understanding j curve

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

Strategic Research December 2006

DANIEL MURPHYVice President Private Equity [email protected](212) 855-0462

Executive SummaryPrivate equity provides a number of benefits to investors, such as access to the private economy,attractive potential returns and diversification. But investing in private equity also exposesinvestors 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 keymetrics used to gauge the performance of private equity investments. Specifically, the J-Curvecommonly refers to attributes such as negative cash flows for several years after commitmentsare 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 forinvestors to assess its impact on apparent fund performance. It is important to keep in mind thatthe J-Curve Effect is not an indicator of the overall performance of a private equityinvestment, but rather an attribute of the investment at a certain point in its life cycle. In ourview, understanding the mechanics behind the J-Curve allows investors to better manage theirexpectations regarding private equity investments.

We begin our analysis by modeling J-Curves for three commonly tracked private equity investmentmeasures: Cumulative Net Cash Flow (CNCF), Interim Internal Rate of Return (IRR) andInterim 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 enoughconsistency 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 contributionsare 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 afund 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 thatwill eventually have a total return of twice the overall contributed capital.

At first glance, these statistics may surprise many investors, given that most private equityinvestments are likely to be profitable at the end of their lifecycle. The discrepancies betweenfinal 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 GeneralPartners (GP) of private equity partnerships.

Although the J-Curve Effect can not be completely eliminated, our research suggests that it canbe mitigated. We discuss how investors concerned about the interim performance of theirportfolios can utilize several methods to minimize the negative impact of the J-Curve, such asadopting steady annual commitment programs and investing in specialized funds that experienceshorter 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 calculatedpart-way into a funds life, and are the performance measures most often associated with private equity investments. See Appendix Afor detailed definitions of these measures.

What is the J-Curve?Investments in private equity boast a wide range of features that set them apart from their publiccounterparts relatively limited liquidity, negative cash flows in the early years of the investment,valuation constraints and management fees based on committed capital, among others. Thesefeatures inherent to the asset class impact the management of investors cash flows as well as thetiming of when the potential returns in private equity funds can be harvested. These impacts areusually measured by the J-Curve, an industry term that derives from the graphical pattern exhibitedby 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 threecommonly tracked private equity investment metrics: Cumulative Net Cash Flow (CNCF), InterimInternal Rate of Return (IRR) and Interim Return on Investment (ROI). The result of this analysis isshown in Exhibit 1.2

The chart of CNCF is the one that most closely follows the shape of the letter J, declining in theearly years of the fund before increasing and turning positive. Although not as visually clear as theCNCF 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

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 investmentsthat often last four years or longer, most cash flows are negative in the first few years after acommitment 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 attractiveopportunities in which to invest all of their capital. Also, GPs will often make subsequentinvestments in the companies in their portfolio to help them expand.

Goldman Sachs Asset Management | 2


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



Furthermore, private equity investments do not typically have a significant current incomecomponent. 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 maybe six or seven years before a fund experiences significant distributions. This slow rate ofdistributions, combined with the time it takes GPs to fully invest their funds, means that investorswill often be called upon to fund their capital commitments for several years before any eventualprofits 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 thefund is profitable, CNCF becomes positive (in other words, all of the capital contributions havebeen 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. Theyboth start out quite low and gradually increase to their final value over several years. In the earlystages of the funds life, performance appears poor, even though the returns on the underlyinginvestments may be quite attractive. Thats because the IRR and ROI curves are largely determinedby the valuation practices of the GPs as well as the management fee structure typically seen in privateequity partnerships (the CNCF curve, on the other hand, is determined by the investment activityand the time it takes to liquidate the funds investments). Thus, while the ultimate values of IRRand 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 fundsmanagement structure.

For example, in the first few years of a funds life, only a fraction of the total commitment is drawndown and invested in portfolio companies. Management fees, however, are typically chargedannually as a percentage of the total commitment amount. Thus, the capital drawn formanagement fees in the first few years of the funds life is a larger fraction of the total capitaldrawn than in the later years of the fund. This translates into a larger impact of management feeson 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 initialpurchase, regardless of whether real changes in value have taken place. This is because privateequity investments, by definition, do not have a public price. Without the price discovery that apublic market affords, it is difficult to assess how much a third party would pay for a givencompany at a particular point in time.

Many GPs choose to hold their investments at cost until a significant third-party transaction hasoccurred.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 somewhatregular basis. However, for many leveraged buyout investments, the only transaction that takesplace following the initial acquisition is the final sale of the company. This can mean that the GPvaluation may significantly under/overstate the true economic value of the investment in the periodbetween 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 thatthe SFAS No. 157 will likely change the valuation practices of some GPs.



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 purposesof 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-Curvesfor funds of funds. Due to their nature and structure, funds of funds which are designed to providediversified exposure to private equity tend to exhibit a unique set of J-Curves.

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

This is because the CNCF is only affected by drawdowns in the early years of a funds life, and theIRR is dominated by the effect of management fees. Differences in return are only observable whenenough time has elapsed for investments to be held at some value other than cost, which may notoccur until the first realization or later. This illustrates a point that most long-time investors inprivate equity have come to realize: Apparent returns in the early years of a private equity fund areoften 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

For illustrative purposes only.Simulated performance results do not reflect actual trading and have inherent limitations. Please see additional disclosures.

Source: GSAM

Accounting MethodologyThe 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 whoholds investments at cost until realized, and another who marks the portfolio to market on a quarterlybasis. We also modeled a hybrid view, in which we approximate the funds net asset value (NAV) byassuming 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 untillate in their life cycle, as they may have identical economic performance early on (while theirinvestments 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 inefficienciescaused by the difficulty in assigning values to private unlisted investments allows talented managers to generate excess returns; and banebecause investors are often forced to accept (and report) poor returns for several years after making a commitment. It is an unfortunatefact 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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It is also worth noting that the FMV line decreases in the last few years of the fund this is due tothe fact that we have assumed that while the GP marks investments to FMV, he or she does not makean allowance for carried interest on the unrealized investments. This practice also varies by fund, anda 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

*ApproximateFor illustrative purposes only.Simulated performance results do not reflect actual trading and have inherent limitations. Please see additional disclosures.

Source: GSAM

Drawdown RateThe drawdown rate of a private equity fund (or how quickly capital is called by a GP) will influencethe behavior of all of the analyzed J-Curves. Exhibit 4, for example, shows the effects of differentdrawdown rates on the CNCF and IRR curves. Assuming the funds underlying investments have thesame return and duration characteristics, a faster drawdown rate will make the CNCF curve steeperand 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 impactof management fees early in the life of the fund, and, as a result, helps the fund move into positiveterritory more quickly. The opposite effects are true for slower drawdown rates the CNCF curve islonger 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


Source: GSAM


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

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


Source: GSAM

Since the IRR of an investment combines both its ROI and its duration, a fund whose underlyinginvestments are realized quickly may be mistakenly identified as a better performer than a fund withlonger-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 averageand 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 beoutperforming, 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 ultimatelyreturns much more capital, and has a higher final IRR, than Fund A. This example illustrates one ofthe reasons why it is important not to put too much weight on the early performance of a privateequity fund.

Exhibit 6 Investors should not put much weight on the early performance of a private equity fund


Source: GSAM


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Funds of FundsFunds 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 uniqueJ-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 ofcapital to 20 different partnerships over the course of 15 months. The CNCF curve for a fund offunds 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 untilits last underlying partnership is fully liquidated. The IRR curve is also more spread out, and itremains negative longer, partially due to the timing spread of the underlying commitments, andpartially due to the additional layer of management fees charged by the fund of funds. The J-Curvefor a fund of funds is typically more predictable and stable than that of a single fund investmentsince differences in returns, drawdown rates and durations are averaged out across severalpartnerships. 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


Source: GSAM

How to Mitigate the J-CurveMany investors concerned about the interim performance of their portfolios wonder about mitigatingthe private equity J-Curve. Unfortunately, there is no guaranteed way to lessen the drawdown ofcapital 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 tofollow a disciplined approach to making annual commitments to private equity. Steady annualcommitments 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 ahypothetical investor targeting $100 million of invested capital. The fast commitment programseeks large initial commitments of capital early in the life of the investment. The steadycommitment 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 ofcapital committed in the first year of each program in our example, $80 million (fast) and $23million (steady).



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


Source: GSAM

While the J-Curve still exists in the early years of either program, its magnitude is mitigated underthe steady commitment program. More importantly, the fraction of the J-Curve that is attributableto the first-year commitments is significantly reduced in the steady plan. In our illustration, weassumed that the monies committed in the first year of the fast program performed well, thusallowing for the fast plan to outperform the steady program in the long run. However, had theperformance of the first-year commitments turned out to be poor, this situation could have easilybeen reversed.

In this light, we believe that adopting a steady program moderates the investors exposure to a largecommitment 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 tounderperform or to have a particularly deep J-Curve.

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

Secondary private equity funds purchase partnership interests from other Limited Partners (LP) infunds that are typically several years old. Since the secondary fund is purchasing the LPs interestwell into the funds J-Curve, it experiences a higher velocity of cash flows (capital is drawn downmore quickly to acquire these mature assets and then distributed more quickly as these assets aregenerally 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 theequity, thus being somewhat safer than a pure equity investment while offering higher returns thanthe debt (sometimes through equity-conversion features). Mezzanine investments typically payregular cash coupons, which can help provide additional positive cash flow early in the funds lifecycle 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 theunderlying securities.




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Meanwhile, distressed funds may incorporate trading strategies that involve purchasing the publicdebt and equity of companies considered to be in financial distress. Since they are associated withpublic 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 theircapital to work quickly when the economy enters a distressed cycle, thereby reducing the ratio ofmanagement fees to invested capital and raising the IRR and ROI J-Curves. Distressed managers alsowill often target holding periods somewhat shorter than typical leveraged buyout or venture capitalmanagers, thus providing earlier distribution of proceeds to investors.

ConclusionPrivate equity is a long-term investment whose performance is difficult to assess in the early years ofa 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 copewith the J-Curve.

Our research shows that private equity investors should expect to contribute capital to a fund for aperiod of five to six years before receiving significant distributions, and they should expect to seepotentially 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 thefunds underlying investments.

Our research also illustrates that many factors influence the profile of the J-Curves, including theprivate equity funds strategy, the economic environment and the pace at which capital is committedto a private equity program, among others. Investors should be aware of these different factors whenthey 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 ontheir investments by using some specific investment strategies, such as setting up steady diversifiedannual commitments to private equity, and/or investing in funds with abbreviated J-Curves, such assecondary, mezzanine and distressed funds.





Appendix ABelow 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 , withcontributions defined to be negative and distributions positive.

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

(2)

The Interim Return on Investment ROI is another measure of the performance of an investmentthat 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 thereported valuation V . Since this value is dependent on the valuation practices of GPs and may notreflect the true market value of investments, and since in the early years of a fund the unrealizedvaluation may be a significant fraction of the total value of the investment, both the Interim IRR andROI 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 ROITare similarly defined as solving:

(4)

(5)

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



Appendix BThe projected cash flows and values used to create the examples in this paper are calculated using animplementation of the cash-flow model described in the paper Illiquid Alternative Asset FundModeling by Dean Takahashi and Seth Alexander of the Yale University Investments Office, publishedin 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 toinclude projections of invested value, management fees, and carried interest; and we utilize aformulation that calibrates the bow parameter described in the article to yield a desired averageduration of investments.

For our base case projection in Exhibit 1, we project quarterly cash flows and values for a fund with alifespan of 10 years, meaning that all investments are fully liquidated 10 years after the close of thefund. We assume that 30% of investable commitments are drawn in the first two years, followed byannual drawdowns of 60% of remaining investable capital. The bow parameter is calculated suchthat 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 be1.75% of commitments per year for five years, then 75% of the previous years fees thereafter. Carriedinterest 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 theweight on FMV is a linearly increasing function of the age of the fund. Unless otherwise noted, all IRRand 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 arethe same as described above):

Lifespan Initial Drawdown Rate Average Duration Gross IRR Exhibit (years) (% of investable capital) (years) (percent)

1 10 30 5 202 10 30 5 0, 10, 20, 303 10 30 5 204 10 20, 30, 40 5 205 10 30 3, 5, 7 206 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 usingthe same parameters as those used in Exhibit 1, but with a gross IRR of 22.5%. It is assumed that thefund makes equal-sized commitments to each of these partnerships, evenly spaced over a period of 15months. The fund of funds itself charges management fees of 1% per year for five years, after whichfees are calculated as 75% of the previous years fees. Carry is calculated as 5% of profits frominvestments, payable after an 8% preferred return has been achieved by the investors in the fund. Thesingle 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, whereeach fund is projected using the same parameters as those used in Exhibit 1. The annual commitmentsof 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



Glossary of TermsAlternative Investments: Broadly, investments in assets or funds whose returns are generated throughsomething other than long positions in public equity or debt. Generally includes private equity, realestate and hedge funds.

Buyouts: Investments made to acquire majority or control positions in businesses purchased from orspun out of public or private companies, or purchased from existing management/shareholders ofpublic equity in going private transactions, private equity funds or other investors seeking liquidityfor 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 theGeneral Partner (GP) of the partnership) asks an investor (typically, a Limited Partner (LP) of thepartnership) to fund a portion of his or her capital commitment in order to make a currentinvestment, or to fund management fees or expenses. Usually, an LP will agree in advance to acapital commitment, and over time the GP will make a series of capital calls to the LP asopportunities arise or the capital is otherwise needed.

Capital Commitment: The total out-of-pocket amount of capital an investor commits to invest overthe life of a fund. This commitment is generally set forth on an investors subscription agreementduring 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 contributedby 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, bothcarried interest and profit distributions to LPs are typically categorized as a capital gain rather thanordinary income.

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

Clawback: A clause in the agreement between the GP and the LPs of a private equity fund obligatingthe GP to return distributions to the LPs to the extent the GP received excess carry distributions, orif the LPs did not receive their preferred return. This can sometimes happen if carry is paid on adeal-by-deal basis, and if the carry paid for early, profitable investments is offset by significantlosses from later investments in a portfolio. The clawback is often calculated on an after-tax basis, sothe GP will not be obligated to return distributions in excess of the tax it was obligated to pay inrespect 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 (resultingfrom the sale, liquidation, disposition, recapitalization, IPO, or other means of realization of one ormore portfolio companies in which a GP has chosen to invest) the proceeds of the realization(s) aredistributed 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 andprofits to LPs and the GP. The GP, for example, may return all capital contributed by the LPs beforetaking carried interest, or take carry on a deal-by-deal basis. Most funds offer a priority return ofrealized invested capital, rather than all contributed capital. LPs are protected from portfolio lossessubsequent to distribution of carry to a GP through the clawback.

General Partner (GP): A class of partner in a partnership. The GP makes the decisions on behalf ofthe 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 LPsare passive investors, typically consisting of institutions and high net worth individuals. The GPearns a percentage of profits.

Internal Rate of Return (IRR): The compound interest rate at which a certain amount of capitaltoday would have to accrete to grow to a specific value at a specific time in the future. This is themost common standard by which GPs and LPs measure the performance of their private equityportfolios and portfolio companies over the life of the investment. IRRs are calculated on either anet (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 outsideinvestor using mostly borrowed capital.

Limited Partner (LP): A passive investor in a limited partnership. The GP is liable for the actions ofthe partnership while the LPs are generally protected from legal actions and any losses beyond theiroriginal 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 theinvestments and is liable for the actions of the partnership while the LPs are generally protected fromlegal actions and any losses beyond their original investment. The GP receives a percentage ofprofits, 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 ofaggregate capital commitments. Management fees in a private equity fund typically range from1.25% to 2.5% of commitments during the funds investment period, and then step down to thesame or a lower percentage based on the funds invested capital remaining in investments. Venturecapital 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 thefund 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 stepdowntypically 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 adebt instrument of lower credit quality relative to the senior debt in a company but ranking senior toany 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 receiveadditional 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 fromthe investment.

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

Private Equity: The Goldman Sachs Private Equity Group defines private equity as anything notpublicly traded, anywhere in the world, except real estate.



Secondary Market: A market for the sale of existing private equity investments prior to theirstated maturity. Traditionally, the secondary market has been focused on partnership interests inprivate equity funds. More recently a market has developed for portfolios of direct private equityinvestments as well. Private equity investors may choose to sell their interests for a variety ofreasons: They may want to raise cash, change their asset allocation, shift their private equityinvestment strategy, reduce their number of private equity managers, recycle capital into preferredmanagers, or they may be in distress and cannot meet their obligation to invest more capitalaccording to a capital commitment schedule. Certain investment companies specialize in providingliquidity 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 isrealized 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 equityinvestments 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 isrealized through an IPO or the sale of the company. The three major classes of venture capitalinvesting 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.



Please contact your relationship manager to obtain a copy of any of these research papers.

The Future of Defined-Benefit Plans: Using LDI Policy toAdapt to New US Pension Regulation(NOVEMBER 2006) US pension rules are in the midst of an overhaul that willsignificantly impact the financial results of defined-benefit pension plans.We believe that the adoption of liability-driven investing (LDI) policies willbecome critical for pension management under the new regulatoryenvironment. In this paper, we show that LDI strategies can help plansponsors cope with the new regulation by potentially lowering the volatilityof the pension surplus (or deficit), while possibly improving the portfoliosrisk-adjusted return. These strategies can also decrease the likelihood thatsponsors will have to make forced pension contributions. Additionally, in thelong run, we anticipate pension plans using LDI to have a healthier fundedstatus than the ones using traditional portfolio construction strategies.

Designing Efficient Return-Generating Portfolios: TiltingAway from Equilibrium toward Alpha and Exotic Beta(OCTOBER 2006) Institutional investing is changing, and we believe investorscan add value to their portfolios by increasing exposures to skill-basedstrategies (alpha) as well as asset classes that are chronically mispriced(exotic beta). This paper provides a framework through which investors canuse equilibrium-theory-based models to build portfolios with an optimalcombination of alpha, exotic beta and market beta. It also illustrates howinvestors can use leverage to enhance potential returns.

Reserve Management in an Equilibrium Framework (AUGUST 2006) In this paper, we provide an investing framework for centralbanks to reconcile their need to maintain adequate liquidity levels whilegenerating higher return on assets. By allocating reserves more efficiently,central banks can designate a portion of their assets to a liquidity portfolioand still have considerable latitude to invest in a return-generating portfolio.We show that the allocation between these two portfolios can be determinedthrough a model that tests a range of factors frequently watched as signalsof potential reserve losses.

Liability-Driven Investment Policy: Managing to the True Benchmark(JUNE 2006) In this paper, we develop a general framework that investors canuse to better formulate liability-driven investment policies across differenttypes of investment organizations and regulatory frameworks. We discusshow portfolio efficiency changes when investors treat liabilities as their truebenchmark, and how they can further improve efficiency by relaxingconstraints 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 marketsequity can play in institutional portfolios. It also includes a series ofobservations about emerging markets equity returns and how theseobservations are consistent with extraordinary returns from exposure to theasset class. Further, it presents the diversification benefits of emergingmarkets equity and offers an alternative interpretation of contagion andchanges in correlation, as well as ideas regarding optimal portfolio structureand the practical aspects of increasing exposure to actively managedemerging markets equity.

Are Constraints Eating Your Alpha? (AUGUST 2005) Is the hedge fund manager who outperforms the traditionalmanager better at forecasting stock returns, or is he or she just facing fewermaterial constraints? Constraints exist for a reason and serve an importantrole ensuring underlying risk control of portfolios. But not all constraints arecreated equal. This paper explores ways to help fiduciaries reach the nextlevel in setting constraints and potentially improve performance for traditionalinvestment managers. It includes information on what to watch for and whatyou 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 investingand analyze the differences between the public and private markets. We findthat the differences are not statistically meaningful. Therefore, investorsshould choose their implementation approach based on the specificcharacteristics of each structure. Given the advantages of public real estate liquidity, diversification and flexibility we believe it should be asubstantial component of a real estate allocation.

Active Risk Budgeting in Action: Assessing Risk andReturn in Private Equity (APRIL 2005) Since private equity investments are not regularly traded and arelimited by poor data quality, a basic investing framework may not be appliedto this asset class. However, we believe private equity can be naturallydecomposed the same way as other investments. This paper provides aframework that puts private equity returns and allocations on equal footingwith other investments. By using our assumptions on residual volatility andinformation ratios, our analysis shows that investors can potentially achievehigher expected returns by including private equity in a traditional portfolioof 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 bypension fund managers and private wealth investors, among others. Bybreaking variations in risk into asset class weights, volatilities andcorrelations deviating from the risk budget, we provide a framework forinvestors to better understand their portfolios, manage risk more optimallyand improve the investment process. This paper also provides guidance onwhen 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 fundperformance across a variety of strategies including tactical trading, equitymarket neutral, equity long/short, event driven, convertible arbitrage andfixed income arbitrage.

Goldman Sachs Asset Management PublicationsFollowing are additional research papers examining a range of investment topics.

Alternative Investments such as hedge funds are subject to less regulation than other types of pooled investment vehicles such as mutualfunds, may make speculative investments, may be illiquid and can involve a significant use of leverage, making them substantially riskierthan 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 anAlternative Investment Fund has total investment discretion over the investments of the Fund and the use of a single advisor applyinggenerally similar trading programs could mean a lack of diversification, and consequentially, higher risk. Investors may have limitedrights 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. Fundperformance 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 highlyilliquid 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 itsaffiliates, who are engaged in businesses and have interests other than that of managing, distributing and otherwise providing services tothe Alternative Investment. These activities and interests include potential multiple advisory, transactional and financial and otherinterests in securities and instruments that may be purchased or sold by the Alternative Investment, or in other investment vehicles thatmay purchase or sell such securities and instruments. These are considerations of which investors in the Alternative Investment should beaware. 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 GSAMsprior written consent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not anemployee, 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 tobuy 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 mayvary substantially.

Simulated performance is hypothetical and may not take into account material economic and market factors that would impact theadvisers decision-making. Simulated results are achieved by retroactively applying a model with the benefit of hindsight. The resultsreflect the reinvestment of dividends and other earnings, but do not reflect fees, transaction costs, and other expenses, which wouldreduce returns. Actual results will vary.

This presentation has been communicated in the United Kingdom by Goldman Sachs Asset Management International which isauthorized and regulated by the Financial Services Authority (FSA). This presentation has been issued or approved for use in or fromHong Kong by Goldman Sachs (Asia) L.L.C. This presentation has been issued or approved for use in or from Singapore by GoldmanSachs (Singapore) Pte. (Company Number: 198602165W). With specific regard to the distribution of this document in Asia ex-Japan,please note that this material can only be provided, upon review and approval by GSAM AEJ Compliance, to GSAM's third partydistributors (for their internal use only), prospects in Hong Kong and Singapore and existing clients in the referenced strategy in the Asiaex-Japan region.

This presentation has been communicated in Canada by GSAM LP, which is registered as a non-resident adviser under securitieslegislation in certain provinces of Canada and as a non-resident commodity trading manager under the commodity futures legislation ofOntario. In other provinces, GSAM LP conducts its activities under exemptions from the adviser registration requirements. In certainprovinces GSAM LP is not registered to provide investment advisory or portfolio management services in respect of exchange-tradedfutures or options contracts and is not offering to provide such investment advisory or portfolio management services in such provincesby delivery of this material.

Copyright 2006 Goldman, Sachs & Co. All Rights Reserved. (06-6447) RP_JCURVE/12-06

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