A J curve is an economic theory that shows the trend of an initial loss followed by significant gains. It is called a J curve due to the characteristic letter J shape when the nominal trade balance is charted as a line graph.
One common use of the J curve theory states a country’s trade deficit will initially worsen following the depreciation of the country’s currency. This occurs as the nominal trade deficit grows after the devaluation of currency and the price of exports increases before quantities can adjust.
The J curve theory can also be applied to other areas such as private equity, the medical field, and politics.
How a J curve works
In private equity, J curves demonstrate how private equity funds historically show negative returns in the initial years following their launch but then begin making gains when they become more established.
Private equity funds may make losses initially due to investment costs and management fees absorbing a large portion of their funds, but as the funds mature they realize gains. More established funds may realize gains through mergers and acquisitions, initial public offerings and leveraged recapitalization.
It is considered that the steeper the positive part of the J curve the quicker gains will be returned to investors. When a private equity firm can provide quick returns to investors it provides them with the opportunity to reinvest that capital into other investments.
What else do you need to know?
Losses are usually short-term
When it comes to private equity funds a J curve shows initial short-term losses but as the private equity fund matures and following events such as initial public offerings and acquisitions and mergers the fund achieves a sharp rise in gains.
Shows a strong rise
Whether in private equity or trade deficit a J curve shows a strong rise following a period of decline. In terms of private equity, the period of growth means that gains can be passed to investors quicker to enable them to seek other investment opportunities.
Can affect competitiveness
In the early stages of a J curve competitiveness can be affected. Private equity funds that are in their infancy will not be able to compete with more established funds and may have difficulties in attracting investors.
