Times Change: The Era of the Private Equity Denominator Effect

After private equity’s extraordinary performance in 2021, private market valuations decoupled from those of both public equities and bonds in 2022. This led many institutional investors to end up over-allocated to private markets.

This is the so-called denominator effect, whereby private asset allocations exceed the percentage threshold established in an allocation policy and must be corrected. The simultaneous negative cash flow cycle has reduced anticipated liquidity that latent paper portfolio losses in traditional assets have already compressed. This makes portfolio adjustment decisions even more challenging.

Last year’s data show that the rebound in equity prices and the pause in interest rate hikes have provided some relief, but they have not solved the private market liquidity issue or addressed the denominator effect’s implications. Liquidity needs have led to a significant increase in 2023 limited partner (LP)-led secondary sales, according to recent Lazard research.

The economic paradigm may have changed and will remain uncertain. Given the potential for higher-for-longer interest rates, NAV staleness, and a negative cash flow cycle, the denominator effect may become more systematic in LP portfolios and force LPs to make more frequent allocation and liquidity decisions.

So, what are some traditional strategies for addressing the denominator effect in private equities, and are there other, more innovative and efficient risk-transfer approaches available today?

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The Current PE Denominator Effect

While 2021 was a year of extraordinary PE outperformance, 2022 was the real outlier as private markets showed unprecedented relative performance/valuation divergence from their public counterparts. A reverse divergence followed in 2023, with the highest negative return difference ever recorded, but it did not offset the current denominator effects.

According to Cliffwater research, PE returned 54% in 2021, compared with 42% for public equities. The following year, PE generated 21%, outperforming stocks by 36 percentage points. In 2023, however, PE returned only 0.8% compared with 17.5% for equities.

Impact of the Denominator Effect

For investors building up an allocation in PE who have not yet reached their target, the denominator effect, albeit painful from the standpoint of negative performance overall, could accelerate the optimal portfolio construction process.

For the (many) other investors with a near-to-optimal allocation, and a related overcommitment strategy, the emergence of the denominator effect traditionally implies the following:

Consequence  Negative Impact 
Reduced allocations to current and
possibly future vintages 
1. Lower future returns
2. Out-of-balance vintage diversification 
Smoothed compounding effect of
PE returns amid curtailed reinvestment
1. Lower returns 
Latent/potential negative risk premium of
the PE portfolio since NAV staleness, which protected
the downside, may limit the “upside elasticity”
that accompanies any market rebound.
1. Compromised risk diversification
2. Suboptimal asset allocation dynamics 
3. Potential impact on future return targets 
Crystallization of losses 1. Lower current returns 
2. Unbalanced vintage diversification 

Tackling the Denominator Effect 

Investors counter the denominator effect with various portfolio rebalancing strategies based on their specific targets, constraints, and obligations. Traditionally, they either wait or sell the assets in the secondary market. Recently introduced collateralized fund obligations (CFOs) have given investors an additional, if more complex, tool for taking on the denominator effect. 

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1. The Wait-and-See Strategy

Investors with well-informed boards and flexible governance could rebalance their overall portfolio allocation with this technique. Often, the wait-and-see strategy involves adopting wider target allocation bands and reducing future commitments to private funds. The former make market volatility more tolerable and reduce the need for automatic, policy-driven adjustments.

Of course, the wait-and-see strategy assumes that market valuations will mean revert and within a given time frame. Cash flow simulations under different scenarios and examinations of how various commitment pacing strategies can, in theory, navigate different market conditions. 

In practice, commitment pacing strategies are inherently rigid. Why? Because no change would be valid for stipulated commitments, legacy portfolio NAVs, and future cash flows thereof. Funding risk is a function of market risk, but private market participants have neglected this for two reasons: because of the secular abundance of liquidity and the cash flow–based valuation perspective, which has limited structural sensitivity to market risk. Internal rates of return (IRRs) and multiples can’t be compared with time-weighted traditional asset returns. Moreover, NAVs have historically carried uneven information about market risk since they are non-systematically marked to market across all funds. What does this mean? It indicates an unmeasured/implicit possibility that the existing stock of private asset investments is overvalued and that a negative risk premium could result with private asset valuations rebounding less acutely than those of public assets. 

According to Cliffwater commentary and analysis, data show that private equity delivered a significant negative risk premium in 2023. 

As of June 2022, the annual outperformance of PE vs. public stocks was worth 5.6 percentage points (11.4% – 5.8%), with excess performance of 12% and 36% for 2021 and 2022, respectively. The public markets rebounded through June 2023 by 17.5% compared with private equity’s 0.8%. As a consequence, the reported long-term trends are adjusted to 11% for PE and 6.2% for the public markets, and to 4.8% for the derived outperformance. Compared with the 17.5% of public stocks, there is a negative risk premium impact of 16.7% on the value of balance sheet assets for which long-term outperformance data do not matter. The allocation strategy is long term, but an actual PE portfolio’s valuation is not. Its true economics are a function of its actual liquidation and turnover terms. 

Patience may be neither mandatory nor beneficial. Whether to hold on to private assets should always be considered from the expected risk premium perspective. Notably, the consequent reduction in future commitments, associated with negative cash flow cycles, may further reduce the benefits of return compounding for private assets.

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2. The Secondary Sale Strategy

Investors may tap into secondary market liquidity by selling their private market stakes through LP-led secondaries, or an LP can sell its fund interests to another LP. Although this provided investors with liquidity and cash in hand, which is critical because of reduced fund distributions, in 2022, LPs could only sell their PE assets at an average of 81% of NAV, according to Jefferies.

By selling in the secondary market, allocators receive immediate liquidity but risk crystallizing the latent losses that stale NAVs may indicate. Selling in the secondary market facilitates portfolio rebalancing, but it also reduces the potential asset base for compounding private market returns.

3. Collateralized Fund Obligation (CFO) Strategy

If open to a slightly more sophisticated technology of asset-backed fixed-income derivation, investors may rebalance their portfolio allocation through a CFO structure. 

Fitch Ratings describes the technology as follows:

“In a private equity (PE) fund securitization, also known as a private equity Collateralized Fund Obligation (PE CFO), the transaction sponsor transfers limited partnership (LP) interests in private equity funds into a special purpose vehicle (SPV). The SPV then issues tranches of debt and equity that are sold to various investors, typically including a portion retained by the sponsor. Proceeds of the sale are used to pay the sponsor for the initial transfer of LP interests. Cash distributions from the underlying funds over time are used to pay for capital calls from the funds, the expenses of the SPV, interest, and principal of the notes, with the remainder going to the equity. The structure is similar to other structured finance transactions, whereby the senior notes benefit from the most credit enhancement, followed by more junior notes, with the equity absorbing any losses first. Some or all of the notes may be rated.”

By selling their assets to an SPV at the latest NAV valuation, allocators avoid bearing any upfront mark-to-market loss and obtain liquidity for part of the PE portfolio at the cost of the interest rates and spreads charged by capital market liquidity providers. These, in turn, are influenced by the quality of the mark-to-market of NAVs and by the cash flow cycle.

So, if a NAV is transferred at par but implicitly valued with secondary market discounts, say at 20%, then a 40% target loan-to-value (LTV) ratio, which is the percentage of the NAV that will be funded by debt, would actually mean funding for 32% (40% × 80%) of the CFO portfolio reference NAV. On the side, it’s worth noting that CFOs also increase the PE portfolio’s sensitivity to market risk, introducing the possibility of default/total loss if market conditions do not turn favorable.

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Redefining Portfolio Management: Transferring PE Risk 

Novel research has made it possible to frame private fund allocations in terms of expected returns in a multi-period temporal context, like any other asset class, rather than in the obsolete terms of IRR and multiples. This way, the risk of private fund allocation becomes fungible as an overlay to the physical allocations. The possibility of transferring risk allows for a radical redefinition of the contribution of private market investments in a multi-asset portfolio. 

Traditional money-weighted measures based on cash flow dynamics are limited by their lack of accurate comparability. To measure private fund performance, the application of time-weighted, duration-based (DARC2) yields provides a robust, forward-looking probabilistic framework. Private funds have forward, self-liquidating dynamics — only noncash commitments are immediate (spot) obligations. Contributions, distributions, and NAVs are future (forward) obligations and outcomes. DARC2 can generate a perfectly matching yield curve for any fund, portfolio, or index of private funds. Leveraging their time-weighted characteristics, the yields can be traded on the curve, with the advantages of a transparent comparability framework and a standardized OTC risk-transfer transaction process.

Currently, trading private funds implies that two parties agree on the spot value of a NAV — usually as of the quarter-end prior to the transaction date — adjusted to current market terms, with or without a discount deriving from negotiation, plus the residual obligations on the traded commitment. 

This process currently plays out without a generalized pricing framework in contrast to what should otherwise be available to both parties in order to define equitable trading terms. Because there is no way to set up a NAV to be exchanged in the future, term contracts cannot currently be used even if they could have offered better risk management possibilities. No one knows in advance how much cash will be drawn, what the NAV will be, or how much capital will have been distributed at a given future date. 

Instead, when private funds are modeled in probabilistic terms, they can be priced, compared, and traded over time and also across assets without any of the limitations that affect current private fund liquidity practices. As a consequence, using private fund yields, it is possible to arrange any risk transfer transaction on single funds, fund portfolios, and indices representative of direct fund allocations, spot and forward, and cross-asset allocation.

Risk transfer transactions are an innovative solution for private markets. They are currently chaperoned on a novel technology platform that provides valuation analytics and pricing information and facilitates counterparty discovery. Procedurally, institutional trading counterparties deal with underwriting financial institutions using existing banking relations. In fact, transactions are executed by relying on trusted banking intermediaries that can adopt standardized derivative protocols (ISDA) and credit collateralization. They are typically settled in cash.

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How Private Fund Risk Transfer Helps Reframe the Denominator Effect 

By trading private fund yields, investors can reshape their portfolio asset allocation. The first step is to transform the PE portfolio into yield curves to communicate returns in the time-weighted language that multi-asset and multi-period transactions require. 

A simplified swap transaction demonstrates the concept in the context of the global financial crisis (GFC). The returns of a portfolio of 2006 vintage buyout funds versus those of the S&P 500 index are depicted in the table below, with the since-inception compounded values and the year-on-year returns, while the chart displays since-inception annualized returns/yields for both the private fund portfolio and public market equity index.

Buyout Portfolio vs. S&P 500

Charts showing Buyout Portfolio vs. S&P 500 performance

Source: XTAL Markets, XTAL Strategies
Calculations performed using the DARC proprietary methodology on Preqin and Refinitiv data.

Using simplified calculations and hypotheses to show the impact and benefits of private fund derivatives, we simulate a swap transaction on 31 December 2008, between the returns of the Buyout Portfolio without price adjustments or discounts applied to the NAV at transaction date and the returns of the S&P 500 index. The swap transaction is thus equivalent to an investor selling the Buyout Portfolio and buying a position in an instrument paying S&P 500 returns as of 31 December 2008.

Buyout Portfolio vs. S&P 500 vs. Buyout Portfolio + Swap

Charts showing performance of Buyout Portfolio vs. S&P 500 vs. Buyout Portfolio + Swap

Source: XTAL Markets, XTAL Strategies
Calculations performed using the DARC proprietary methodology on Preqin and Refinitiv data. Indexed returns calculated using compound returns of the public market index from figure above. The effects of the swap strategy are taken into account as of 2009.

This allows the calculation of loss of risk premium that would have been followed by a decision of not trading the Buyout Portfolio, assuming no discount on NAV, against S&P 500 returns on 31 December 2008. The opportunity cost of the loss of risk premium would be quantified in 66.21 indexed points (233.06 – 166.86) or a cumulated additional 40% (233.06 / 166.86 – 1) above the performance of the standalone Buyout Portfolio.

This example does not imply that a buyer of the Buyout Portfolio returns would necessarily agree to start a swap transaction at par NAV. Rather, it highlights the opportunity cost of stale NAVs and of portfolio management inaction. In numbers, applying a 39% discount to the average 2008 NAV (estimated at 56% of the total value of the Buyout Portfolio) would reduce the loss of risk premium from 66.21 to 28.75 indexed points.

By adapting existing ISDA protocols, since the Buyout Portfolio is fully collateralized and self-liquidating, credit-worthy counterparties trading private fund yields can adjust their portfolio asset allocation efficiently and at limited cost, potentially increasing returns without giving up compounding benefits, managing market risk, and planning future liquidity needs with certainty. 

These results demonstrate the economic rationales for trading the risk premium expectations for both sides of the swap transaction. The greatest limitation so far has been the inability to determine a fungible and representative rate of return for private funds and compare expectations.

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Given future macroeconomic scenarios, including potentially higher-for-longer interest rates and prolonged negative cash flow cycles, the denominator effect may leave no room to delay decisions. This time is different. Investors will have to act to suit their needs. Technology and innovation can help investors navigate cash flow, valuation uncertainty, and the opportunity cost of a negative risk premium.

What worked in the past may now work better with a more efficient toolkit.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images / Rudenkoi

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