The denominator effect is a way of describing the impact the crisis had on portfolios, especially those of large institutions such as endowments. As portfolios shrank during the crisis, the size of illiquid and potentially toxic assets relative to the entire portfolio, grew. Thus, while the denominator (portfolio) shrank, the numerator (illiquid assets) grew. In order to rebalance portfolios and regain desirable ratios of illiqiud assets to overall portfolio size, investors were forced to sell their illiquid assets – a difficult task in such markets.
Q. You say that lots of PE and RE funds managers are hearing this term these days?
A. Yes, its a very big issue now for major institutional investors and what they’re looking for in alternative investing. Basically, as a result of the denominator effect, they’re looking for more hedge funds and less PE/RE.
Q. OK, so what does it mean?
A. It refers to the impact of the crisis on portfolio composition. Because institutions’ endowments got much smaller (the “whole pie” shrank), the % of illiquids– the things they couldn’t sell, like PE and RE, became a much bigger percentage of the new pie. That is: the denominator got smaller, so the components of the numerator that didn’t get sold suddenly constituted a disproportionately high % of the total.
Q. And I think we have a chart that illustrates the idea…
A. Yes, here’s a simple example: “before” pie chart: allocation is a typical 2007 foundation allocation of 40-40-20 (stocks-PE/RE-bonds). For simplicity, assume stock portion lost 50% over 2008, bonds were flat, and the illiquids remained marked at cost. So, “after” the crash, the mix goes to 20-60-20 because of the denominator effect. Yikes!
Q. So, now they have to rebalance to get allocations back to where they want them.
A. Yes, but to do so requires shedding RE/PE, which is why a lot of distressed selling of PE/RE LP interests was/is going on. Also, institutions now understand that *liquid* alternatives are very important, driving more of them into hedge funds. All this explains why HF total allocations have surpassed previous peak, but PE/RE allocations have not.