Private equity investors are familiar with the “denominator effect,” where fluctuations in broader portfolios influence private equity allocations. However, current market conditions, specifically declining distributions resulting in larger-than-expected unrealized portfolios, have created a related but different challenge: the “numerator effect.”

The Numerator Effect

Pacing, or determining how much to commit to private equity over a certain time period, is an essential consideration when determining annual allocations for a private equity portfolio. Given commitment dynamics, which are typically called over a two-to-five-year period and then distributed through the remainder of a fund’s life, investors must utilize historical averages to project total portfolio cash flows several years into the future.

The ”denominator effect” is a commonly cited challenge related to pacing. Essentially, the significant increase or decrease in the remainder of a total portfolio, most often equities, can result in under- or over-allocation to private equity, respectively, relative to a long-term target. This is, in large part, due to the lag in private equity valuations relative to the public market.

2022 through 2024 have been slow years for distributions relative to historical averages, following a record 2021, in large part due to increased interest rates, public market uncertainty, and a relatively closed IPO window. As depicted in Figure 1, exit value was lower in 2022 and 2023 than any year dating back to 2014, which is even more significant given that capital raised has increased materially over the past decade. This has resulted in the numerator, or private equity exposure, to remain higher than expected as instead of declining, the number has remained relatively flat or even increased due to unrealized appreciation. Thus, the “numerator effect” has become a frequent discussion related to investor portfolios.

Exit Count and Exit Value

Figure 1. Source: Pitchbook Q3 2024 U.S. PE Breakdown Summary

*As of September 30, 2024

Impact and Recommendations

As we begin 2025, investors are finalizing their pacing models and determining how much capital to commit to private equity for the year ahead. Given that many portfolios are currently over-allocated, one solution is to significantly reduce, or eliminate, new commitments during the year to decrease exposure and move closer to the target allocation.

While decisions should be contingent upon an investor’s specific circumstances, there are two potential downsides to the above decision:

• Vintage Year Diversification: Vintage year diversification is an essential component of a private equity portfolio. Given the long life of funds, timing “good” vintage years has proven to be difficult to impossible, as one must predict market conditions over a 10+ year period, from the investment phase through portfolio liquidation. Essentially, it is not possible to predict the cycle, and therefore investors should, whenever possible, allocate consistently across vintage years to mitigate this risk.

• High Distributions Following Low Distributions: Historical data from periods of low distributions, specifically the Dot-Com bubble and the Global Financial Crisis, show that periods of materially increased distributions have followed (Figure 2 and Figure 3). It should be noted that this situation does differ from those prior instances given that there has not been a sustained market downturn. With that said, given the maturity of portfolio companies in private equity funds, it is likely that General Partners will seek to exit mature companies when the market environment turns more favorable.

Distributions (% of Committed Capital) During the Global Financial Crisis

Figure 2. Source: Cambridge Associates and Fact Sheet, via Neuberger Berman

Distributions (% of Committed Capital) During the Dot-Com Bubble

Figure 3. Source: Cambridge Associates and Fact Sheet, via Neuberger Berman

2024 has represented an uptick in distributions, with exit value already exceeding the prior two calendar years through the first three quarters, with Q2 ($95.9 billion) and Q3 ($90.8 billion) representing the highest quarterly values since Q4 2021, creating optimism that distributions may continue this trend, and the “numerator effect” as a result will diminish in significance. However, if distributions do continue an upward trend, or do so in the future, investors that materially reduced commitments will likely find themselves under-allocated and playing catch-up over the next several years. Due to this dynamic, we recommend that, if policy constraints, portfolio dynamics, and liquidity allow for it, investors utilize long-term averages when determining 2025 allocations and beyond, even if this results in a temporary over-allocation to the asset class.

Sources

Figure 1: Pitchbook Q3 2024 US PE Breakdown Summary

Figures 2 & 3: Cambridge Associates and FactSet, via Neuberger Berman

Disclosures

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