Private Equity Faces Numerator Effect After Lack of Exits

When the Federal Reserve kicked off its rate hikes, markets took a dive, and private equity was forced to reckon with the denominator effect: limited partners’ total portfolios had lost more value relative to their illiquid private equity holdings, so their percentage allocation to private equity jumped above their pre-determined targets.

In such a scenario, new commitments become more challenging to obtain for firms actively fundraising. If the asset class is broadly overallocated, there are fewer new dollars to go around.

The recent market rebound has largely alleviated that particular concern, but private markets dynamics have opened up another potential sticking point for firms and their investors.

Heading into 2024, there’s a chance that the so-called numerator effect comes into play. In such a scenario, private equity’s total value in the portfolio rises relatively more than an investor’s other holdings (like public equities, fixed income, etc.).

The end result is the same — limited partners become over-allocated to private equity and are forced to reign in new commitments.


Why Is This a Problem Now?

The reason this is a concern isn’t because private equity-backed companies have seen runaway valuation growth relative to everything else. Rather, firms have had a difficult time securing favorable exits for their existing portfolio companies. That’s led to longer fund lifecycles and a lack of distributions back to their LPs.

Data compiled by Bloomberg show that private equity firms’ asset sales as a percentage of their new investments dropped below 40 percent for each of the last three years. That hasn’t happened since 2009.

With firms loathe to mark down their existing holdings, largely stable asset values combine with both new investments and the lack of distributions to push private equity’s allocation above the level that LPs want.

It’s quickly becoming a problem for firms hoping to raise their next fund. And, even if they don’t run up against the issue of overallocated LPs, those LPs will still be hesitant to re-up their commitment without having first seen meaningful cash returned from previous funds.


Market Dynamics

The past year has been a story of valuation mismatch, with sellers’ price expectations stuck at elevated levels and buyers unable to make the returns math work (for those prices) at current interest rates.

So far, sellers have generally opted to hold out for better days, kicking the can down the road in hopes of a future exit in an improved market. Alternatives like continuation funds or GP-led secondaries have also become more popular.

At some point, however, investors will have to face reality and pick up the pace of portfolio exits. That time might be coming soon — activity has ramped up early in the year as firms prepare to test the market with new first-half processes.

Sam Hillier

Sam Hillier is a reporter at Transacted covering private equity and investment banking. He previously spent time as an investment professional focused on direct buyouts, as well as an earlier strategic advisory stint.

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