The denominator effect is a phenomenon in investment portfolios where the allocation of assets to specific asset classes or investments appears to decrease as a percentage of the total portfolio due to changes in the overall market value of the portfolio. 

When the market values of certain asset classes rise significantly, such as publicly traded stocks, the proportion of the portfolio allocated to other asset classes, like private equity or real estate, may appear to diminish, even if the actual amount invested in those asset classes remains constant.  This is because the denominator (the total market value of the portfolio) has increased, making the allocation percentages to other asset classes smaller and it can impact an investor's ability to maintain their desired asset allocation.

This can necessitate portfolio rebalancing to maintain the desired asset allocation and avoid unintentional deviations from the intended investment strategy. It is also sometimes referred to as the "private equity over-allocation problem."

The denominator effect is particularly relevant for institutional investors who have specific target allocations to various asset classes, as it may necessitate rebalancing their portfolios to align with their desired asset allocation. Failure to do so could result in a portfolio that deviates from the intended risk-return profile.

Limited Partners’ Overallocation in 2022

In 2022, many Limited Partners (LPs), including institutional investors like pension funds and endowments, found themselves facing an over-allocation issue in their private equity portfolios. 

This over-allocation was a result of the strong performance of public markets during that period, which led to an increase in the market values of their publicly traded assets, such as stocks and bonds. 

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As a consequence, the allocation to private equity, which is typically set as a percentage of the total portfolio, appeared to shrink in relative terms due to the denominator effect.

As public markets improved, LPs began to see the gap between their private equity allocation targets and actual allocations gradually closing.  

A 2023 survey conducted by Capstone Partners provided some key insights into this situation. The survey found that 72% of LPs reported experiencing lower distributions from their private equity investments in 2023 compared to the previous year. This lower distribution may be attributed to the lag in private equity returns catching up with the strong returns seen in public markets in 2022.

The Denominator Effect Long Term Outcomes

While the 2022 over-allocation process abates, there are long-term outcomes that can result from LP over-allocation.

1. Mismatched Diversification Goals: Institutional investors often have a target allocation to various asset classes, including equities, fixed income, real estate, and private equity, among others. These allocations are typically based on their investment objectives and risk tolerance. Private equity is considered an illiquid asset class because the capital invested is tied up for several years in private companies, and it's challenging to sell these investments on short notice.
2. Portfolio Rebalancing: To maintain their target allocation to private equity, institutional investors may need to buy more private equity investments or reduce other asset classes, which can be challenging. Buying more private equity may not be feasible due to limited opportunities or capital constraints, and selling other assets during market peaks may not be optimal from an investment perspective.

Failing to rebalance the portfolio to maintain the desired allocation to private equity can expose investors to risks. If the private equity allocation falls significantly below the target, the investor may miss out on the potential returns and diversification benefits that private equity can offer.

How Does the Denominator Effect Impact PE General Partners 

The denominator effect can impact General Partners GPs differently depending on whether the PE allocation is over or under. If the PE asset class is under-allocated, and LPs are looking to re-allocate, it can be a huge opportunity for a new fund. If the asset class is over-allocated, it can mean an even more competitive fundraising environment. 

With the private equity landscape becoming increasingly competitive, GPs are recognizing the need to establish stronger relationships with LPs.

Here are just a few reasons why GPs need to focus on their current LP relationships and extend their network to new LPs:

1. Differentiation: In a crowded market, GPs must differentiate themselves. Building rapport with LPs through transparent communication, alignment of interests, and demonstrating a track record of successful investments can set GPs apart from their competitors.
2. Repeat Investments: LPs often commit to multiple funds with GPs they trust. Maintaining strong relationships can lead to repeat investments in subsequent funds, providing GPs with a stable source of capital.
3. Co-Investment Opportunities: Collaborative relationships with LPs can open doors to co-investment opportunities, allowing GPs to deploy larger amounts of capital in promising deals.
4. Risk Mitigation: GPs and LPs share the risk in private equity investments. Effective communication and partnership can help navigate challenges and reduce potential conflicts.

The competitive nature of the private equity market necessitates that GPs actively engage with Limited Partners to secure capital, stand out in the market, and foster long-term partnerships that benefit both sides. 

‍Hear Directly from LPs on Fundraising in 2023

The denominator effect is a challenge faced by institutional investors who allocate capital to private equity.  Managing the denominator effect is an important consideration for investors with allocations to illiquid asset classes like private equity. 

In October 2023, Grata hosted a webinar with LPs from Steward Asset Management and MetLife where they shared tactical advice for a debut fund raise. Download the recording.