Mini denominator effect may spur sales

Volatility in public markets may cause investors to sell private equity commitments to cushion themselves against an imbalance in allocations.

Continued volatility in the public markets may spur a slight denominator effect, causing institutional investors to sell private equity interests in order to rebalance their portfolios, according to market participants.

“With the shrinking of the public side of the house, the exposure to the illiquid side of the house may start increasing or getting too close to some target allocation,” said a managing director of a global investment firm in London, calling it a “mini denominator effect”.

The denominator effect refers to when the value of listed equities drops, and portfolio managers, who have strict guidelines for asset allocation, find the value of their private equity is greater than their maximum allowed allocation. Some limited partners including CalPERS and Harvard Management Company were particularly affected by this during the global financial crisis, selling off large chunks of private equity commitments.

“You would obviously need a big swing in the market to create that event, but you’d want to start watching some of the private equity institutional investors and whether a potential denominator effect could become a source of concern,” he noted. “They would want to adjust their portfolio ahead of getting to that point to give them more of a cushion.”

Global stock markets have seen increased volatility in recent months. The Dow Jones Industrial Average has lost 8.5 percent this year, and China’s stock markets have seen big swings.

“People with large public portfolios as well as illiquid portfolios may want to start looking carefully to make sure they’re building the cushion they need to sustain a further decrease in the market,” the source said. “It’s going to be a more proactive adjustment of their illiquid portfolio, more than reactive.”

European insurance companies were already selling private equity stakes this year for rebalancing purposes, the source said, although he added that regulatory concerns may also have been part of their reason for selling.

Thomas Liaudet, a partner at Campbell Lutyens’ secondary advisory team, said sharp drops in the value of listed equities can sometimes catch investors unawares, in a guest commentary published by Secondaries Investor.

“A sharp drop might take the investor by surprise, and if the drop is lasting, it may require remedying,” he said. “The markets will dictate whether or not investment committees will have to more widely face the denominator effect again, but some already have.”