Mar 4, 2023 - Economy

VC's "mythical" denominator effect, debated

Illustration of money in the shape of downward pointing arrows.

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.'"


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