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The return of the ‘denominator effect’

Since the chastening experience of the global financial crisis, LPs are wary of being over-allocated to private equity.

The denominator effect is rearing its head once again.

To recap: when public markets fall in value, the relative value of less liquid asset classes – such as private equity – in an investor’s portfolio (the numerator in this scenario) grows, while the overall portfolio (denominator) shrinks. This throws target allocations out of whack and limited partners suddenly find themselves over-allocated to illiquids. Particularly if they had a punchy over-commitment strategy to begin with.

  • In extreme circumstances, such as those experienced in the depths of the financial crisis, LPs can be forced to take dramatic remedial action, trimming their existing private equity exposure by offloading fund interests, putting the brakes on commitments to new vehicles and even negotiating reduced commitments to existing funds.

  1. “Everyone has scars from their ’08 experience,” a European family office reportedly told Atlantic Pacific Capital, whose latest client update heralded the return of the denominator effect. It noted this was “causing many LPs to pull back on their commitment pace for the first half of 2016”. 

This chimes with reports from elsewhere in the market; a case in point being The Massachusetts Pension Reserves Investment Management Board.

With a target allocation to private equity of 10 percent, the pension fund’s actual allocation to the strategy as of 31 December was 11.4 percent – while a slight over-commitment strategy is not unusual as LPs work to hit their target asset allocations, it can cause problems in more turbulent times. As a result, the pension is slowing the pace of its primary fund commitments, reducing the $1.8 billion figure committed last year to $1.4 billion for 2016.

“Our outlook has not changed; we just have to compensate for the denominator effect,” chief investment officer Michael Trotsky told Private Equity International. “Right now we’re running a little bit over-allocated in terms of private equity because of its relative strength.”

Another significant European pension fund manager told PEI it has slowed down on new investments for 2016 as it is so close to its target allocation.

Let’s be clear: this is not 2008, and a number of cautious LPs deciding to slow their investment pace is a very far cry from the distressed secondaries sales and cancelled commitments seen eight years ago. As the European family office told Atlantic Pacific, most organisations actively allocating to private equity bear some scars from ’08 and have learned to head off any issues before they require more drastic corrections.

The fact is, despite any anecdotal doom and gloom brought on by various macroeconomic headwinds in the first quarter, fundraising figures are holding up well. Preliminary data from PEI Research & Analytics show that the first quarter fundraising total will be near to the $100 billion-mark: closely in line with figures for the previous four buoyant quarters. Clearly, however, those funds that closed in Q1 2016 are the result of months or even years of marketing. Any impact of the denominator effect will be felt later in the year.

After bumper fundraising in 2014 and 2015, it was widely predicted that activity in 2016 would slow. From the hefty fund closes already achieved this year, that doesn’t seem to be happening just yet.

However, managers returning to market later in the year would be wise to keep one eye on the rocky public markets; the investors on the other side of the table certainly will.

Look out for the full interview with The Massachusetts Pension Reserves Investment Management Board's CIO Michael Trotsky and director of private equity Michael Bailey in the April issue of Private Equity International.