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A combination of rising valuations in 2021 followed by a stark drop in public market assets in 2022 have caused many institutional investors to be overallocated to the private markets. The resulting denominator effect—caused by public market values falling faster than private market assets—has left many  allocators wondering how to manage their skewed portfolios and approach new commitments.

Here we dive into the denominator effect, exploring the current market conditions that have led to overallocation, along with some portfolio rebalancing strategies institutional investors can use to find relief.

What is the denominator effect?

The denominator effect occurs when one portion of a portfolio decreases dramatically, diminishing the total value of the portfolio. As a result, any segments of the portfolio that did not decrease in value now comprise a larger percentage of the total. This dilemma most commonly affects investors with mature private market portfolios, as those ramping up to a target allocation are unlikely to find themselves facing overallocation concerns.

Most institutional investors construct their portfolios within an allocation framework, determining target allocations for asset classes based on a fund’s strategies and goals. Some allocators, such as insurance companies, need more immediate liquidity to be able to pay out insurers in the case of an emergency, while others, like foundations, invest with a perpetual mindset and are more comfortable sacrificing liquidity and holding their assets for extended periods. When the denominator effect hits, an allocator's portfolio strays from these carefully constructed investment targets—affecting its entire risk-return profile. 

How current market conditions are causing the denominator effect

Stock market decreases and climbing interest rates have caused sharp declines in the values of public market investments. By contrast, the private markets have remained relatively unaffected, as it typically takes two-to-three quarters for private asset markdowns to catch up with public market declines. This downward movement of public market investments absent of private market decreases has created a scenario where many allocators are dealing with the denominator effect.

To illustrate how this is affecting allocator's portfolios in the current environment, let’s consider the following example from our recent Analyst Note, Insights into LPs’ Approach to 2022’s Market Challenges.

Let’s say an a limited partner (LP) chose to allocate 20% of their portfolio to PE and 40% each to public equity and fixed income. The portfolio value was $100 million, but because of the recent drop in public equities, the $40 million public equity stake declined by 35%. At the same time, rising interest rates caused the public fixed income stake to drop by 10%, but the PE portfolio was left unaffected. The total portfolio value has now dropped to $82 million. As shown in the graph below, if the LP was at their target PE allocation before the public market declines, they now find themselves overallocated.

Asset class	Before value ($M)	Target allocation	After value ($M)	After allocation
Public equity	$40	40%	$26	31.7% (Under)
Fixed income	$40	40%	$36	43.9% (Over)
Private equity	$20	20%	$20	24.4% (Over)
Total (denominator)	$100	N/A	$82	N/A

Why is rebalancing a portfolio important?

In theory, given the portfolio’s skew, the allocator should rebalance. The current overallocation towards private equity and underallocation to equities puts the investor outside their desired risk-return profile. But private market asset classes, like PE, VC, and real assets, are illiquid investments—many of which have a 10+ year fund cycle and are difficult to sell in the medium- to short-term. Allocators can’t simply offload PE assets and buy equities to rebalance their portfolio.

Additionally, institutional investors adopt a long-term mindset when they invest in the private markets. When markets experience volatility, asset allocations will inevitably drift from long-term strategic targets. If an allocator has matched their investments and allocations with the horizon of their liabilities, they should be able to stay the course during times of market stress and stick to their deliberate goals. Trying to time the market is no way to maximize the long-term success of a portfolio.

So, how are allocators to respond to the denominator effect?

4 ways institutional investors can manage the impacts of the denominator effect

Allocators trying to mitigate the denominator effect can employ a variety of portfolio rebalancing strategies. Each  situation is unique, and institutional investors are far from uniform in their goals or governance; ultimately, how an allocator chooses to respond to a stressed portfolio will depend on their specific circumstances. An underfunded pension fund with a growing base of retirees, for example, will likely be less tolerable towards skewed allocation targets than a sovereign wealth fund without explicit cash flow obligations.

Here we look at some common portfolio rebalancing mechanisms.

1. Wait it out

Private market positions do not operate in a silo to the larger macroeconomic forces affecting the public markets. It’s highly likely that the values of private market asset classes will be marked down significantly. In fact, according to our Global Fund Performance Report, PE and VC funds saw markdowns in Q3 2022, with the asset classes exhibiting negative returns of -0.6% and –4.8%.

Allocators can choose to wait out the storm giving either their public market holdings the chance to rebound or their private market assets a chance to catch up in markdowns. However, waiting for the public and private markets to arrive at some kind of equilibrium has its own implications. Investors who hold their assets for too long could miss out on valuable opportunities, like investing in funds formed during a recessionary vintage year, which have historically produced the strongest returns.

Additionally, they could spend several quarters or a year outside of their allocation targets depending on how long public markets are disconnected from private market valuations. This could result in the compounding of asset classes outside the fund’s risk tolerance and therefore material distortions to the portfolio, exposing it to excessive risk over time.

2. Widen target allocation thresholds

Following the Global Financial Crisis in 2008, an approach investors took to mitigate the denominator effect was rewriting their investment policy statements to be more flexible by allowing for wider target allocation thresholds. Applying a wider threshold to a target allocation is one portfolio rebalancing mechanism that can help investors weather market volatility and avoid selling off their assets.

However, as described above, staying outside a target allocation for an extended time horizon impacts the entire risk-return and liquidity profile of a portfolio, and can increase an investor’s exposure to riskier asset classes. It also requires allocators to get approval to change their investment policy statement, which is easier said than done. Many institutional investors have boards with strict views on their allocation policies.
 

How widening target allocation bands can mitigate the denominator effect

3. Pull back on forward commitments

Some allocators are finding that their prior commitment schedule might be too aggressive, with less capital available than previously thought for new commitments, and therefore, they may choose to pull back on forward commitments to manage the denominator effect.

Allocators looking to adjust their commitment schedule have several options. They could choose to forego commitments to new or emerging managers, and only re-up with existing managers. They could also decide to keep the same number of commitments they had planned but write much smaller checks. According to our Global Fundraising Report, both options were popular paths for allocators in 2022.

Ultimately, the question for allocators is how much to pull back, or whether pulling back at all is the best course of action. Historically, institutional investors who pause or sell their private market investments during market dislocations find themselves increasing commitments and exposure to vintage years with inferior returns than those in which they sat out or sold.

Instead, investors looking to reassess their current commitment schedules could benefit from using cash flow forecasting and commitment pacing models to stress test their portfolios and manage target allocations during the market downturn. Knowing the expected cash flows of contributions, distributions, and NAV alongside commitment schedules can help investors to manage the liquidity of their portfolio and make informed commitment schedules on a recurring basis.

4. Sell assets on the secondary market

Allocators can also choose to sell their private market stakes through LP-led secondaries, or transactions in which an LP sells their fund interests to another LP. And many investors are choosing this path—according to a recent Jeffries report, roughly 48% of institutional investors selling secondaries in the first half of 2022 were first-time sellers, as LPs sought to remedy overallocation by selling off assets.

In addition to providing a supportive tool for portfolio rebalancing, the secondary market provides institutional investors with liquidity, and many allocators are eager to have more cash on hand because of fewer fund distributions.

But the rising number of LP sellers has caused price declines in the secondary market. Jefferies reported that LPs were only able to sell their PE assets at an average of 81% of net asset value in 2022—a sharp decline from 92% of NAV in 2021. This means allocators turning to the secondary market will likely be selling at a significant discount.

However, if investors sell their private market stakes with vintage years before 2022 and reinvest their money into newer funds, they could have the potential to experience the superior returns from funds formed in recessionary years. For some allocators, it’s more advantageous to capitalize on the attractive pricing in the market today than to avoid selling assets at a discount.

These are just some of the portfolio balancing strategies institutional investors can leverage to manage the denominator effect. Ultimately, allocators should assess their situation, stay strong in their long-term thinking and goals, and adjust their portfolios according to their unique needs—and those investors nimble enough to take advantage of current conditions should consider pursuing opportunistic investments.