Concerns over private equity’s dreaded denominator effect seem to re-emerge every few years. In 2022, however, those fears were realised.
Private asset values have been slow to reflect the sharp drop in public markets this year. Shrinking public portfolios left many institutional investors overallocated to PE – a dynamic that is particularly problematic for the likes of US pension funds, which operate within strict allocation targets or ranges.
This latest market shock came off the back of a particularly good year for private equity returns, meaning the issue was exacerbated by a simultaneous numerator effect. A wave of mega-funds returning to market at the same time then forced LPs to consider whether they had capacity for every re-up while remaining within their policy limits.
Investors have responded to this headache in different ways: some have reduced ticket sizes, while others have declined re-ups altogether. “In cases where we have a good relationship, where we would love to have re-upped but just don’t have the capital, it can be easier to skip a fund and come back [than to write a smaller cheque],” one West Coast pension CIO, who manages a $2 billion portfolio, told Private Equity International for our March deep dive.
In other cases, investors have sought to redefine the boundaries in which they operate. State of Wisconsin Investment Board, for example, increased its allocation range for private debt and private equity from 3 percent to 5 percent in either direction to prevent it from having to offload assets. The move followed a whopping 47.5 percent rise in its PE assets under management over the course of last year.
Denominator issues have had a knock-on effect for managers. Funds are generally taking longer to reach a final close due to a combination of smaller tickets, greater selectivity and budget constraints, with the latter prompting some LPs to ask their managers to remain open into 2023.
Apollo Global Management is among them. “Due to the impacts of the denominator effect and the sheer number of GPs in the market this year, we’ve agreed to keep [Fund X] open until the first half of ’23 to accommodate our investors’ annual allocation budgets,” co-president Scott Kleinman said on the firm’s third-quarter earnings call in early November.
Of course, valuations are gradually starting to come down in the back end of 2022, meaning the problem may – at least to some extent – resolve itself. Massachusetts Pension Reserves Investment Management Board, for example, marked its PE portfolio down by 5.7 percent gross of fees in the third quarter alone.
GPs may also take some comfort from Probitas Partners’ latest Institutional Investors Private Equity Survey, which found that 53 percent of respondents were roughly at or over their target and still looking to maintain or increase their allocations in 2023 – a similar result to last year. The proportion of respondents who were over target and looking to reduce exposure remained at just 4 percent, while only 6 percent plan to temporarily slow their investment pace, up from 1 percent last year. None said next year’s allocations were already entirely spoken for.
The bottom line is that, while LPs will – for multiple reasons – be more selective with their commitments in the New Year, the fundraising hose doesn’t appear set to run completely dry. Managers should, however, expect the process to be harder going than in prior years.