Amid stock markets panic, LPs dread the denominator effect

Extreme volatility in the public market is forcing investors to once again rethink their exposure to private equity, writes Christopher Witkowsky.

Type “roller coaster” into your browser today and the results turn up thousands upon thousands of news stories focused on the plunge-and-surge patterns the world’s stock markets have experienced lately. Over the past two weeks, global markets have been in a wild flux – at the mercy of alternating “greed and panic” as one commentator put it.

As we pointed out last week, though they have the luxury of longer time horizons, private equity fund managers could indeed be impacted by the shorter term volatility.

Limited partners, too, are busy analysing potential scenarios and how their investment strategies and portfolios might be affected. Sources have told us in the past week that public pensions in particular are starting to think about how they will run their private equity programmes should stock markets sink and the so-called denominator effect rear its head once again. At least one large US pension was already considering a defensive pullback on new commitments until markets stabilise.

The denominator effect occurs when the overall value of a pension fund’s investment assets decline while the illiquid holdings stay the same, driving the percentage allocation to illiquid assets above target levels.


This happened to many institutions in 2009, which led to speculation that some LPs would have to default on commitments or become distressed sellers on the secondary market. The predictions never really materialised, however, as private equity deals slowed and by extension, so too did capital calls. Some fund managers even allowed their LPs to reduce the size of prior commitments in an effort to throw liquidity-starved investors a lifeline.

Given the severity and duration of the prior downturn – markets stayed depressed from the autumn of 2008 and didn’t start to pick back up until spring 2009 – the denominator effect had time to sink in and throw many LPs’ investment programmes off-kilter. In response, several of them, including the Pennsylvania Public School Employees’ Retirement System and the Alaska Permanent Fund, cancelled hundreds of millions of dollars-worth of “soft” commitments their staff had recommended.

This time around, while LPs are right to brace themselves for the worst, so far, the consensus seems to be that the current turmoil is not the same as what was experienced post-Lehman Brothers, and may indeed stabilise, thus the denominator effect would not have time to take hold and make an impact. But with a significant macro event such as a sovereign debt default triggering a market collapse and broader economic downturn, all such bets will of course be off.

In both the current climate, as well as any potential doomsday scenario, sophisticated institutional investors are not expected to abandon the private equity asset class. But it wouldn’t be far-fetched to wager that fresh commitments will need to be made even more prudently – causing an already difficult fundraising climate to become even more challenging and complex.