Email | Print    Type Size  -  +

Private equity's basic math problem

Investor Daily: A balancing problem is causing a selloff in private equity - and providing opportunity for a little-known subset of investors.

By Michael V. Copeland, senior writer
Last Updated: November 17, 2008: 9:15 AM ET

Hand-me-down shops
These are the firms buying up steeply discounted private equity shares from endowments, pension funds, and other firms.
  • Coller Capital: The London-based firm's latest secondaries fund, at $4.8 billion, is the industry's largest. Said to be interested in some of Lehman's private equity investments still on the market.
  • Lexington Partners: When Calpers restructured its private equity holdings early this year, Lexington was one of five buyers.
  • Saints Capital: This San Francisco-based firm focuses on buying up direct interests in private companies - like the shares that Paris-based Innovacom held in ten different outfits.

(Fortune Magazine) -- Not since fourth grade have so many sophisticated investors been so troubled by a basic math equation. An asset-allocation problem called the "denominator effect" is forcing the selloff of billions in private equity and alternative investments.

The problem is straightforward. Portfolio managers have strict guidelines for asset allocation (Harvard's endowment, for instance, is offloading $1.5 billion in private equity to get back to its 13% target.) As the public markets have collapsed and the prices of liquid assets have plummeted, the value of the overall portfolio, or the denominator, has shrunk.

But allocations to venture funds, buyouts, and real estate, which aren't priced often, have held - at least in theory. So a slice that once accounted for 10% of a portfolio now might suddenly account for 15%.

There are two things that fix the problem: a rising market for stocks or portfolio managers rebalancing by selling off the private-money investments.

The latter is starting to happen, with Harvard, Duke, and others unloading alternative-asset portfolios or portions of them. If they aren't already, say industry insiders, practically every big endowment or pension fund soon will be putting something up for sale.

The Great Unwinding of 2008 is providing opportunity for investors in the so-called private equity secondary market, an obscure corner of the private-money universe that trades preexisting commitments to alternative-asset funds.

By buying these castoff units, secondary-market investors hope to capture the higher returns of alternative assets, and because they can pick and choose among funds or even individual companies, they do it with slightly less risk.

Because the shares provide liquidity, they are typically discounted; in bad times, when everyone is scrambling for cash, they can get dirt cheap. Bids for shares in the top buyout funds have already fallen by almost 14% this year, according to NYPPEX, a Greenwich, Conn., secondary-markets advisor.

Secondary buyers are anticipating further write-downs and lower prices in coming months, especially for the sale of shares in firms like Blackstone (BX), Bain Capital, and others that from 2005 to 2007 paid huge multiples and used massive leverage for companies now in their portfolios.

Some buyers are bidding as little as 50 cents on the dollar; earlier this month, according to industry sources, Lehman Brothers sold part of its $3 billion private equity portfolio at a 50% discount.

As prices fall, the volume of these transactions is soaring. Larry Allen, managing member of NYPPEX, estimates that there will be some $27 billion in private equity secondary deals this year, up from $18 billion in 2007.

"We expect the volume to accelerate into 2009 for all kinds of alternative assets," he says. 'The buyers smell blood in the water."

Not sure how to invest as markets gyrate wildly from one day to the next? Ask us your investing question and we'll answer it in an upcoming Investor Daily. E-mail Fortune.  To top of page

Company Price Change % Change
Bank of America Corp... 16.15 0.00 0.00%
Facebook Inc 58.94 0.00 0.00%
General Electric Co 26.56 0.00 0.00%
Cisco Systems Inc 23.21 0.00 0.00%
Micron Technology In... 23.91 0.00 0.00%
Data as of Apr 17
Index Last Change % Change
Dow 16,408.54 -16.31 -0.10%
Nasdaq 4,095.52 9.29 0.23%
S&P 500 1,864.85 2.54 0.14%
Treasuries 2.72 0.08 3.19%
Data as of 4:29am ET
More Galleries
50 years of the Ford Mustang Take a drive down memory lane with our favorite photos of the car through the years. More
Cool cars from the New York Auto Show These are some of the most interesting new models and concept vehicles from the Big Apple's car show. More
8 CEOs who took a pay cut in 2013 Median CEO pay inched up 9% in 2013 to $13.9 million. But not everyone got a bump last year. Here are eight CEOs who missed out. More
Sponsors
Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.