The Denominator Effect – How volatility and market turmoil in the public markets have impacted fundraising in the private markets 

by Andrés Ramos, Content Marketing Specialist – eVestment Private Markets

The Denominator Effect occurs when the value of one portion of portfolio decreases drastically and pulls down the overall value of the portfolio. As a result, any segments of portfolio, which did not decrease in value, now represent a large percent of the overall pie.  

In and of itself, the Denominator Effect does not negatively impact those other segments of the portfolio, but in the context of the institutional investing, when the Denominator Effect hits, it is the private markets holdings of LP investors that generally increase in terms of portfolio sizing. This is of course because valuations for private markets funds are calculated on a lag compared to the LPs public markets holdings, which are essentially valued in real-time. 

With the spread of COVID-19 and economic closings, pension plan investors have seen significant impacts to the valuations of their public markets holdings and as a result, their private markets holdings have ticked up as an overall percentage of their respective portfolios. 

While this public markets holdings will likely recover in value over time, in the short-term, the Denominator Effect is having a direct impact on fundraising and new commitment activity to private markets fund managers. Stringent governance and target allocation policies mean that LPs who are now over-allocated to the private markets cannot make new commitments that would push them farther beyond those limits.  

Who’s feeling the pressure from the Denominator Effect?  

Using eVestment’s Market Lens platform, we’ve identified several documents that offer a look into how LPs commitment pacing has been impacted by the pandemic and how they are reacting. 

Los Angeles County ERA (LACERA) 

In an update from June 10, 2020, LACERA indicated that their private equity exposure was 12.1% of the Total Fund at the close of 1Q 2020. This is less than one percentage point below their upper policy range for the asset class (13% of total assets). The update noted that if the plan’s private equity allocation exceed 13%, “[It] could trigger a need to rebalance the portfolio by selling off private equity positions at unfavorable valuations.” 

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Alaska Permanent 

A Sensitivity Analysis of their projected investment pacing by Alaska Permanent found that the Denominator Effect was having a large impact on their overall portfolio, but would not cause their Private Equity and Special Opportunities allocations to exceed their “green zone limits”.

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San Francisco ERS (SFERS) 

SFERS announced in a recent presentation that due to market volatility caused by the pandemic they are operating in a “No Growth” scenario and have reduced their annual pacing schedule 33% from $2.45 billion to $1.65 billion. 

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A challenge for some managers and an opportunity for others 

All that said many LPs were sufficiently under-allocated to Private Equity and other private asset classes and therefore still have capacity to make commitments. According to data presented in a recent eVestment Private Markets webinaras of May 31, 83 LPs were underweight to private equity with $27.7 billion in open commitment opportunities. 

For fundraising managers, the Denominator Effect is without question an impediment to closing commitments, but at the same time it has also narrowed the list of potential investors they need to focus on. Tools like Market Lens help fund managers identify those LPs who are still in the market to make new commitments and can help them tailor their message to the needs of those investors.  

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