WTF is the denominator effect?

The previous couple of weeks have simply been dreadful for asset managers. Not solely have the markets tanked the previous few weeks (if barely recovered from their lows for the reason that signing of the U.S. stimulus invoice), however the every day volatility of various property is making it very exhausting to maintain portfolios balanced. For instance, the important thing benchmark for oil is under $20 a barrel in the United States, rather a lot not seen in virtually twenty years.

So let’s discuss one thing that's fairly worrying for lots of VCs on this context: the so-called denominator impact.
Earlier than we get to what the denominator impact portends for VCs, let’s outline it. Within the restricted accomplice world, LPs are allocators of capital, which simply implies that they make investments cash in a group of property following a technique. For example, these LPs might need technique of one thing like: “I need 60% equities, and 40% bonds” or maybe one thing like “40% equities, 30% bonds, 10% VC, 10% hedge funds, and 10% pure assets.”
Each fund has its personal targets. Some funds want extra speedy liquidity to pay for operations (i.e. faculty endowments) whereas others focus way more on the longer term and don’t thoughts lengthy maintain durations on their property (i.e. sovereign wealth funds). The position of a portfolio supervisor is to put money into property in such a method as to match these aims.
As a part of working any portfolio, a fund supervisor commonly rebalances it to make it possible for the underlying property align with the chosen technique. In case you personally use a contemporary asset administration service like Wealthfront, then you might be already accustomed to this: each interval (which might be months, quarters, years, and many others.), the service transfers cash between your property to reset your portfolio again to its authentic technique. So if you'd like 60% shares, however your portfolio is at 70% proper now, the service will robotically promote 10% of these property in an effort to put money into different property.
The first fraction right here is (the capital inside an asset class) divided by (the entire capital of the portfolio). Sure, it’s actually basic math.
Right here’s the place it begins to get sophisticated although. Let’s say for illustration that you're managing a $1 million portfolio, and you've got 70% ($700,000) invested in NASDAQ, which is comparatively liquid, and the opposite 30% ($300,000) is invested in VC funds, that are extremely illiquid since they'll take ten years or extra to be returned to you.
Let’s say your fund was balanced as of February 19, when the NASDAQ hit an all-time excessive shut of 9,817.18. Since that point, NASDAQ has misplaced 20.57% in worth in line with Yahoo Finance. Which means your total portfolio is now price about $856,010, or $556,010 for equities and nonetheless $300,000 for VC.
Despite the fact that you haven’t elevated or decreased your funding in VC, your portfolio is now closely skewed towards that asset class. Equities signify $556,010 / $856,010 = ~65% of your portfolio, whereas VC now represents ~35%, up from the supposed 30% in your authentic technique.
Provided that skew, you need to rebalance … however you may’t. Since VC funds have a ten-year fund cycle (if not longer), you may’t merely promote some VC property and purchase equities to rebalance your portfolio. The portfolio supervisor is successfully caught.
That’s the “denominator impact” — a decline within the worth of 1 asset ought to end in different property being bought to correctly rebalance a portfolio, however many property like enterprise capital, personal fairness, actual property, pure assets and others will be fairly exhausting to promote within the short-to-medium time period.

Fractional possession

That’s the define of what the denominator impact is, however what does it imply in follow for VCs and in the end for founders?
For VCs, the large problem as we speak is that lots of their LPs are exactly within the state of affairs described above, with over-investment in VC as an asset class and an enormous liquidity crunch that they should work by way of. LPs need (or in some circumstances, should) scale down their VC investments in an effort to make their funds operate. Not solely will they reduce investments in new funds, they don’t even need to put money into the funds they've already dedicated to.
The irony right here is that given the declining valuations for lots of startups, that is exactly the time to speculate extra. That’s the elemental stress of the denominator impact — it isn’t about psychology or investor reticence pushed by worry, however somewhat strategic concerns which are rational for a fund’s key aims.
LPs have a few methods on the way to cope. One is that they generally have a little bit of flexibility with their common companions to attend out the storm, since they'll push them to decelerate the tempo of investing in an effort to scale back the quantity of capital calls. As well as, they'll halt the variety of new funds they put money into or simply stretch out the time it takes to make a brand new funding in an effort to unfold their investments extra evenly.
After which there may be the secondary market, during which LPs promote their VC fund stakes in an effort to safe liquidity — a sliver of a market, however one that's fairly attention-grabbing nonetheless. My colleague Connie Loizos talked a bit more about this angle last week, discovering that these transactions will take a while to be consummated whereas the market discovers what startups are presently price.
In brief, because of the denominator impact, LPs are going to do no matter they should do to rebalance their portfolios within the coming months. If the markets occur to quickly get well, they may shortly reopen their investments in VC and different various property. But when the markets keep bitter for longer, then anticipate additional downward gravitational pull on the VC asset class as portfolio managers reset their portfolios to the place they want them. It’s the tyranny of fifth grade arithmetic and a posh monetary system.

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