An Essential Tool for Private Products
It would be safe to assume that most investors do not know what the J-Curve means and its relevance to a complete understanding of private investments. This article discusses the J-Curve, and why it is so important for investors in private products, so you can become a better exempt market investor.
What is the J-Curve?
The J-Curve applies to almost 100% of private exempt market offerings sold in Canada. The basic concept is that, in the early stages of an investment opportunity, the fund will experience losses. Then eventually, due to the return profile of the investment, the loss becomes zero at some point and moves into an ongoing position of consistent surpluses. As can be seen in the picture, the journey from deficits to profitability takes on the shape of the letter J:
Why Are There Deficits in the Early Stages?
There are a few common causes of early deficits:
- Commissions- Initial commissions vary, but can be perhaps 10%, depending on the offering. On a 10% initial commission this means that only $.90 of every dollar is actually invested in private, return-generating assets, causing an obvious fund deficit on day 1
- Additional Fund Expenses- There may be additional legal, administrative, or marketing expenses causing a deficit
- Time drag- Most if not all private offerings suffer from a sort of “chicken and egg” syndrome. It takes time to raise money. Once enough funds are raised to acquire an asset, time is required to legally own the asset, and additional time can be required to start earning actual cash returns from the asset. Some funds, that may earn regular income, would become cashflow positive before a real estate development project for example (which would earn no income possibly for many years)
- Yields Paid to Investors- Many funds will start paying a yield to investors beginning day 1. This regular monthly or quarterly cashflow is essentially repaid principle until actual funds can catch up
- Management Fees- Some funds may have annual management fees in the 2% range which add to the deficits
The Investor is Repaid Commissions and Expenses
There are some very important considerations associated with common J-Curve type offerings:
- Written in the offering memorandum, there is often language that states the investor will be repaid all initial expenses and commissions at some point, and made whole again, in year 5 of the project for example
- For example: An investor purchases $100,000 of preferred units in a private income trust. There may be a structure in place where the entire 100K is repaid to the investor (see example below)
- If the product pays a regular fixed target yield, say 8% per annum, it is very important to remember that the 8% income is paid on the $100,000 of units, not $90,000 (in the example of 10% initial expenses). This example would yield target income of $8,000/yr.
- If the product only repays principle and profits after a few years (no yield), for example, again the initial $100,000 would be repaid, making the investor whole. If the annual “hurdle rate” of an investment is 10%, for example, that 10% is on the initial 100K invested and not 90K as one might assume
- The common structure is for profits generated to be able to pay regular yield, and make the investor completely whole in the future, while leaving additional surplus profit for management to participate in.
Initial Reactions to the J-Curve
As an individual retail investor who is used to the public markets, a natural reaction would be “How on earth can this fund recoup 10% commission, plus expenses, and management fees, pay me 8-10% per year on top of this, and repay all of my principle? The answer is actually quite simple. It is common for private investments to generate returns that are much higher than traditional investments. For example, some assets will generate annual cash returns of 25%+/ yr. If the assets purchased generate 25%, the numbers tell us that all fees and commissions will be repaid at some point in the reasonably near future. This is when the “J” part of the curve rises above zero and continues it’s upward trajectory. Some products may also borrow funds, which magnify returns and make the J-Curve work, also adding to leverage risk of the investment.
Your Advisor Should be Able to Explain the J-Curve
Since the J-Curve is common to just about every private exempt market offering out there, any licensed advisor should be able to explain this concept to you, and how it applies to the particular product you are discussing. Simply ask them how the J-Curve applies to the product and make sure they can explain this to you competently.
The J-Curve is perhaps the most common feature of private exempt market products that is also quite misunderstood. Make sure you learn it, and understand how it applies to any private investment considered, before making a purchase.
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