Superannuation funds struggle with private equity

Similarly to hedge funds, superannuation trustees have struggled to understand and allocate towards private equity — but the outlook remains positive.

Mike Taylor, managing editor, Super Review: Welcome everyone to this roundtable. As you know, the central topic is private equity.

And looking at private equity investment in the context of superannuation, it seems to me that it is not unlike, I guess, the situation with hedge fund investment five years ago.

There’s a lot of talk about investing and allocating towards private equity but, in fact, the levels of those allocations are still well below 10 per cent. So my question to the roundtable panel is, what is an appropriate level of investment by institutional superannuation funds in private equity?

Pauline Vamos, chief executive, Association of Superannuation Funds of Australia (ASFA): It’s an interesting question because, particularly with private equity, it opens up the whole question of the level of influence investors like superannuation funds want to have on their investment; so along the scale of being a steward at the business with private equity where you have a very clear and large vested interest — so you virtually are running the shop — to an ambivalent investor investing across the whole economy.

I’m not sure if that question has been answered, and I think the answer may be different for different funds, different sectors and different sizes.

Pierre Jond, chief executive officer, BNP Paribas: There’s another angle as well to consider. Okay, we see private equity as if it was a standard or a uniform type of asset, but under private equity you can have a very different economy called underlying investments.

You could have a tall road in Chile, you could have a forest in New Zealand, or you could have Silicon Valley types of companies that are not listed.

I think rather than saying this is private equity as such, you might want to consider one level deeper [which sort of] fundamentally economic assets you want to have exposure to. So breaking it down, you’re looking for infrastructure, for a particular sector, for the type of company.

Chris Adams: I think the other thing is that the recent financial crisis has shown that lots of private equity classes that were supposedly non-correlated with a list of assets actually were [correlated]. So in many cases, when one is investing, it’s much more about the liability side of the investment rather than the asset side of the investment and how it’s structured.

And certainly in response to what Pierre said, all of those kinds of things are important because in many ways private equity as a separate asset class is not as separate as people once thought in some cases — and if you think about the logic of the actual underlying asset, that shouldn’t come as an enormous surprise.

Daryl Crich, head of product and strategy, BNP Paribas: I think the range of allocations across the different super funds is interesting in itself because you have a very small allocation to a lot of the larger funds averaging around 10 per cent, but some are quite high, some are as high as 20 per cent, 30 per cent. I think that can indicate a couple of things.

One, that there is no industry consensus per se. You’ve got to realise that while it is an industry of super funds, it is also a very different mix of investment profiles and risk appetites within those funds based on member profiles and product profiles. And I think that’s a very complicating factor when you’re trying to look for a trend across such a broad spectrum of funds.

Pauline Vamos, ASFA: It also depends on the strategy, on how to engage with the asset class, because the larger funds clearly can take more of an active role in the asset, whereas the smaller funds will tend to just take a fund approach, so like in the other asset class.

That’s an important consideration as well, and it reflects that percentage when it comes to the whole portfolio.

Liquidity issues

Mike Taylor, Super Review:  One of the factors that emerged through 2008-09 where we’re looking at the global financial crisis and the general downturn was that when it came to liquidity, private equity, like a lot of things, is regarded by super fund trustees in large part as a highly illiquid investment — it’s not as if you can cash in your investment overnight and basically turn things around.

So I wonder, given the lessons that were learned a mere 18 months to two years ago, whether we should really expect Australian super funds to be enthusiastic about it at this point.

Pauline Vamos, ASFA: But I think they’re fairly short-term compared to other unlisted asset categories; private equity seems to be on a much shorter time horizon. So I don’t think there is a reason to shy away from it.

Bruce Russell: I think just from an operational perspective too — the clients that we’ve dealt with — some of the observations have been not only the liquidity but also the perceived lack of transparency that you have when you invest in private equity asset classes, and particularly around trying to measure your risk exposures from a market risk, from a counter-party risk, et cetera.

I know from a sort of chief operating officer’s perspective that there’s still probably a level of nervousness around [whether we can] properly monitor the risks and get transparency down to the underlying asset, because the very nature of the product is sometimes actually quite difficult.

Pauline Vamos, ASFA: I agree. And it’s not only the transparency, it’s the cost of managing the asset — you’re really managing a business.

And the further you are away from managing the business, the more guesses you have to make, and that certainly causes some of the smaller funds some concern because they can’t get close to the asset.

Queensland floods and infrastructure investment

Mike Taylor, Super Review: Because we are in part talking a lot about private equity in terms of infrastructure, I wonder whether given recent events in Australia, and the rebuilding that’s clearly now confronting the Commonwealth and the states, across three or four states as it happens, whether the whole private equity question and the infrastructure question becomes a matter of government policy more than it has been to date?

We were discussing before the roundtable began the fact that the Government is facing a problem which it didn’t budget for. So I wonder whether 2011 by default becomes a year in which super funds are very heavily encouraged to invest?

Pauline Vamos, ASFA: Well that encouragement has already started, and this has been on the table for quite some time.

But the big processes around infrastructure assets, and the lack of any certainty on risk as well as term, fundamentally is at odds with what most superannuation funds really are here to do.

And it also throws up the public policy issue [that] infrastructure in the main is the responsibility of state and federal governments. And that is their responsibility — you don’t turn that responsibility over to the private sector.

Chris Adams: We’re looking here from Europe at the devastation that’s happened in Brisbane and so on.

And I think where you’re talking about public infrastructure — bridges, roads, airports, terminals and things of this nature — what we’ve seen obviously in other locations, in the Middle East and to a certain degree in Europe, is the kinds of take or pay contracts where the state can intervene to a degree, but it does create an environment in which private investments can play a valuable part.

But as you say, I think the public policy needs to move in a certain direction decisively for it to be successful because, particularly with the super funds, with their trustees, there are certain types of responsibilities that they have.

I think obviously they’re going to be naturally cautious about the levels of commitment that will be required.

But I think somebody has to pick up the tab, and if it’s not going to be the Australian taxpayer ... there are also political issues around infrastructure investment being owned by foreign companies.

So from what I’ve seen in other locations, it very much depends on the decisiveness of the political decisions, which clearly need to be made very, very quickly.

And how public policy will then influence the extent to which the economic climate is made attractive for private investments to rebuild that infrastructure.

But from what I understand, that final bill is going to be colossal, and the Australian taxpayer cannot sustain it on their own.

Pauline Vamos, ASFA: They can’t, but when you look across the global governments, the level of debt of Australian and state governments is very, very low.

And that’s the change of policy that needs to happen. It’s okay to borrow.

We all borrow to fund our homes, it’s okay to borrow. And that’s a political sell that has to be made.

Remember, the superannuation monies in Australia, like many countries, but particularly in Australia because of its Australian bias, is across the whole economy — it’s not sitting in a box under somebody’s bed.

So if you have a change in government policy where you have to skew more into infrastructure, with the risks and the lack of transparency the same as private equity, then it would have to abandon another asset class, and that is the domino effect.

In fact, that impact on the Australian economy would make the Australian market very, very jittery.

Bruce Russell: I think it’s a useful case study perhaps to look at New Zealand and some of the requirements that the Government have put on New Zealand super funds with respect to having minimum amounts invested in that local economy. And that’s actually had some interesting implications on them in terms of sourcing assets.

And I think your earlier point around there’s no free lunch — if you’re forced into a particular asset class then there’s an opportunity cost of not going into those other asset classes.

So I think the Government encouraging investment into infrastructure has to be mindful of what you give up on the other side, and also the fact that that may impact the returns to funds.

Pauline Vamos, ASFA: Big time, that’s right.

Pierre Jond, BNP Paribas: If you want to have, for instance, financing of infrastructure done by super funds, you need to have a way to enforce a return on that investment.

And I don’t know if you can actually put a toll on every street, on every road in Queensland — some investment interest will not be generating returns.

Fundamentally, that’s what you have a state for, which is initially to build a number of infrastructures.

You will not get the super funds to invest in infrastructure if you don’t have a proper return simply because the trustee has got the responsibility vis a vis the holders of these funds, or you are not in a situation where you have by law a requirement for all super funds to have five, 10, 20 per cent investment in infrastructure.

But that’s the fact of a nationalisation of the industry.

Pauline Vamos, ASFA: And the difficulty with that is that we still have enormous liquidity pressures on the industry.

Those industries that do invest heavily in infrastructure are defined benefit funds. So you have a much greater ability to calculate when the money is going to start going out. We have 30 days, so the importance of liquidity is vital.

Chris Adams: I agree with all of those comments. I think the only thing we’re talking a little bit about is fiscal policy, and the only thing I’d say is, here in Europe, there are some interesting case studies going on at the moment about what happens when you increase public debt significantly — and they’re not pleasant.

If we look at the way investments have been made to industrialise certain parts of India and China, particularly the roll out of railways and things of this nature, I think placing the majority of the burden on the taxpayer through debt is a path that people, certainly in Europe, are very, very cautious about at the moment.

Daryl Crich, BNP Paribas: I think also you need to be very careful. Over quite a number of years, the Australian super industry with the oversight of the regulators has been very careful in making sure members understand the investment risk return profiles that they’re going into with their options.

To then slant existing pools of money towards one asset class ... is totally changing the risk return profiles that the financial planners and advisers have been taking ... people through over the last 20 years to set them up for their retirement.

Regulators put a lot of pressure onto the super funds in terms of disclosure, ‘plain English’, so that the investors understand.

To then pull the rug out from under people and just say, ‘Well yeah, that’s good but we have to take 10 per cent of your fund and stick it into infrastructure’, that could really undermine confidence in the super industry.

Pauline Vamos, ASFA: The other big one is the costs of monitoring and managing, and the cost of that asset class.

And this is the big unknown in infrastructure, and it’s one of the unknowns of course in private equity as well.

And I think it’s going to be interesting as we go through stronger super, and there’s some more transparency on trustees to disclose the underlying management costs of various asset classes, and they actually start to do the analysis, then we’ll start to see some interesting decisions made.

And then you’ve got the issue where the broader your investment is across those sub-asset classes, if it’s property, or if it’s utilities, you’ve got to have that expertise, and you’ve got to pay for that expertise on the government side.

And because that is a fairly unknown cost, and because there’s so much pressure on trustees to keep their costs down, it will never be a big part of a portfolio because there is very little control over it.

Bruce Russell: The other point I’d add to that is the legal and tax costs that we see associated with investing in that asset class.

An example is we’re working for a client at the moment that’s launched a private equity-like fund. In order to really eliminate tax leakage through withholding tax, they’ve had to create quite a complicated structure, which means flying to Luxembourg to attend support meetings to approve transactions.

And the reason they need to do that is ultimately to make sure that the returns are competitive with alternative products.

Quite often you do need an army of lawyers and accountants on-hand just to navigate some of the complexities associated.

A good example is if you happen to invest in the US and you’re deemed to be deriving active US income, it puts you in an extraordinarily difficult position where you have to do some fake tax returns, et cetera.

If you were going to make it a more attractive asset class, if there was a way to try and streamline some of those minefields around tax and accounting, I think that would be helpful.

Kar-Mei Tang: I agree entirely.

Pauline Vamos, ASFA: But it’s very hard when you’ve got assets based in different tax jurisdictions as well.

Kar-Mei Tang: That’s one thing I’d like to add to the point — that it’s not a big section of your asset allocations at the moment.

I think for the most part those that do invest, invest something around 2 per cent to 8 per cent of assets in private equity as a whole.

But it’s probably a kind of growing maturation of the industry. As superannuation funds grow and begin to invest more resources into private equity they will then be able to do better due diligence on the funds and do better assessments and reporting.

Hopefully we will see that begin to grow because it’s not a big part of US investors’ portfolios as well.

But like the CALPERS [California Public Employees’ Retirement System], which has probably two allocations to private equity and so on on a proportional basis, it’s still larger than what superannuation here invests in private equity.

Pauline Vamos, ASFA: But they don’t have liquidity challenges because they are defined benefit funds.