a weighted average of invested value and fair market value (FMV), where the
weight on FMV is a linearly increasing function of the age of the fund. Unless otherwise noted, all IRR
and ROI J-curves are calculated using this estimate of NAV.

For the exhibits shown in this paper, the following parameter sets were used (all other parameters are
the same as described above):

Lifespan Initial Drawdown Rate Average Duration Gross IRR

Exhibit (years) (% of investable capital) (years) (percent)
1 10 30 5 20
2 10 30 5 0, 10, 20, 30
3 10 30 5 20
4 10 20, 30, 40 5 20
5 10 30 3, 5, 7 20
6 6 (Fund A) 30 2 (Fund A) 15 (Fund A)
10 (Fund B) 7 (Fund B) 20 (Fund B)
Source: GSAM

In Exhibit 7, we construct a fund of funds that is composed of 20 identical partnerships projected using
the same parameters as those used in Exhibit 1, but with a gross IRR of 22.5%. It is assumed that the
fund makes equal-sized commitments to each of these partnerships, evenly spaced over a period of 15
months. The fund of funds itself charges management fees of 1% per year for five years, after which
fees are calculated as 75% of the previous years fees. Carry is calculated as 5% of profits from
investments, payable after an 8% preferred return has been achieved by the investors in the fund. The
single fund shown in the example uses the same parameters as Exhibit 1.

In Exhibit 8, we assume equal quarterly commitments are made to identical funds each year, where
each fund is projected using the same parameters as those used in Exhibit 1. The annual commitments
of each program are illustrated in the table below:
Year 1 2 3 4 5 6 7 8 9 10 11 12
Steady Commitments ($mn) 23.0 23.0 23.0 23.0 23.0 23.0 23.0 23.0 23.0 23.0 23.0 23.0
Faster Commitments ($mn) 80.0 4.0 14.0 19.2 28.0 26.0 23.0 23.0 23.0 23.0 23.0 23.0
Source: GSAM

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Understanding the J-Curve: A Primer on Interim Performance of Private Equity Investments

Glossary of Terms
Alternative Investments: Broadly, investments in assets or funds whose returns are generated through
something other than long positions in public equity or debt. Generally includes private equity, real
estate and hedge funds.

Buyouts: Investments made to acquire majority or control positions in businesses purchased from or
spun out of public or private companies, or purchased from existing management/shareholders of
public equity in going private transactions, private equity funds or other investors seeking liquidity
for their privately held investments. Buyouts are generally achieved with both equity and debt.
Examples of various types of buyouts include: small, middle market, large cap and growth.

Capital Call/Drawdown: Occurs when a private equity fund manager (typically acting through the
General Partner (GP) of the partnership) asks an investor (typically, a Limited Partner (LP) of the
partnership) to fund a portion of his or her capital commitment in order to make a current
investment, or to fund management fees or expenses. Usually, an LP will agree in advance to a
capital commitment, and over time the GP will make a series of capital calls to the LP as
opportunities arise or the capital is otherwise needed.

Capital Commitment: The total out-of-pocket amount of capital an investor commits to invest over
the life of a fund. This commitment is generally set forth on an investors subscription agreement
during fundraising, and is accepted by the GP as part of the closing of the fund.

Carried Interest: Also known as carry or promote. A performance bonus for the GP based
on profits generated by the fund. Typically, a fund must return a portion of the capital contributed
by LPs plus any preferred return before the GP can share in the profits of the fund. The GP will
then receive a percentage of the profits of the fund (typically 20% to 25%). For tax purposes, both
carried interest and profit distributions to LPs are typically categorized as a capital gain rather than
ordinary income.

Catch-Up: A clause in the agreement between the GP and the LPs of a private equity fund. Once the
LPs have received a certain portion of their expected return, often up to the level of the preferred
return, the GP is entitled to receive a majority of the profits (typically 50% to 100%) until the GP
reaches the carried interest split previously agreed.

Clawback: A clause in the agreement between the GP and the LPs of a private equity fund obligating
the GP to return distributions to the LPs to the extent the GP received excess carry distributions, or
if the LPs did not receive their preferred return. This can sometimes happen if carry is paid on a
deal-by-deal basis, and if the carry paid for early, profitable investments is offset by significant
losses from later investments in a portfolio. The clawback is often calculated on an after-tax basis, so
the GP will not be obligated to return distributions in excess of the tax it was obligated to pay in
respect of the carry distributions.

Distressed/Turn-Around Securities: The equity or debt instruments of troubled or bankrupt companies.

Distribution: When an investment by a private equity fund is fully or partially realized (resulting
from the sale, liquidation, disposition, recapitalization, IPO, or other means of realization of one or
more portfolio companies in which a GP has chosen to invest) the proceeds of the realization(s) are
distributed to the investors. These proceeds may consist of cash or, to a lesser extent, securities.

Distribution Waterfall: The order and priority in which a private equity fund distributes capital and
profits to LPs and the GP. The GP, for example, may return all capital contributed by the LPs before
taking carried interest, or take carry on a deal-by-deal basis. Most funds offer a priority return of
realized invested capital, rather than all contributed capital. LPs are protected from portfolio losses
subsequent to distribution of carry to a GP through the clawback.

Goldman Sachs Asset Management | 12

Understanding the J-Curve: A Primer on Interim Performance of Private Equity Investments

General Partner (GP): A class of partner in a partnership. The GP makes the decisions on behalf of
the partnership and retains liability for the actions of the partnership. In the private equity industry,
the GP is solely responsible for the management and operations of the investment fund while the LPs
are passive investors, typically consisting of institutions and high net worth individuals. The GP
earns a percentage of profits.

Internal Rate of Return (IRR): The compound interest rate at which a certain amount of capital
today would have to accrete to grow to a specific value at a specific time in the future. This is the
most common standard by which GPs and LPs measure the performance of their private equity
portfolios and portfolio companies over the life of the investment. IRRs are calculated on either a
net (i.e., including fees and carry) or gross (i.e., not including fees and carry) basis.

Leveraged Buyout (LBO): The purchase of a company or a business unit of a company by an outside
investor using mostly borrowed capital.

Limited Partner (LP): A passive investor in a limited partnership. The GP is liable for the actions of
the partnership while the LPs are generally protected from legal actions and any losses beyond their
original investment. The LPs receive income, capital gains and tax benefits.

Limited Partnership: A legal entity composed of a GP and various LPs. The GP manages the
investments and is liable for the actions of the partnership while the LPs are generally protected from
legal actions and any losses beyond their original investment. The GP receives a percentage of
profits, while the LPs receive income, capital gains and tax benefits.

Management Fee: A fee paid to the investment manager for its services, typically as a percentage of
aggregate capital commitments. Management fees in a private equity fund typically range from
1.25% to 2.5% of commitments during the funds investment period, and then step down to the
same or a lower percentage based on the funds invested capital remaining in investments. Venture
capital funds tend to have higher management fees than traditional private equity funds.
Management Fee Stepdown: Provides for a reduction of the management fee once the majority of the
fund is invested (i.e., the investment period has expired) and much of the intensive work and costs
required to build a portfolio of companies has been completed. The management fee stepdown
typically occurs in a reduction of the base of the management fee from commitments to invested capital.

Mezzanine Financing: Financing provided by a bank or specialized investment fund to invest in a

debt instrument of lower credit quality relative to the senior debt in a company but ranking senior to
any equity claims. The instrument may include equity features, such as warrants.

Preferred Return: Also known as the hurdle rate. Preferred returns are typically found
in buyout funds. After the cost basis of an investment is returned to the LPs, they will also receive
additional proceeds from the investment equal to a stated percentage, often 8%. Once the
preferred return is paid, then the GP will be entitled to its carried interest on all profits realized from
the investment.

Present Value: The sum of money which, if invested now at a given rate of compound interest, will
accumulate exactly to a specified amount at a specified future date.

Private Equity: The Goldman Sachs Private Equity Group defines private equity as anything not
publicly traded, anywhere in the world, except real estate.

Goldman Sachs Asset Management | 13

Understanding the J-Curve: A Primer on Interim Performance of Private Equity Investments

Secondary Market: A market for the sale of existing private equity investments prior to their
stated maturity. Traditionally, the secondary market has been focused on partnership interests in
private equity funds. More recently a market has developed for portfolios of direct private equity
investments as well. Private equity investors may choose to sell their interests for a variety of
reasons: They may want to raise cash, change their asset allocation, shift their private equity
investment strategy, reduce their number of private equity managers, recycle capital into preferred
managers, or they may be in distress and cannot meet their obligation to invest more capital
according to a capital commitment schedule. Certain investment companies specialize in providing
liquidity to these investors, acquiring partnership interests or portfolios of directs as secondaries.

Valuations: Traditionally, private equity funds have carried their assets at cost until an investment is
realized or until some type of financing event occurs (such as additional investment, merger, sale,
realization or an upround of financing for a venture capital fund).

Venture Capital: A private equity asset class that seeks to build businesses through equity
investments in young private companies. Many venture capitalists also seek to provide management,
industry or technical expertise to add value to the company or their investment. Liquidity typically is
realized through an IPO or the sale of the company. The three major classes of venture capital
investing are early, middle and late stage, referring to the level of development of the companies.

Vintage Year: The year in which a private equity fund has its final closing.

Goldman Sachs Asset Management | 14

Goldman Sachs Asset Management Publications
Following are additional research papers examining a range of investment topics.
The Future of Defined-Benefit Plans: Using LDI Policy to
Adapt to New US Pension Regulation
(NOVEMBER 2006) US pension rules are in the midst of an overhaul that will
significantly impact the financial results of defined-benefit pension plans.
We believe that the adoption of liability-driven investing (LDI) policies will
become critical for pension management under the new regulatory
environment. In this paper, we show that LDI strategies can help plan
sponsors cope with the new regulation by potentially lowering the volatility
of the pension surplus (or deficit), while possibly improving the portfolios
risk-adjusted return. These strategies can also decrease the likelihood that
sponsors will have to make forced pension contributions. Additionally, in the
long run, we anticipate pension plans using LDI to have a healthier funded
status than the ones using traditional portfolio construction strategies.
Designing Efficient Return-Generating Portfolios: Tilting
Away from Equilibrium toward Alpha and Exotic Beta
(OCTOBER 2006) Institutional investing is changing, and we believe investors
can add value to their portfolios by increasing exposures to skill-based
strategies (alpha) as well as asset classes that are chronically mispriced
(exotic beta). This paper provides a framework through which investors can
use equilibrium-theory-based models to build portfolios with an optimal
combination of alpha, exotic beta and market beta. It also illustrates how
investors can use leverage to enhance potential returns.
Reserve Management in an Equilibrium Framework
(AUGUST 2006) In this paper, we provide an investing framework for central
banks to reconcile their need to maintain adequate liquidity levels while
generating higher return on assets. By allocating reserves more efficiently,
central banks can designate a portion of their assets to a liquidity portfolio
and still have considerable latitude to invest in a return-generating portfolio.
We show that the allocation between these two portfolios can be determined
through a model that tests a range of factors frequently watched as signals
of potential reserve losses.
Liability-Driven Investment Policy: Managing to the
True Benchmark
(JUNE 2006) In this paper, we develop a general framework that investors can
use to better formulate liability-driven investment policies across different
types of investment organizations and regulatory frameworks. We discuss
how portfolio efficiency changes when investors treat liabilities as their true
benchmark, and how they can further improve efficiency by relaxing
constraints on alpha portability and increasing exposures to active strategies.
Emerging Markets Equity: Structural Opportunities
for Investors
(MARCH 2006) This paper highlights the important role that emerging markets
equity can play in institutional portfolios. It also includes a series of
observations about emerging markets equity returns and how these
observations are consistent with extraordinary returns from exposure to the
asset class. Further, it presents the diversification benefits of emerging
markets equity and offers an alternative interpretation of contagion and
changes in correlation, as well as ideas regarding optimal portfolio structure
and the practical aspects of increasing exposure to actively managed
emerging markets equity.
Please contact your relationship manager to obtain a copy of any of these research papers.
Are Constraints Eating Your Alpha?
(AUGUST 2005) Is the hedge fund manager who outperforms the traditional
manager better at forecasting stock returns, or is he or she just facing fewer
material constraints? Constraints exist for a reason and serve an important
role ensuring underlying risk control of portfolios. But not all constraints are
created equal. This paper explores ways to help fiduciaries reach the next
level in setting constraints and potentially improve performance for traditional
investment managers. It includes information on what to watch for and what
you can do when investment guidelines become out of date.
Public and Private Real Estate: Yesterday, Today
and Tomorrow
(MAY 2005) In this paper, we discuss the landscape of real estate investing
and analyze the differences between the public and private markets. We find
that the differences are not statistically meaningful. Therefore, investors
should choose their implementation approach based on the specific
characteristics of each structure. Given the advantages of public real estate
liquidity, diversification and flexibility we believe it should be a
substantial component of a real estate allocation.
Active Risk Budgeting in Action: Assessing Risk and
Return in Private Equity
(APRIL 2005) Since private equity investments are not regularly traded and are
limited by poor data quality, a basic investing framework may not be applied
to this asset class. However, we believe private equity can be naturally
decomposed the same way as other investments. This paper provides a
framework that puts private equity returns and allocations on equal footing
with other investments. By using our assumptions on residual volatility and
information ratios, our analysis shows that investors can potentially achieve
higher expected returns by including private equity in a traditional portfolio
of global equity and global fixed income.
Understanding Variations in Risk of Multi-
Strategy Portfolios
(OCTOBER 2004) In this paper, we tackle the real-life decisions faced by
pension fund managers and private wealth investors, among others. By
breaking variations in risk into asset class weights, volatilities and
correlations deviating from the risk budget, we provide a framework for
investors to better understand their portfolios, manage risk more optimally
and improve the investment process. This paper also provides guidance on
when and how to rebalance portfolios back to strategic weights.
Active Risk Budgeting In Action: Understanding
Hedge Fund Performance
(MAY 2004) This paper develops a framework for analyzing hedge fund
performance across a variety of strategies including tactical trading, equity
market neutral, equity long/short, event driven, convertible arbitrage and
fixed income arbitrage.
Alternative Investments such as hedge funds are subject to less regulation than other types of pooled investment vehicles such as mutual
funds, may make speculative investments, may be illiquid and can involve a significant use of leverage, making them substantially riskier
than the other investments. An Alternative Investment Fund may incur high fees and expenses which would offset trading profits.
Alternative Investment Funds are not required to provide periodic pricing or valuation information to investors. The Manager of an
Alternative Investment Fund has total investment discretion over the investments of the Fund and the use of a single advisor applying
generally similar trading programs could mean a lack of diversification, and consequentially, higher risk. Investors may have limited
rights with respect to their investments, including limited voting rights and participation in the management of the Fund.
Alternative Investments by their nature, involve a substantial degree of risk, including the risk of total loss of an investor's capital. Fund
performance can be volatile. There may be conflicts of interest between the Alternative Investment Fund and other service providers,
including the investment manager and sponsor of the Alternative Investment. Similarly, interests in an Alternative Investment are highly
illiquid and generally are not transferable without the consent of the sponsor, and applicable securities and tax laws will limit transfers.
There may be conflicts of interest relating to the Alternative Investment and its service providers, including Goldman Sachs and its
affiliates, who are engaged in businesses and have interests other than that of managing, distributing and otherwise providing services to
the Alternative Investment. These activities and interests include potential multiple advisory, transactional and financial and other
interests in securities and instruments that may be purchased or sold by the Alternative Investment, or in other investment vehicles that
may purchase or sell such securities and instruments. These are considerations of which investors in the Alternative Investment should be
aware. Additional information relating to these conflicts is set forth in the offering materials for the Alternative Investment.
Opinions expressed are current opinions as of the date appearing in this material only. No part of this material may, without GSAMs
prior written consent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an
employee, officer, director, or authorized agent of the recipient.
This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to
buy or sell securities.
These examples are for illustrative purposes only and are not actual results. If any assumptions used do not prove to be true, results may
vary substantially.
Simulated performance is hypothetical and may not take into account material economic and market factors that would impact the
advisers decision-making. Simulated results are achieved by retroactively applying a model with the benefit of hindsight. The results
reflect the reinvestment of dividends and other earnings, but do not reflect fees, transaction costs, and other expenses, which would
reduce returns. Actual results will vary.
This presentation has been communicated in the United Kingdom by Goldman Sachs Asset Management International which is
authorized and regulated by the Financial Services Authority (FSA). This presentation has been issued or approved for use in or from
Hong Kong by Goldman Sachs (Asia) L.L.C. This presentation has been issued or approved for use in or from Singapore by Goldman
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please note that this material can only be provided, upon review and approval by GSAM AEJ Compliance, to GSAM's third party
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Copyright 2006 Goldman, Sachs & Co. All Rights Reserved. (06-6447) RP_JCURVE/12-06