Landmark: Denominator effect may be exaggerated

Net asset values will decline more over the next few quarters, brining allocations back into balance, according to a white paper published by the secondaries specialist.

Limited partners that forego making new commitments to private equity because of over-allocations to the asset class will be missing out on an historic chance to buy into valuable investments, argues Landmark Partners.

Landmark, which focuses on private equity and real estate secondaries, has published a white paper that concludes some LPs’ concerns about over-weighting private equity in their portfolios due to the so-called denominator effect may be exaggerated.

The denominator effect happens when the value of other asset classes in an investor’s portfolio decline, bringing down the total assets of the portfolio. As the investors’ total assets under management shrink, exposure to private equity as a percentage of total assets naturally rises, causing an over-weighted allocation.

Landmark believes LPs worried about the denominator effect may be overreacting. According to the firm, private equity net asset values as reported do not reflect reality, in that the values still have more declining to do. LPs that curtail future commitments to private equity because of the denominator effect should wait until private equity values come down to realistic levels, the firm said.

The average decline in net asset value for private equity firms in the third quarter was 5 percent, Landmark said. According to the State Street Private Equity Index, private equity funds turned in an average 2008 performance of negative 25.76 percent.

Investors who do not make private equity commitments in the next year or two will be missing good buying opportunities.


Barry Griffiths, vice president of Landmark Partners, said he expects the net asset values to decline even more in the next few quarters. As private equity values decline, the allocation to private equity will come back in balance, he said.

LPs not facing liquidity crises should stick with the asset class, especially in the current environment when the best deals can be found, Landmark said.

“We believe that investors who do not make private equity commitments in the next year or two will be missing good buying opportunities,” Landmark said. “To the extent that prices in the public equity market have declined substantially, there are good buying opportunities in both the public and private markets. Good buying opportunities by themselves don’t guarantee good prospects for returns in new private equity funds.”

LPs that need to get their NAV down to acceptable levels can sell interests on the secondaries market and continue making commitments “sized in proportion to the overall portfolio”, Landmark said.

LPs that decide to exit from private equity completely will still have to fund capital calls arising from earlier commitments, and distributions from those commitments could take 10 years or more to be realised.

“Alternatively, these investors might consider a secondary sale of all or part of their existing private equity portfolios in order to completely remove the exposure from their balance sheets,” Landmark said. “This approach would not only relieve them of their existing commitments, but could bring them additional cash in the short term.”