VC's "mythical" denominator effect

Illustration: Shoshana Gordon/Axios

A common refrain to venture capitalists contemplating raising new funds over the last year has been the so-called "denominator effect," which impacts limited partners' portfolio compositions.

Yes, but: Some VCs just aren't buying it. "The denominator effect is largely a mythical beast that was manufactured largely to kindly say, 'no, I don't want to invest in you,'" John Ruffolo, managing partner at Maverix Private Equity, said during a panel on Wednesday at this year's Upfront Summit.

  • And he wasn't alone — fellow panelists echoed his comments on stage, as did others privately to me at the conference.

The big picture: For the uninitiated, the so-called effect refers to the imbalance that a public market downturn creates when an asset allocator's overall portfolio shrinks, because of its equities holdings decreasing in value.

  • Suddenly, its private capital and venture holdings are much larger in proportion to the rest than they were previously.
  • "In the private markets … valuations are subjective and at managers’ discretion … and for many reasons people don’t necessarily want to mark things down," said Greycroft managing partner Dana Settle, speaking about the more opaque valuations of private portfolios.

Between the lines: The VCs' argument is that because private holdings remain artificially inflated in value (at least for a while), they create the appearance of a lopsided portfolio.

  • "When I see public markets going down on average 30% yet private equity is going up 15% it’s like, come on," Ruffolo said.
  • Cleo Capital managing director Sarah Kunst added that the allocation limits themselves are in a way "fake," though no investor is going to risk their job to prove that.

The other side: Naturally, LPs are insisting that the denominator effect is, in fact, very much real.

  • "Most people are slaves to their models," one fund-of-funds managing partner tells Axios, speaking about the pressure institutions face when allocations exceed their targets.
  • And some of this attitude from GPs is biased, he suggests. "If I lived in a 'heads-I-win, tails-you-lose' paradigm for 90% of my existence, I'd call bullshit on any prick of reality that might pierce my bubble of self-righteous comfort, too."

Still: Ruffolo did note that liquidity tightness is indeed a real challenge for institutions, especially those that have to balance payout pensions every month, for example.

The bottom line: "It's kind of like when you wake up really hungover and you're like, 'I'm never drinking again,'" the LP says. "That's where I feel like we've been for the last few quarters, but I might see people starting to loosen their tight grip and saying, 'maybe one beer won't kill me.'"

Source: Read Full Article