With a degrading macro and a stock market plunge, investors may have to face some old daemons. For instance, the denominator effect, rarely observed since 2009, may reappear on CIOs’ agendas, explains Thomas Liaudet, a partner at Campbell Lutyens’ secondary advisory team.
Some market terminology may be as seasonal as the markets themselves. In the ever more sophisticated world of asset allocation, some limited partners remain subject to strict portfolio target allocations. Such targets typically include a guideline by asset class. For instance, the Harvard endowment’s “portfolio policy” for private equity was set at 15 percent for 2015, a constituent of the 51 percent allocated to equities in aggregate.
A drop in the absolute value of listed equities as a result of public market losses can see investors’ relative allocations to private equity rise, potentially resulting in a deviation from intended exposures. A more significant drop may take the investor beyond their target guideline for private equity. A sharp drop might take the investor by surprise, and if the drop is lasting, it may require remedying.
One has to look back to the 2008-2009 news archives to find the term “denominator effect” last used regularly.
However, in the last few weeks, it has re-emerged as a number of LPs have, as a result of the sharp drop in public valuations, seen their exposure to private equity pushed close to or beyond their guideline thresholds.
What does it mean for the secondary market?
Some investors may seek to take action to remedy this over allocation – however the market they now face is significantly more mature, functional and fairer than when this was last an issue. It is now five times as large as in 2009 and twice as large as in 2010, offering greater liquidity and deeper pricing to potential sellers. The level of demand for assets still outweighs current secondary market deal volumes, particularly for fund interests, given the proportion of current deal flow accounted for by the GP-led liquidity offerings.
These allocation restrictions can constrain an investor’s ability to make new primary commitments, negatively skewing vintage year diversification or causing them to miss the opportunity to support core manager relationships. A well-executed, price-maximising, secondary transaction can be completed in a matter of months, freeing up investment capacity and allowing investors to make new commitments. Such sales can also be designed to retain all existing GP relationships by selling only a partial interest in selected funds, avoiding any radical changes to the investor’s portfolio composition. Depending on how the sale is reflected in the vendor’s books, a deferral of consideration may achieve a similar impact on allocation release but can optimise the timing of portfolio cash inflows to better align them with new commitments.
If the past 12 months have been characterised by active portfolio management driven sellers, maybe the next period will be led by active portfolio recyclers.
The markets will dictate whether or not investment committees will have to more widely face the denominator effect again, but some already have. They will hopefully find a more sophisticated secondary market to help them better achieve their investment objectives.
Campbell Lutyens is an independent private equity advisory firm founded in 1988 focused on private equity and infrastructure fund placements. It also provides specialist advice on the sale or restructuring of portfolios of private equity fund or direct investments.