The Denominator Effect Isn’t Over Yet

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Welcome to Unlocking Liquidity, the podcast from PrimaryMarkets that brings the dynamic world of private capital to life. Each week, we dive into the trends, opportunities and challenges shaping today's investment landscape, from emerging asset classes and market innovation through to strategies for navigating liquidity in unlisted markets. Whether you're an experienced investor, a dealmaker, or simply curious about private markets, Unlocking Liquidity offers analysis and real-world insights to help you make sense of complexity and stay ahead of what's next.

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In today's episode, we explore why the denominator effect hasn't fully unwound, and what that means for liquidity, capital flows and investor behaviour across private markets. From slower exit environments and constrained distributions through to the rapid rise of secondary transactions, the impact is still being felt across institutional portfolios globally - including here in Australia.

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For sophisticated investors, this is not just a story about allocation pressure. It is a story about how private markets are evolving, how liquidity is being repriced, and where new opportunities may emerge for those with patient capital and access to structured transaction environments.

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For much of the past decade, private markets benefited from an environment defined by abundant liquidity, low interest rates and expanding valuations. Institutional investors steadily increased allocations to private equity, venture capital, infrastructure, private credit and other alternative assets as public market volatility remained manageable and traditional fixed income returns compressed. Large pension funds, family offices, sovereign wealth funds and sophisticated investors around the world embraced private markets as a core component of portfolio construction.

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Then conditions changed.

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The sharp repricing of public markets that began in 2022 created a structural imbalance across institutional portfolios. Public equities and listed fixed income assets declined materially while private market valuations adjusted more slowly. The result was a dramatic increase in the relative weighting of private assets within many institutional portfolios. Investors who believed they had prudent private market exposure suddenly found themselves overallocated without making a single new investment.

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This phenomenon became widely known as the denominator effect.

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At first, many market participants treated the denominator effect as a temporary disruption. The expectation was that public markets would recover, private market valuations would normalise and capital flows would eventually stabilise. Yet several years later, the effects are still shaping institutional behaviour, liquidity conditions and transaction activity across global private markets.

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Importantly, the denominator effect is no longer simply about portfolio mathematics. It has evolved into a broader liquidity issue affecting capital raising, secondary transactions, exit timelines, valuation expectations and investor psychology. For investors operating in unlisted markets, understanding why the denominator effect persists is increasingly important.

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The denominator effect may not dominate financial headlines in the same way it did during the initial market correction, but its influence remains deeply embedded within private market activity.

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At its core, the denominator effect is relatively simple.

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Institutional portfolios are generally managed according to target allocation ranges. A superannuation fund, pension fund or endowment may target, for example, a 20 percent allocation to private markets, 40 percent to public equities and the remainder to fixed income and other assets.

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When public markets fall sharply, the total value of the portfolio declines. If private asset valuations do not fall at the same speed, private assets automatically become a larger percentage of the total portfolio.

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The denominator has shrunk.

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Even if the actual value of private holdings remains unchanged, their weighting increases relative to the rest of the portfolio. This can push investors above mandated allocation limits or internal risk tolerances.

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The implications are significant because private assets are inherently illiquid. Unlike listed securities, they cannot easily be sold to rebalance exposures. Investors therefore respond by slowing or pausing new commitments, reducing deployment activity or seeking liquidity through secondary markets.

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This dynamic became highly visible during the post-2022 environment as public market declines collided with historically large institutional allocations to private markets.

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What initially appeared to be a cyclical issue has since become a more structural adjustment process.

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One of the reasons the denominator effect remains relevant is that the recovery process has been uneven.

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Public markets have experienced periods of rebound, particularly within large technology stocks and select growth sectors, yet many private market portfolios continue to face slower valuation resets and delayed liquidity events. The return of capital to investors through IPOs, trade sales and recapitalisations has not fully normalised.

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This matters because distributions are the engine that sustains private market allocation cycles.

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Institutional investors rely on realised exits to recycle capital into new opportunities. When exits slow, liquidity tightens. Investors become more selective about new commitments even if they remain supportive of private markets over the long term.

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In many cases, the issue is less about confidence in private assets and more about portfolio management discipline.

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A pension fund may still believe strongly in private equity or infrastructure as an asset class, but if distributions have slowed and private allocations remain elevated relative to policy targets, it may have little flexibility to increase exposure.

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Higher interest rates have reinforced this dynamic.

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During the low-rate era, cheap leverage supported elevated acquisition multiples, strong M&A activity and favourable refinancing conditions. As interest rates rose globally, financing conditions tightened materially. Buyers became more cautious, debt costs increased and valuation expectations between sellers and buyers diverged.

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This has created an exit bottleneck across many private market segments.

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Assets that may have been sold relatively easily during 2021 or early 2022 are now taking longer to transact. Some managers have delayed exits in the hope that pricing conditions improve. Others have explored continuation vehicles, structured liquidity solutions or secondary transactions to provide partial liquidity.

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The longer exits remain delayed, the longer the denominator effect lingers.

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One of the clearest consequences of the denominator effect has been the continued growth of private market secondary activity.

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Secondary markets were once viewed primarily as niche liquidity tools used during periods of financial stress. Today they are increasingly becoming a mainstream portfolio management mechanism.

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Institutional investors facing allocation pressure have turned to secondary sales to rebalance portfolios, reduce unfunded commitments or generate liquidity. This has accelerated demand for structured secondary solutions across private equity, venture capital and private credit.

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At the same time, specialist secondary buyers have expanded rapidly.

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For sophisticated investors with available capital, secondary markets can present attractive opportunities. Investors may gain exposure to mature portfolios, shortened duration profiles and discounted entry valuations relative to traditional primary commitments.

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The denominator effect has therefore created both constraints and opportunities.

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Some investors are liquidity sellers. Others are liquidity providers.

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This shift is particularly relevant in private markets because liquidity itself has become increasingly valuable.

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In Australia, interest in secondary market solutions has also increased as institutional investors, family offices and sophisticated investors seek greater flexibility around private asset exposure. Platforms facilitating structured private transactions and managed secondary activity are becoming more important as investors look for ways to navigate extended holding periods.

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Australia provides an interesting case study because of the scale of its superannuation system and its growing allocation to private assets.

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Large Australian super funds have become significant investors across global private equity, infrastructure, property and private credit markets. Over many years, these allocations delivered diversification benefits and strong long-term returns.

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However, the denominator effect has forced many institutions globally, including some Australian investors, to reassess liquidity management frameworks.

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Australian super funds are in a relatively strong position compared with many global pension systems because of ongoing compulsory contributions and positive long-term cash inflows. Nevertheless, allocation management still matters.

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When public markets decline or private assets become difficult to realise, portfolio flexibility narrows.

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Several large Australian institutional investors have increasingly focused on liquidity stress testing, portfolio pacing models and selective commitment strategies in response to changing market conditions. There has also been greater scrutiny around valuation transparency, liquidity assumptions and private market concentration risk.

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Importantly, Australia's sophisticated investor ecosystem continues to mature.

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Private market participation is no longer limited to large institutions. Family offices, wholesale investors and sophisticated individuals are increasingly participating directly in unlisted opportunities, secondary transactions and private capital raisings.

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As this investor base expands, understanding liquidity dynamics becomes increasingly important.

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The denominator effect is ultimately a reminder that private market investing requires patience, capital planning and realistic expectations around liquidity.

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The denominator effect has arguably had one of its most visible impacts within venture capital.

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During the ultra-low-rate environment of 2020 and 2021, venture valuations expanded rapidly. Capital availability surged, funding rounds accelerated and many companies raised capital at historically elevated multiples.

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When interest rates rose and public technology valuations corrected, private venture markets faced a delayed adjustment process.

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Many institutional investors reduced or paused new venture commitments as portfolio allocation pressures intensified. At the same time, IPO markets weakened significantly, reducing exit opportunities for later-stage venture-backed companies.

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This created a difficult environment for both managers and founders.

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Companies that expected near-term public listings often needed additional private funding. Investors became more selective around deployment. Down rounds became more common. Fundraising timelines lengthened.

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Yet despite these pressures, venture capital activity has not disappeared.

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Instead, the market has become more disciplined.

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Sophisticated investors are placing greater emphasis on capital efficiency, realistic valuations, governance quality and sustainable business models rather than growth at any cost.

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In many respects, the denominator effect has accelerated a broader normalisation process within venture markets.

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Private credit has often been viewed as a relative beneficiary of higher interest rates because floating-rate structures can improve yields.

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However, private credit markets are not insulated from denominator-related pressures.

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Institutional investors facing liquidity constraints may still reduce commitments to private credit strategies even if the underlying asset class remains attractive. At the same time, slower M&A activity can reduce deal origination volumes while refinancing risk increases for some borrowers.

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There is also growing focus on liquidity mismatch.

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Some investors entered private credit expecting relatively stable returns and lower volatility compared with public markets. Yet liquidity conditions become more important during periods of market stress or when investor redemptions increase.

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Secondary trading in private credit portfolios has therefore expanded as investors seek flexibility.

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This trend reinforces a broader point.

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The denominator effect is not isolated to one asset class. It influences the entire private capital ecosystem.

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Perhaps the most important long-term consequence of the denominator effect is that liquidity itself is being repriced.

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For many years, investors were comfortable accepting illiquidity in exchange for the potential for higher returns. In a stable or rising market environment, this trade-off appeared manageable.

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But periods of stress expose the true value of liquidity.

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Investors increasingly want optionality.

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This does not mean private markets are becoming less attractive. In fact, many institutional investors continue to view private assets as essential components of long-term portfolio construction.

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However, investors are becoming more thoughtful about pacing, duration and liquidity management.

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There is growing demand for structures that provide greater flexibility around exits, partial liquidity and portfolio rebalancing. Secondary markets, continuation vehicles and structured liquidity programmes are all evolving in response.

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This is one reason why organised secondary trading environments in unlisted markets are becoming increasingly relevant.

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Liquidity in private markets does not necessarily require a public listing. It requires structure, governance, participant confidence and efficient transaction mechanisms.

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As private markets continue to mature, structured liquidity solutions are likely to play a larger role in capital formation and shareholder management.

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For sophisticated and wholesale investors, the persistence of the denominator effect creates both risks and opportunities.

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The risks are relatively clear.

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Extended holding periods, slower exits and valuation uncertainty can all affect portfolio construction. Investors who require short-term liquidity may find private assets more difficult to manage during periods of stress.

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Yet opportunities are also emerging.

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Periods of constrained liquidity often create pricing inefficiencies. Secondary opportunities may become available at attractive valuations. Companies seeking structured liquidity solutions may offer differentiated transaction opportunities. Managers with patient capital and disciplined underwriting may gain access to stronger terms and higher-quality assets.

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Importantly, investor behaviour is also shifting.

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Rather than pursuing maximum exposure during periods of market optimism, many sophisticated investors are increasingly focusing on portfolio resilience, diversification and liquidity planning.

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This is arguably a healthier long-term foundation for private market investing.

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The era of assuming permanently abundant liquidity has ended.

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Private markets are adapting to a more disciplined environment where capital efficiency, governance quality and liquidity management matter more.

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One mistake investors can make is viewing the denominator effect purely as a temporary anomaly.

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While the initial trigger may have been the sharp public market correction beginning in 2022, the broader consequences are reshaping how institutional investors approach private assets.

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The experience exposed vulnerabilities in portfolio construction assumptions that had developed during an unusually accommodative monetary period.

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Many investors discovered that private market allocations can expand rapidly during periods of public market stress while liquidity simultaneously contracts.

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That lesson is unlikely to be forgotten quickly.

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As a result, future private market cycles may involve more active liquidity management, wider allocation bands, larger secondary market participation and greater emphasis on structured transaction environments.

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In many ways, the denominator effect is accelerating the institutionalisation of private market liquidity.

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This has important implications for platforms facilitating private transactions and shareholder liquidity solutions.

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Companies, fund managers and investors increasingly recognise that organised liquidity mechanisms can provide strategic advantages even before a public listing event.

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For unlisted companies, shareholder liquidity is no longer viewed purely as a late-stage IPO issue. It is increasingly becoming part of broader capital management strategy.

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The denominator effect may no longer dominate headlines, but it remains highly relevant across global private markets.

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Its persistence reflects more than simple allocation mathematics. It reflects a market environment where liquidity is tighter, exits are slower, valuation discipline has returned and institutional investors are reassessing how they manage private asset exposure.

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For sophisticated investors, this environment requires patience, selectivity and a clear understanding of liquidity dynamics.

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At the same time, it also creates opportunity.

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Periods of market dislocation often reshape how capital flows through financial markets. Investors with available liquidity, disciplined underwriting standards and access to structured transaction environments may be well positioned as private market activity continues to evolve.

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The denominator effect is therefore not simply a story about constraints.

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It is also a story about how private markets are maturing.

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Liquidity in private markets is becoming more organised, more structured and more strategic. As institutional investors, companies and sophisticated investors adapt to this new environment, the role of secondary transactions and structured liquidity solutions is likely to become increasingly important.

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The denominator effect is not over yet.

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And neither is the evolution of private markets.

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And that brings us to the end of this episode of Unlocking Liquidity. Thanks for spending your time with us, we hope today's conversation gave you a fresh perspective on private markets and how liquidity is evolving. If you enjoyed the episode, please follow or subscribe wherever you listen, and feel free to share it with someone who'd get value from it. For more insights, opportunities and episodes, visit PrimaryMarkets.com. Until next time, thanks for listening, and we'll see you in the next conversation.