In order to understand Denominator Effect and the Reverse Denominator Effect, this post will first review basic portfolio allocation and rebalancing, and then will briefly review fractions.
Portfolio Allocations and Rebalancing
Most investors will develop a portfolio investment strategy by allocating a portion of the portfolio to different investment classes (called “asset classes”) such as public equities (stocks), fixed income securities (bonds), real estate, cash and private equity. Investors may define asset classes differently and may allocate their portfolio across asset classes differently.
Let’s say an investor has $1 billion to invest. After working with their investment advisor, they have decided to create target allocations for their portfolio as follows: 40% to public equities, 40% to fixed income and 20% to private equity. (We’re keeping it simple here; most investors will allocate to more than 3 asset classes). These are target allocations – the actual values may vary from the target value.
The target allocation will look like this:
A fraction looks like this:
The top number is the numerator and the bottom number is the denominator.
Applying this to private equity, consider the value of an LP’s private equity portfolio compared to its entire portfolio of stocks, bonds and private equity. The fraction is as follows:
The Denominator Effect
As was stated at the outset, the denominator effect refers to private equity exceeding its target allocation due to the decline in value of other elements in the portfolio. This over-allocation may result in a rebalancing of the portfolio by selling some private equity investments.
To illustrate the denominator effect, let’s use an example. Assume that on 1/1/2008, an LP had $1 billion in assets under management and had a target allocation of 40% to public equity, 40% to fixed income, and 20% private equity. Let’s also assume that on 1/1/2008 the value of each asset class was exactly equal to the target allocation. This means the LP has the following holdings:
When target allocations are made, the intent is that if a component is not at its target allocation, then the portfolio must be adjusted, or “rebalanced” so that the target allocations can be obtained. This rebalancing is performed on a periodic basis.
A couple of other items that play into understanding the denominator effect. First reporting lag. Public equities and fixed income are traded and quoted continuously on public markets, and so their value can be easily determined at any time. Private equity investments are private, and the valuations are determined on a quarterly basis, and are typically provided to LPs 45 days after the end of the quarter, and 60 days after the end of a fiscal year. This means private equity valuations lags public market valuations considerably. The impact of this is that if public markets fall rapidly, an investor’s allocation to public equities and fixed income will also fall rapidly, but because private equity valuation lag, private equity valuation adjustments also lag. Second, because private equity valuations are not market-based, a number of factors are considered when a valuation for a privately-held company is conducted. These factors include the company’s valuation of the most recent financing round, how the company is progressing (technology development, revenue growth, customers, etc.), how publicly-traded comparable companies are trading, and other factors. The net result is that private equity valuations do not behave the same as public market valuations, and so if public markets decline significantly, private equity valuations may not decline very much at all.
Back to our example:
Assume that during 2008 the markets suffered significant declines, and the public equities and fixed income portfolios declined in value by 40%, while value of its private equity portfolio stayed flat. As shown in the table below, this means the value of the overall portfolio has declined to $680 million, a 32% decline. The impact of this is that the allocation to private equity has increased to 29.4%, significantly exceeding its target allocation of 20%. If the LP rebalances its portfolio at the end of each year, it may be forced to sell a significant portion of its private equity portfolio and use the proceeds to purchase public equity and fixed income to rebalance the portfolio. This actually happened to many LPs during the economic crisis of 2008-2009.
Reverse Denominator Effect
The reverse denominator effect occurs when the other asset classes in an LPs portfolio grow in value quickly, causing the private equity portfolio to fall below its target allocation.
Let’s now assume that 2008 is a great year for public stocks and fixed income, and these portfolios increase in value during the year by 30% each. Private equity has increased in value by 15% over the year. The table below shows the impact of this. Because the returns for public stocks and fixed income rose so much, the effect is that Private Equity is now below its target allocation and public stocks and fixed income are above their target allocations. If the LP rebalances at the end of the year, it will sell some of its public equity and fixed income portfolios and invest more in private equity. That the “reverse denominator effect.”
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