As Asset Prices Recover, Private Equity Investors Deal With the ‘Numerator Effect’

• Thanks to strong performance and other market forces, many investors are witnessing a “numerator effect” on their private equity portfolio allocations, with private equity weights rising more on a relative basis versus their other holdings.

• Investors may need to re-evaluate how they are diversifying their private equity allocations.

• We believe investors should consider middle market strategies via new commitments or secondary purchases to help counter concentration risk in their portfolios.

The decline of most asset classes in 2022 left private equity, which posted only modest unrealized losses, as an outlier. And as we commented in a 2023 paper, this created a “denominator effect” whereby institutional portfolios became overweight in buyout, venture capital, and related strategies versus other assets. For some investors, their portfolios are now experiencing a “numerator effect,” with private equity allocations rising more on a relative basis versus their other holdings. A variety of forces are driving this development.

First, the broad rally across markets in the successive 12 months erased most losses from the prior year, but private equity moved in stride, also recording considerable unrealized gains. Consequently, the discrepancy between asset classes continues – though now the overweight toward private equity is a result of outsized growth in the asset class, rather than the contraction of everything else. Welcome to the rise of the “numerator effect.”

A look at the two-year period from the start of 2021 through the end of 2023 shows little net decline for asset classes that are extremely sensitive to rising interest rates, such as real estate investment trusts (REITs) and high yield bonds. Considerable drops in the first half of this period were offset by a subsequent rebound. While those strategies recovered, private equity returns were propelled even higher, posting 44.9% growth during this three-year span, according to data from Preqin.1 That is a remarkable level of outperformance, exceeding 2,000 basis points versus public equities, the next-best asset class.2

Private Equity Has Strongly Outperformed Other Asset Classes Over the Past Two Years

Asset class performance: 1 January 2021 – 31 December 2023

Source: FactSet data including FTSE All World Index (equity); FTSE G7 Government Bond Index (government bonds); Markit iBoxx USD Liquid Investment Grade Index (investment grade credit); Bloomberg U.S. Treasury Inflation Protected Securities (TIPS) Index (inflation-linked bonds); Markit iBoxx Global Developed Markets Liquid High Yield Capped Index (high yield bonds); JPMorgan EMBI Global Core Index (emerging market debt); FTSE EPRA Nareit Global REITS Net Total Return Index (real estate); and LBMA Gold Price (gold). Private equity represented by Preqin Private Capital Quarterly Index.

Despite the growth in assets, the conversion of NAV into cash has declined

Institutional investors who committed to private equity funds are likely pleased to see the strong outperformance generated during a phase of market correction. However, the shrinking component of that return coming back as cash distributions may be a concern for some.

The appreciation of net asset value (NAV) is increasingly a result of markups directed by fund sponsors themselves. In 2016, limited partners received 30.6% of the NAV managed globally back via liquidity events. That percentage steadily fell over the subsequent seven years and ended 2023 at just 8.5% of NAV on an annualized basis. Though private equity demonstrated strong unrealized growth from 2021 through 2023, the pace of distributions shrank. The industry supported 24,000 buyout-backed companies at the start of 2021, but this had ballooned by 16.7% by the end of 2023, as 4,000 new companies were added to portfolios while most older investments remained in place.3

Annual Distributions Have Dropped as a Percent of NAV

Annual distributions as % of net asset value: 2000 – 2023

Source: Preqin database, Annual Distributed as ratio of Unrealized Value for all private equity as of 30 June 2023.

A reduction in liquidity would be less of an issue if it were not for the ceaseless calls for more capital from private equity firms worldwide. The combination of demand for investments in new funds with a slowdown in distributing cash from older vehicles has led to an acceleration of assets under management among general partners. Since 2000, the industry’s AUM has risen at a 14% compound annual growth rate (CAGR), but this has jumped to a 20% CAGR since 2018.4 Investors are absorbing an unprecedented rate of asset growth on their balance sheets.

Private Equity AUM Has Shot Up Since 2018

Global private equity assets under management: FY 2000 – 2Q 2023

Source: Preqin database, Assets Under Management for all private equity as of 30 June 2023.

The ‘numerator effect’ and its consequences

Institutional investors who find their programs overweighted toward private equity must start by asking if they truly want to reduce exposure to their best-performing asset class. Those who are reluctant to take any dramatic steps nonetheless also appear reluctant to grow their positions: Fundraising for new private equity funds has steadily declined from record highs in 2021 through an erosion of new commitments each quarter through fourth-quarter 2023.5 Limited partners are becoming increasingly vocal that general partners must prove their efficacy by selling assets in existing portfolios before they can expect to get fresh capital to build anew.

Fund Sizes Have Risen as the Amount of Funds Raised Dropped

Private equity fundraising: 1Q 2021 – 4Q 2023

Source: Preqin database, Private Capital Fundraising as of 31 December 2023.

The steep drop in fundraising has been accompanied by an unexpected counter-trend: The average amount of private equity funds raised is up considerably. In 2021, the average vehicle raised less than $300 million.6 Emerging managers found an eager audience ready to provide capital across all types of private market strategies. By the fourth quarter of 2023, according to Preqin, the average fund raised over $600 million in commitments. That doubling of size comes entirely at the expense of smaller, younger managers. Large cap managers with deep resources dedicated to raising capital were able to maintain the pressure on investors to renew their commitments to the latest vehicles. Smaller managers, who are often not core to an investment program, were not nearly as fortunate.

A decision to weight a portfolio further toward large cap managers may be deepening the problem. The groups least able to generate distributions are those most reliant on the capital markets. Large cap general partners that manage funds over $2 billion, which typically invest in companies with more than $250 million of enterprise value, are largely reliant on buoyant equity markets for IPOs or bond markets that allow other financial sponsors to conduct successive leveraged buyouts. In 2021, both routes provided ample opportunities to generate liquidity. In 2022, this changed sharply as new equity issuance evaporated and sponsor-to-sponsor transactions became much harder to finance, given tightening conditions for debt.

In the past two years, sales to strategic buyers represented nearly 80% of all exits, since these larger businesses are best able to pursue acquisitions without the need for new third-party financing. Middle market sponsors were able to take advantage of this narrow path to liquidity since their companies are often small enough to be easily digestible by larger strategic acquirers. Large cap funds, however, focus on companies whose enterprise value at exit can be many billions of dollars, making exits much more difficult given the limited number of larger companies that can pursue such a purchase. Without the release valve of distributions, the base of assets focused on large cap managers in institutional portfolios grew unabated, furthering the numerator effect.

Value of Private Equity Exits Declines

Private equity exit value by type

Source: Dealogic as of 31 December 2023.

A few years ago, investors started grumbling in earnest that general partners should find a way to exit or else abandon any expectation of new commitments. This pressure on general partners led to an unprecedented trend – the rise of general partner-led secondary transactions. Transactions to create continuation vehicles, which allow a fund manager to maintain control over one or more portfolio companies while providing limited partners with the option of selling their exposure to secondary buyers, accounted for just 4% of sponsor-backed exit volume in 2019.7 Four years later, this share of exits had tripled to 12%. Per data from Jefferies,8 the median equity value of single-asset deals of this type was $385 million, which is well into the large cap strategy for buyouts. General partners who control these bigger investments increasingly appear to be more interested in their own businesses than any other acquirers. This casts doubt on the valuations that are supposed to reflect the value of portfolio companies if sold to a third party.

GP-Led Secondary Transactions Have Shot Up as Exits Become Tougher

Continuation vehicles as % of total sponsor-backed exit volume

Source: Jefferies Private Capital Advisory, 2023 GP-Led Market Update, February 2024

Investors who decided to take an active approach to portfolio management may have unintentionally doubled-down on this portfolio concentration. Performance is not the key metric that sellers use to determine which assets to prune. Instead, relationships with general partners are often the first consideration. Institutions that spend many years developing connections with the biggest managers are loath to suddenly sell their commitments due to a transitory portfolio imbalance.

When limited partners initiated secondary sales in 2023, the most common assets sold were middle market buyout funds, according to a survey by Campbell Lutyens.9 Commitments made to these smaller funds may have been intended to generate alpha, but they are not core holdings, so they were the most likely to be jettisoned during a time of portfolio stress. This creates a unique opportunity for secondary buyers to direct their own vehicles into assets managed by smaller managers. Inadvertently, this may lead institutional investors to consider making larger commitments to secondary funds to make up for their lack of middle market exposure.

Middle Market Buyout Funds Dominated LP Secondary Sales in 2023

Types of funds sold in LP-led secondary transactions: FY 2023

Source: Campbell Lutyens 2023 Secondary Market Review (February 2024).

Resolving the numerator effect

The private equity markets need not apologize for their strong performance over the past few years. Yet this growth is creating consequences for investors and fund managers alike. The ramifications of the “numerator effect” are starting to become clear and will likely affect private equity portfolios into the foreseeable future. That said, investors who stay the course during this transitory period may be rewarded.

Trying to resolve the numerator effect by reducing new primary fund commitments and selectively selling older fund interests in the secondary market may have the inadvertent effect of further concentrating a portfolio in the assets that are causing the problem. To mitigate this imbalance, investors should consider the exact opposite approach by leaning into middle market strategies via new commitments or secondary purchases.