Private Equity Funds, Illiquidity and the "Denominator Effect"
By: Ricardo J. Hollingsworth, and John W. Kaufmann
Historically, the ranks of institutional investors in private equity funds have been dominated by a relatively small number of public and private pension plans, foundations and endowments. The vast majority of their institutional counterparts were content to invest their assets in public securities, usually through third-party investment managers. After realizing that the best-performing private equity funds provide risk-adjusted returns that significantly exceeded those that were being obtained in the public markets, a broader group of institutional investors came to embrace alternative investments generally, and private equity specifically, as integral parts of a diversified portfolio. This led to a significant expansion in the number of institutional investors seeking to invest in private equity and a period of unprecedented growth in the asset class. In 2007, private equity funds raised almost $500 billion.
The turmoil in the credit markets and its attendant effects on both the public securities markets and the private equity market have strained the private equity portfolios of institutional investors in two respects—portfolio allocations and liquidity. As a result of the recent declines in value of institutional investors’ public equity holdings, their proportional holdings in private equity and other illiquid investments in many cases are higher than originally targeted. This “denominator effect,” so named because the decrease in the value of public equity holdings causes a decrease in the value of the investor’s overall portfolio (the “denominator”), which in turn causes the private equity portion of the portfolio (the “numerator”) to account for a disproportionately large part of the overall portfolio, causes over-allocation to the private equity asset class. The problem has been exacerbated by the fact that valuations of private equity investments, given their illiquid nature, have trailed declining valuations in the public equities markets. While this will be ameliorated to some degree by the implementation of FAS 157 on January 1, 2009, which essentially will require private equity firms to mark their assets to market, certain institutional investors have decided to begin rebalancing their portfolios in order to bring their private equity allocations within range of their original allocation targets. This is one reason why several very large university endowments have reportedly been considering selling parts of their private equity portfolios in the secondary market and others have reportedly refused to meet capital calls.
Liquidity concerns are also affecting institutional investors in private equity. The frozen credit markets have prevented private equity firms from liquidating investments in their portfolio companies through leveraged recapitalizations, sales to strategic buyers or public offerings. This has slowed the distributions that private equity firms are making to their investors. Emerging as we are from an unprecedented period of private equity fund raising, many institutional investors have concluded that the expected payouts from their existing private equity investments may not even be enough to meet their commitments to invest in the new private equity funds to which they have recently committed. This decrease in liquidity, which is made more severe by the drop in the value of the liquid, public equity portions of their portfolios, is adding to the pressure on endowments trying to fund university operating expenses and pension funds facing ever-increasing benefit obligations.
Taken together, the “denominator effect” and the decrease in liquidity could lead many institutional investors to reduce their investments in private equity funds, which potentially signals a period of consolidation or even contraction for the private equity industry.
