Friday Letter The upside of write-downs

Many GPs have long considered mark-to-market accounting a fiend. But now that fair value write-downs of private equity portfolios seem inevitable, they may well bring relief for over-weighted LPs suffering the denominator effect.  

Nowadays there is no shortage of things for private equity general partners to worry about. The effect of the global financial crisis and economic downturn on their investment portfolios is one of them. Under mark-to-market accounting rules, sharp reductions in interim valuations are now a prospect facing many GPs.

No one can know by how much investments will have to be marked down – there is still no across-the-board valuation methodology in place for private equity, and existing valuation guidelines, such as the ones produced by the EVCA, leave ample room for interpretation and case-by-case judgment. But equally, it is widely considered a certainty that many, if not most, private equity groups will have to significantly mark down holdings in coming months, as corporate earnings weaken and purchase price multiples deteriorate.  

Perversely, this might help assuage what keeps the limited partners awake at night: the so-called denominator effect, whereby the plummeting value of an investor’s public equity programme causes its private equity exposure to rise as a percentage of the fund’s total assets. This, of course, has been exacerbated lately by wild global stock market swings and diminishing distributions from private equity funds that now have fewer routes to exit.

Make no mistake: the denominator effect is real and often painful. This week, for example, the $54 billion Oregon Public Employees Retirement Fund, told PEO that because its private equity allocation recently surpassed 20 percent – its target is 16 percent, with an acceptable range of 12 percent to 20 percent – that it would not add any new relationships next year. And this year, save for a potential commitment to First Reserve’s latest energy mega-fund, it’s effectively closed for business.

But again, the pressure on portfolios such as Oregon’s is likely to ease as soon as the coming private equity write-downs take full effect. Come the valuation reports of 30 June 2009, the worst effects of the denominator effect will have been partially offset by these write-downs, pulling the numerator in the opposite direction.

This will restore some of the LP portfolios’ old balance, and enable investors to make some new private equity commitments sooner than they might currently expect – a prospect both LPs and GPs are sure to savour.