The denominator effect is impacting limited partner portfolios and slowing the private equity fundraising market. Matt Levin asks whether it will result in changes to the LP-GP relationship.

After raising record capital commitments last year at the height of the buyout boom, anecdotal evidence of a slowdown in private equity fundraising has crept out from the desks of placement agents and limited partners and into the headlines.

Chicago-based buyout giant Madison Dearborn Partners has reportedly cut the target of its latest fund from $10 billion to $7.5 billion. The Blackstone Group is reportedly set to receive a $250 million commitment from the California State Teachers' Retirement System, down precipitously from the $1.7 billion the pension invested with the firm last year.

kohlberg kravis Roberts and Fortress Investment Group have similarly been linked to funds with longer than expected road shows.

Although each of these firms and funds have their own unique back-stories, when added together they provide a snapshot of what many insiders are saying could be the beginnings of a weaker fundraising climate.

“The environment is worse [than in the early 2000s],” says Mac Hofeditz, partner at San Francisco-based placement agent Probitas Partners. “The problem in 2001 to 2003 was that LPs had a bit less money due to the market correction and were unwilling to take risk. Today, LPs may be more squeezed for cash because they over-allocated based on an assumption that distributions would continue.”

Put another way, a general partner at a recent, off-therecord industry gathering described a fundraising market where some LPs have told him: “We'd love to invest, but we're out of money.”

In retrospect, a dip in the frantic fundraising pace from last year was fairly predictable. But what accounts for the slowdown, which seems to have caught so many by surprise?

Part of the answer can be found in a four-page memo buried in the August investment committee agenda of the $228 billion California Public Employees' Retirement System.

The memo candidly revealed that CalPERS, often considered a bellwether of limited partner attitudes, may soon have to change its private equity target allocation as it battles what is increasingly becoming the most loathed expression in private equity fundraising – the “denominator effect”.

The memo estimated that because of the pension's plummeting total assets under management and decline in fund distributions, CalPERS' actual allocation to private equity was rising and could reach 12 percent by the end of 2008. The upper limit of CalPERS' target allocation range stands at 13 percent.

The memo, which recommended a potential alteration in target allocation at the end of the year, finally confirmed what placement agents, gatekeepers and limited partners of all stripes had been aware of for months – that institutional investors were struggling with the denominator effect, and that LP appetite was diminishing as a result.

“[The denominator effect] is absolutely affecting LPs, and it has the potential to be more severe than ever,” says Saul Meyer, a partner in Dallas-based fund-of-funds and co-investment firm Aldus Equity.

The science behind the denominator effect is relatively easy to understand. Largely because of a precipitous fall in the value of their public portfolios, institutional investors such as CalPERS have watched their total assets under management drop significantly over the last six months.

Combined with shrinking distributions from the private equity funds to which they are already committed, capital devoted to the asset class rises as a percentage of the investor's total assets under management.

In order to temper an over-weighted allocation, investors have shrunk back on the number and size of commitments they are willing to make to funds – but not all institutional investors are able to react in the same way.

Endowments and family investment offices typically have more flexibility than public funds in making quick changes to their allocation policies to accommodate more investments in a given asset class.

That may mean a boon for private institutional investors, as historically the vintage years of private equity funds that coincide with downturns in the broader economy show the best performance.

“Ironically, the folks who are a little more tactical in their private equity allocations – fund of funds, endowments, family offices, etc – are actually the ones who are benefiting from this environment,” says Hofeditz. “Because it's actually a pretty attractive time to invest in private equity.”

Instead of hiking their allocations to enable a steady pace of commitments, however, many investors are seeking liquidity by freezing commitments or going to the secondaries market.

CalPERS is certainly not alone among public pensionswho have confronted this dilemma. The California State Teachers' Retirement System, The State Investment Board of Wisconsin, and the Michigan State Employees' Retirement System have all watched their actual private equity target allocations increase by a full percentage point while their total assets under management have declined dramatically.

Even some institutional investors which rolled out or expanded their private equity allocations in recent years could be tipped into over-weighting if the public markets plummet.

“There's awareness [of the denominator effect],” says Jay Fewel, chief investment officer of the Oregon Public Employees Retirement System, which bumped the upper limit of its allocation range from12 percent to 20 percent last year. “We did a pacing study in July and it indicated under various market scenarios, we could go over the top. But it would really take a dramatic fall in the public markets.”

As expected, limited partners' first instinct has been to back away from commitments to the mega-buyout funds in which they have poured unprecedented amounts of capital over the last three years.

Fundraising for buyout funds for the first half of 2008 is down 20 percent fromlast year, according to a study by Dow Jones.

Mega-buyout GPs, however, are not the only ones feeling the pinch.

As limited partners put a renewed premium on long track records displaying consistent performance across previous cycle downturns, emerging managers are finding it nearly impossible to raise money.

“Certainly if you're a first-time fund it's even more difficult,” says Fewel. “If you have an established track record, you've demonstrated that you've invested through multiple market cycles, you're in a better position to raise money than someone who is out for the first time. But that's just common sense too.”

OVERWEIGHT?A cross-section of prominent LPs nearing or surpassing their target allocation for private equity.

Limited partner Market value of Target allocation Actual allocation* Target range allocation
PE investments*
CalPERS $24.8bn 10% 10.3% 7-13%
CalSTRS $i7.ibn 9% 10.7% 4-11%
Oregon Public Employees $S>bn 16% 17.1% 12-20%
Louisiana Teachers' $2.5bn 18% 17% N/A