What is the Denominator Effect, and why is it significant for institutional investors? Jeff Shell, BMO GAM’s Head of Alternatives, Commercial ESG & Innovation, breaks down the concept and provides insights into the secondary market for private assets.
What is the Denominator Effect?
You may have heard of the Denominator Effect, especially with respect to private assets. It refers to a situation in which the public holdings of a portfolio decline in value, while private assets’ values hold firm. As the public holdings drag down the overall value of your portfolio, the denominator – the relative weight of the private holdings – now represents a bigger slice of the pie.
Situations like this prompt certain questions. How can an asset owner (limited partner, or LP), who finds themselves overweight to a certain asset, rebalance? And secondly, why have private market valuations not changed in line with publicly traded assets?
Why the Denominator Effect matters for asset owners
For LPs, the Denominator Effect can cause private asset holdings to challenge the limit of their strategic weighting within the overall portfolio. However, rebalancing by selling private holdings can be challenging as they aren’t traded as easily as public equities and bonds. One option is the secondary market. There are large, sophisticated, specialty “secondaries” firms that will buy existing private holdings in funds or direct investments with the intention of holding them in secondaries funds, and other firms that serve an agency-type role to broker the sale of these holdings to interested buyers.
The secondary market process has prompted some debate about the integrity of private asset valuations, because when you examine secondaries’ values today, you’ll find that the clearing price is significantly lower than in recent history, and from that, some observers have concluded that private asset valuations may be inflated. Many general partners (GPs) have gone to great pains to explain their basis of valuation. Our view is that the primary driver of lower prices is simply supply and demand driven by the Denominator Effect – you’ve got lots of motivated sellers and fewer buyers to absorb the inventory, causing prices to drop.
How secondary markets work
The nuts-and-bolts of secondary market transactions can be complex, so let us consider two populations of potential sellers – institutional investors and asset owners (LPs, in this instance). Suppose an LP has a $2 billion book that they would like to rebalance to $1.5 billion. They will typically engage a secondaries specialist who will examine the portfolio’s holdings, determine what’s most attractive to them, and offer a bid, either on their own behalf or as an agent for another buyer. To determine what is most attractive to the bidder, they will start with what they are trying to accomplish. Bidders often bring a detailed, line-item understanding of what is in each fund, an advanced view of what each of these positions are worth (“bottom up”), and an opinion as to how well these positions complement their existing portfolio. They are unlikely to provide a competitive bid on assets, GPs, and sectors they don’t know, so finding a good match between seller and bidder is often a central challenge. The transaction is typically conducted in an auction process in which the seller chooses from a handful of secondaries bidders by employing a progressive filtering process to find a good match. In the current market, there can be a fairly wide spread between bid and ask prices for private assets, and provided they have flexibility, transactions may not close if the potential sellers believe the discount to value to be too great.
Similarly, with fewer private markets transactions happening this year, GPs who manage seasoned funds nearing their expected lifespan are feeling pressure to exit positions and return capital to LPs. This could require selling high-quality assets at depressed pricing, which would do a disservice to their LPs. In that case, one option they have is to buy time and hold on to those assets by launching a continuation vehicle—a new fund that ends up buying the position in question, providing the option for current LPs to stay in by putting their proceeds to work as investors in the continuation vehicle, and also serve as a valuable seed to build a new fund and attract new LPs. Our Alternatives team at BMO GAM approaches continuation vehicles with caution, in large part because of concerns arising from conflicts of interest. When the position is “sold”, or transferred to the new fund, the value of that asset is crystallized in the old fund. This can trigger a performance fee payout to the GP based on the value at which the asset is being transferred to the new fund, creating an incentive to push up value. In these cases, it is important for investors to look for conflict mitigants, such as investing alongside a sophisticated secondaries investor who can help establish value, and asking the GP to come along for the ride on the same basis, including requesting that they defer crystalizing performance fees of retiring funds.
Correlation between public and private markets
One noteworthy impact of the Denominator Effect is that it is increasing the correlation between public and private markets, at least temporarily.
Public vs. private valuations mismatch
Secondary pricing falls in 2022
Source: Preqin, Jefferies.
The chart on the left shows the Preqin Private Equity Index in comparison to the S&P 500. As you can see, the private equity index has stayed relatively consistent in a period when public markets have experienced a lot of volatility. However, if you examine the secondaries market, shown in the chart on the right, you can see that during the COVID period, there was a significant reduction in the value of secondaries positions, largely driven by the Denominator Effect. Is the private market index simply not representative of private assets’ true value? It’s not quite that simple.
The key questions are: does there need to be convergence in value between private and public markets, and what drives the value of these private assets? On convergence, historically, the culmination of success for a privately held company was “going public” to get access to deep public capital markets. However, capital formation through private markets is now greater than through public markets, and the majority of “exits” happen through sales to other private equity managers and strategic buyers (e.g., competitors). Furthermore, the private markets generally adopt a longer-run investment horizon, allowing for patient investing, where buyers often have five or so years to deploy committed capital, and once deployed, they may have more than a decade before they are compelled to sell. As a result of the lack of natural convergence, and the ability for the private markets to think about time differently than the public market investor, there can be more than temporary disagreements in value between private and public markets over a similar asset type. Of interest, where there are significant-in-the-moment disparities, we are seeing companies that have recently gone public being taken back private.
On value, let us consider private equity buy-out funds, where GPs principally raise capital and deploy it by buying controlling interests in privately held companies. Once owned, at a high enough level, there are only so many levers of value creation. One is financial engineering — the various methods a GP may employ to optimize the balance sheet of an acquired company, such as increasing leverage or lowering borrowing costs. Another is the valuation expansion that we’ve seen consistently over the last twenty years as low interest rates have created an environment where cash flow becomes increasingly valuable to investors. And finally, there’s GPs’ ability to improve the underlying value drivers of a company by improving the businesses in their portfolio — some combination of increasing revenue and reducing costs.
In this higher interest rate environment, we would expect financial engineering to not be a significant source of value creation, and our expectation is that in the coming years, valuation multiples will contract, not expand, as cash flows become less valuable relative to fixed income alternatives. This places a much higher emphasis on the basics — value creation driven by an improvement in the fundamental performance of the acquired companies. To get the full benefit of these improvements embedded in the exit value, we expect GPs to hold on to quality assets longer and be more inclined to launch continuation vehicles for the right reasons — not to crystalize carry, but because they don’t see eye-to-eye on value with the pool of buyers or they see greater growth and expansion opportunities for the business.
Looking ahead: outlook for secondary markets
Our belief is that over the next several years, the Denominator Effect will continue to drive inventory into the secondary market. That doesn’t necessarily provide insight into what private assets are worth – for the visible future, price and value may be disconnected. This highlights what happens when LPs and GPs who hold illiquid assets are forced to realize that value on a limited time horizon, and when the GPs toolbox gets restricted to fundamental value creation. We think there are very attractive opportunities in the secondaries market right now, especially for buyers who have the ability to narrow the aperture and conduct bottom-up valuation analysis (or those investing in their funds).
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