Even as the denominator effect fades, LPs are tapped out

The dreaded denominator effect, which has been front of mind for LPs since last year, appears to have lost some of its bite more recently, sources have told us.

Public markets have improved, which is relieving overallocation issues for many LP institutions. As public market holdings increase, private equity’s percentage of an institution’s total investment fund shrinks. This has been occurring more recently, with the S&P 500 jumping 16 percent in the first half and the Nasdaq soaring by 32 percent, according to a Bain & Co half-year private equity report.

Many LPs chose to wait out their overexposure issues since last year, and that strategy appears to have paid off. “The denominator effect is getting erased,” an investor relations exec at a mid-market buyout firm told me.

As this pressure factor eases, the biggest concern on LPs’ minds is slowing distributions from a lack of exits. This is a result of the tough M&A environment, which is gummed up by higher interest rates and tighter lending.

As deals slow, so do exits, to some extent, as PE-to-PE sales is one of the big exit channels. The other is public markets, which have been shut since early last year. The third big exit path is large strategic buyers, but there are only so many of those to go around.

LP concern about distributions is borne out in a recent survey from Capstone Partners. The survey shows that 72 percent of LPs in North America have experienced lower distributions compared to last year. With less capital flowing back into LP coffers, capital calls have not slowed as much, the survey said, “putting further pressure on LPs’ ability to commit capital.”

This year, realizations are key, the survey said, reinforcing a point we’ve made here in this column. “Realizations are key even in established GP relationships, with the bar for new relationships remaining very high,” the survey said.

Some numbers around this from the survey:

• 38 percent of North American LP respondents are willing to commit to a fund when there’s been no realizations in the prior fund;
• 99 percent of North American LP respondents are willing to commit to new managers if the prior fund DPI is up to 0.5x;
• 18 percent of North American LPs expect “meaningful distributions” from the prior funds in re-ups

North American investors are more willing than their overseas counterparts to commit to a re-up with minimal DPI but want to see strong underlying portfolio performance, the survey said.

As GPs struggle to find exits, fundraising continues to fall. North American private equity funds collected $228 billion between January and June, down 26 percent from a year earlier. There’s also a steep drop in fund closing, totaling 347, down 45 percent, according to Buyouts’ data.

This malaise does not seem to be breaking, despite the scattered success stories of certain firms like CVC, Genstar, TA and Hellman & Friedman, which have all closed or are approaching targets in relatively routine fundraising time periods.

Sources recently have told us that LPs are mostly tapped out for the rest of the year, and are requesting fundraising GPs consider them for 2024. And even then, many LPs likely have their commitment schedules for next year set, setting the stage for another potential year of sluggish fundraising.

“It’s a traffic jam at the moment of managers, and very few LPs with money,” the IR professional told me.