News & Analysis

In a packed hot yoga class last Friday morning in downtown Seattle, the woman next to me launched into a forearm stand, her legs dangling in the air above my head. With nowhere to move but the far edge of my mat, I willed her to avoid toppling onto me. After a minute or two, the instructor cued our descent; my neighbor floated her legs back to the mat with ease and met the rest of us in downward dog.

Like a yogi's inversion, the act of portfolio balancing requires years of experience and strategy to look effortless and produce the intended result. Amid inflation, rising interest rates, geopolitical turmoil and the buzzy denominator effect, this balancing act requires even more fortitude to avoid a hard landing, especially if asset values tumble in the new year.
 

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In 2022, steep losses in the public markets shrank the value of the public portion of institutional portfolios, and as private markets continued to see strong returns, private market allocations suddenly comprised a much larger piece of the pie.

In the wake of these threats to institutional portfolio balance, some investors are turning to the secondaries market to steady the teetering through LP-led transactions. Institutions are crawling back into equilibrium, and there are infinite ways this could play out.

Here are three ways LPs could find their balance.

Try a modified pose

Private-market returns aren't going to magically drop enough to rebalance an over-allocated portfolio without some outside intervention.

Some institutions are bringing their portfolios back into alignment by increasing their target allocations to the private markets, which helps them remain in-policy. Last year, Calpers increased its private equity target from 8% of the total fund portfolio to 13%, IPERS upped its PE goals by 4%, and the Employees Retirement System of Texas knocked its PE target 3 percentage points.

Raising target private asset allocations gives institutions a bit more wiggle room to either commit a bit more capital to the private markets or avoid selling off a bulk of their private market assets. For an institution with a skewed portfolio, this slight modification can help sidestep some panic this year.

Trust your core strength

Private market asset values will fall, meaning returns will fall, meaning the overall value of the private equity portions of institutional portfolios will fall back in line with the public market allotments.

Portfolios could also rebalance without any outside intervention if public equities rebound. Or public and private values could meet somewhere in the middle. Either way, it's unlikely LPs would be incentivized to flock to the secondary market to get out of their private market commitments if their portfolios are moving back onto more level ground anyway.

LPs could just hold on to their private market investments until a better market appears. Institutional investors understand the nature of their long-term commitments and aren't in dire need of liquidity.

But this wait-and-see approach has its pitfalls. LPs who hold on to assets for too long could be forgoing opportunities, like building new and stoking old relationships with managers or capitalizing on funds formed in a potential recessionary vintage year, which typically produce the strongest IRRs.

Grab a prop

The secondary market is a supportive tool for investors maneuvering portfolios within the confines of allocation targets. Institutional investors like public pension plans, endowments and foundations have boards that grant the go-ahead on any changes to the portfolio structure. Institutions that have perhaps pushed their boards to their limits on their levels of private market exposure are prime candidates for selling their extra or unwanted assets on the secondary market, because this act allows them to offload assets and make new investments without crossing the boundaries their boards have agreed on.

In its Global Secondary Market Review, Jefferies estimates that 48% of institutional investors selling secondaries in the first half of 2022 were first-time sellers, as LP sought to remedy overallocation by selling off assets. If LPs remain over-allocated to the private markets and see cash flow losses in their private equity programs, supply for the secondary market will likely boom.

If this scenario plays out, there's going to be a surge of LPs looking for liquidity options in 2023, Peter Martenson, managing director at Eaton Partners, Stifel Financial's fund placement subsidiary, told me. In early January, Eaton/Stifel surveyed 41 of the top secondary GPs, and three-quarters of the respondents said they expect LP-led secondary market volume to grow in the first half of 2023, citing liquidity needs, over-allocation to PE and the denominator effect as the top three driving forces.

Another driver of potential LP-led secondaries deal flow: LPs are re-evaluating the commitments they've made in the private markets over the past three to four years. They might decide that they no longer find certain sectors attractive, or they see stronger opportunities with other managers in other verticals. Whatever the reason, the secondary market poses a tempting option for LPs hoping to better position their portfolios in a challenging market environment.

For an institution with a strong foundation, all three scenarios are plausible and even favorable in their own ways. While each LP has its own strategy for navigating the turbulence, stability means having options for where and how to invest their assets. With some prudent moves—or patience—even the most overallocated LPs can find their balance.

Namaste.

Featured image by Chloe Ladwig/PitchBook News