Free CFA Level III: Private Markets Private Investments & Structures Practice Questions

B is correct. The denominator effect occurs when the total portfolio value (the denominator in the allocation percentage calculation) declines due to public market losses, while private market NAVs are based on lagged appraisals and adjust more slowly. This causes the PE allocation percentage to rise above the target, even though the PE portfolio value may have also declined in economic terms. This can force investors to reduce new commitments or sell PE positions on the secondary market.

A is incorrect. The reduction in active portfolio companies is a normal part of the fund lifecycle (the harvest period), not the denominator effect.

C is incorrect. Fee compounding is a separate consideration in PE fund economics. The denominator effect specifically relates to the mechanical impact of changes in total portfolio value on allocation percentages.

C is correct. The J-curve effect describes the typical pattern of private equity fund returns: negative IRR in early years because management fees and organizational costs are charged against a small base of invested capital before the portfolio companies have had time to generate value. As companies mature and are exited at gains in later years, cumulative returns improve, producing a J-shaped return curve over time.

B is incorrect. The J-curve does not describe a decline in the final years. While some "tail-end" assets may be sold at discounts during fund wind-down, this is separate from the J-curve concept.

A is incorrect. This describes vintage year variation, not the J-curve. The J-curve is a within-fund temporal pattern, not a cross-vintage phenomenon.

A is correct. Vintage year diversification spreads capital deployment across multiple economic cycles. Funds raised in different years deploy capital at different valuation environments and exit in different market conditions. This reduces the risk that an entire PE allocation enters at peak valuations (leading to poor returns) or is forced to exit during market downturns.

B is incorrect. While vintage year diversification can smooth the aggregate cash flow profile (mature fund distributions partially offset early fund capital calls), it does not eliminate the J-curve effect. Each individual fund still exhibits its own J-curve. The smoother cash flow profile is a benefit, but it is a consequence of overlapping fund lifecycles, not an elimination of the J-curve.

C is incorrect. There is no guarantee that aggregate IRR converges to public market returns. PE returns vary significantly by vintage year, manager skill, and strategy. The purpose of diversification is to reduce dispersion and concentration risk, not to guarantee convergence to a benchmark.