Denominators & Markdowns in Private Equity - be careful what you wish for.

Rants and ravings: “denominator effect” & "markdown" special

As the financial press is now filled with articles about denominator effects & markdowns, we would like to recycle a piece we wrote for our internal newsletter about this topic. In a still festive spirit, sharing is caring.

Let's start with explaining the denominator effect and the consequences for private equity. Feel free to skip this part if you have seen it all before but to my shock, no press article really explains it in depth.

The denominator is nothing more though than the bottom figure in a fraction. For instance, 0.8 x or 80% is 8/10, with 8 being the numerator and 10 being the denominator.??

All of this is basic maths, even for me who has done only law school. But speaking of law, combine this with financial regulations and some statistics, and the fun has started.

From a statistical point of view, institutionals such as pension funds and endowments are the biggest allocators to private equity. We do not have reliable aggregate data but in large cap funds, for instance, easily up to 60 or 80% or more is held by institutionals such as pension funds, insurers, endowments and sovereign wealth funds. Many of these larger institutional allocators hold about 20% of their assets in private equity and debt, the rest being in public equity and debt.?

Let’s now add the financial regulatory point of view. This states that pension funds should always have, say, 80% of their assets liquid, in a mix of stocks and bonds and treasury paper in order to get a balanced, resilient portfolio. It is a bit more complicated than this but as a basic idea, this should do.

Fast forward to 2022. A perfect storm for as both the stock market and bonds went down.

So imagine you have a 100 billion pension fund portfolio conservatively balanced 10/90 in private/public markets.? That is 10/100 private + 90/100 listed. If your 90 to listed goes down by say 10%, you lose 9 billion. This makes your total of 100 billion go down to 91 and your listed to go down from 90 to 81. So you listed is suddenly 81/91 or about 89%.?

Now imagine the private equity part does remain equal and so stays at 10 billion. This means your private equity allocation is suddenly 10/91 or about 81%. In this case, about 1% of your portfolio or say 1 billion is where it shouldn’t be if you want to remain neatly in the 10/90 range.?In other terms, you have 1 billion in overexposure to private equity.

If you do the same exercise, on a 30/90 private public portfolio with a similar drop of 10% in the public portfolio, you need to shed about 2.26 billion in private equity if you want to go back to your 30/90. If you apply the famous 40/60 Yale model, a 10% drop in your public portfolio will need you to rebalance 2.55 billion USD. Awwch.?

For your entertainment, I made a little crude model (remember, I did law school):

Does this mean pension funds are forced to sell their overexposure in private equity?

Will this create massive discounts in the secondaries markets?

We started asking secondary fund specialists this question for the last two years.

Their answer was “probably not”. Every year, about 2% of private equity funds get churned over in secondaries. In critical circumstances like 2008 (Great Financial Crisis), that number went to 4%. There was definitely more offer than demand in 2008 so you could buy at very nice discounts. Many however pointed out that secondary funds raised massive amounts over the last two years so there is a lot of absorption capacity which means discounts will be lower if any.

Next to that, a lot of pension funds and endowments regretted having to sell assets in 2008-2010 that in hindsight performed better than listed alternatives. Also, why sell at a discount an 8 year old buyout fund at the moment the cash is coming back to you??

We think it’s more reasonable to assume that institutionals prefer to sit it out. Keep your existing positions and delay / decrease new allocations to new private equity funds raising right now. In the meantime, they just need to wait for the public markets to go up again, which will allow them to allocate again.?You can always sell a bit to simplify your portfolio but it is less trouble to simply stay put.

This is what we hear and see daily with buyout funds raising right now. The money is still there but it takes at least twice as long to fundraise.

This is of course great news for Top Tier Access Buyout 2 as fundraisers suddenly like us even more, or at least, that is what they tell us to our faces.

In all seriousness, the pace of fundraising was perhaps too frantic in the last years which makes this a more sane market. It also means harder questions are asked, also with regards to the fund size increase of the buyout funds.

At Top Tier Access, we are not complaining.

So, are you still with us?

Let us then go to the second part, which is whether private equity should mark itself down.

I have lost count of all the articles and opinion pieces stating private equity should mark down their portfolios. The thinking, broadly summarized, is that if the valuations of listed companies go down, then the same must be true of unlisted companies. So far, many private equity funds have barely marked down their portfolios.

Much ink has been spilled here already, so I will spare you my opinion. We do not have a dog in this fight anyway.

But let’s just assume that suddenly all the major private equity funds - Apollo, Ares, Apax, Blackstone, Carlyle, CVC, EQT, KKR, Thoma Bravo, TPG, Vista… the whole club (feel free to add more names) decide to write down their portfolios with, say, 20 percent.

Why? Just for the heck of it. And to finish this debate. Everyone can go back to their office, boardroom and spreadsheets. Time to crack on.

I followed suit (or the suits) and also went back to my trusted little spreadsheet. Here is a 20% markdown in private equity portfolios:

The conclusion is that all the pension funds really need to up their private equity positions! Rebalancing goes both ways after all.

Good news for investors following the Yale model (40 private / 60 private).

You can indulge in 2.79 more in private equity! Absolutely fabulous, darlings!

For all the private equity critics clamouring for mark downs, be careful what you wish for.

This being said, as a fund of fund, we would hate this to happen as it suits us just fine if institutional investors are dragging their proverbial feet. We like it this way. It is like commuting to work in the first week of the New Year. There is less traffic, it is nice and quiet and you get things done.

But shout-out to all major private equity houses.

Remember it was Top Tier Access who solved your little funding problem!

You know where to find us.