Private equity investment is a relatively illiquid investment with a long-term horizon. This is best illustrated by the so-called J curve – a typical return profile of a private equity investment.
The J curve illustrates that private equity investment returns for the first 2-3 years are typically negative. The J curve is primarily a result of the costs of setting up and operating a fund and of the temporary measurement at cost of the investments made. As a result of the fund set-up costs and the initial temporary measurement of the private equity fund’s investments at cost (often equal to the acquisition price), the book value of the private equity fund in the first years is lower than the paid-up capital. Another possible explanation for the J curve is that successful investments are not always revalued right away, based on conservative accounting principles.
The long-term nature of a private equity investment is also illustrated by the fact that a private equity fund only becomes active once it has obtained capital commitments. At the time of the capital commitment, subsequent investments are not disclosed. Finally, part of the illiquidity can be ascribed to the fact that private equity investments do not offer the same transparency as those in listed companies. For instance, companies owned by a private equity fund are not monitored by equity analysts and they disclose much less information. However, private equity fund investors usually have access to detailed information about developments in the individual portfolio companies.
The return on a private equity fund cannot be finally determined until all investments have been sold and the private equity fund has been dissolved, usually ten years or more after establishment. Until then, investment values are estimates – based on recognised measurement methods – and thus subject to the uncertainty involved in the valuation of unlisted companies.
Valuation of a private equity fund is updated at regular intervals, usually semi-annually. Revaluation of investments in private equity funds is thus delayed relative to equity market price movements, as the equity market’s valuations of comparable listed companies usually form part of the valuation of investments in private equity funds.