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What Is The Denominator Effect?

Posted on December 1, 2022 By

When it comes to selling your business, and you are considering waiting or pausing, there are several factors to consider, such as market conditions and interest rates. But there is also something called the denominator effect.  

The denominator effect is when the value of one part of the portfolio decreases substantially and drags down the overall value of the portfolio. Consequentially, any parts of the portfolio that did not decrease in value now represent a large portion of the
overall pie.  

It comes into play when asset allocators have diverse portfolios that are weighted toward specific assets. In a sell-off, these allocations can go off target, as some assets depreciate more than others. When this happens, investors must sell some assets to get the portfolio back on track.

In and of itself, the denominator effect does not negatively impact the other segments of the portfolio. However, in the context of institutional investing, when the denominator effect occurs, it is the private market holdings of limited partnership (LP) investors that generally increase in terms of portfolio sizing. This is because valuations for private markets funds are calculated on a lag compared to the LP’s public markets holdings, which are valued in real-time. 

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Private equity (PE) funds raise the majority of their money from institutional LPs, insurance companies, pension funds, and university endowments, among others. These groups put much of their investable funds into public equity markets. Those investments have taken a hit and are likely to continue to struggle throughout 2023. They can also be marked to market in real-time. This means that we know the dynamic value of that portfolio at any given time. Alternative investments such as venture capital and hedge funds cannot be easily marked to market. An approximate valuation is done quarterly, but the only real way to value an unrealized PE investment is to sell it. So, the value of those investments remains the same. When the public market portion goes down, it brings the value of the entire portfolio down. This means that the overall pie gets smaller, but the PE dollar value investment stays the same, so that slice gets bigger. As such, when funds go to raise their next round of funding, they find that LPs are less willing to commit, regardless of the fund’s performance. These groups have parameters that they need to stay within, and the PE portion is now over-allocated because of the denominator effect.

As the public markets slip into a bear market, pension plan investors have seen significant impacts on the valuations of their public market holdings. As a result, their private market holdings have ticked up as an overall percentage of their respective portfolios.

The public market holdings of pension plans will likely recover in value over time. But in the short term, the denominator effect has the potential to impact fundraising and new commitment activity for private market fund managers. Stringent governance and target allocation policies mean that LPs that are now over-allocated to the private markets cannot make new commitments that would push them farther beyond those limits.

Funds with a solid track record should find that fundraising is more challenging in the next year or two. Those without much of a track record will really struggle to pull together a fund. This means that if you are going to sell your company in the next few years, you are better off doing it sooner rather than later.

 

 

Schedule A Call

 

 

Americas: Sam Smoot at +1 (813) 898 2350 / Smoot@BenchmarkIntl.com

Europe: Michael Lawrie at +44 (0) 161 359 4400 / Enquiries@BenchmarkIntl.com

Africa: Anthony McCardle at +27 21 300 2055 / McCardle@BenchmarkIntl.com 

ABOUT BENCHMARK INTERNATIONAL:

Benchmark International is a global M&A firm that provides business owners with creative, value-maximizing solutions for growing and exiting their businesses. Benchmark International has handled over $8.25 billion in transaction value across various industries from offices across the world. With decades of M&A experience, Benchmark International’s transaction teams have assisted business owners with achieving their objectives and ensuring the continued growth of their businesses. The firm has also been named the Investment Banking Firm of the Year by The M&A Advisor and the #1 Sell-side, Privately Owned M&A Advisor in the World by Pitchbook’s Global League Tables.

Websitehttp://www.benchmarkintl.com
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