The time of reckoning for those super and other funds offering ready access to investors while holding large exposures to illiquid assets was going to come one day. Most thought it would be when member bases had aged, and money being drawn down was significantly more than money being contributed. In which case, super funds felt they would have had plenty of time to prepare.
However, the COVID-19 crisis has bought this forward. The increasing ease with which investors can make switches between investment options in a nervous environment and the government’s recent announcement allowing many Australians to make $20,000 withdrawals from super has accentuated the looming storm. Good policy? Perhaps not, but you play what is in front of you.
Recent days have seen considerably more discussion on the dilemmas facing super and other funds with large exposure to illiquid assets. Perhaps the more important focus should be considering what will/needs to change as a result of these pressures and how to get to a more robust industry solution capable of handling extreme scenarios.
What could change
The possibility of the RBA helping to facilitate liquidity for super funds in the current environment has been raised, especially if the $20k withdrawals are greater than the $27 billion currently expected by the government. Perhaps such involvement could temporarily allay some of the concerns I have raised further on in this article, but I fail to see how this is a good long-term solution contributing to financial system stability in the future.
Among changes possible as a result of these pressures my speculations are as follows:
- The trend to larger funds via mergers will accelerate with fewer small/mid-sized funds.
- Potentially, only the largest of funds will be able to invest significantly in illiquid assets and most of this will be via direct holdings in assets rather than via institutional funds. (not good for the institutional illiquid asset management industry).
- A possible cap on the amount of illiquid assets (direct and funds) that could be held by super funds (and even non-super retail managed funds) offering regular redemptions/switches.
- Super funds may place greater constraints on switching, at least for investment options that hold illiquid assets.
- Some super funds, especially remaining smaller ones, will move over time to have significantly less exposure to unlisted assets, and especially if listed assets continue in a bear market and become cheaper.
- Investors and the industry will become even more skeptical of volatility of return as a sensible measure of risk.
- Overall, investors will become more risk averse as a result of their current investment experience and the more uncertain economic situation over coming years. Much of the money leaving growth-oriented investment options won’t be coming back any time soon.
The pain of an investment crisis happens first in listed assets and only later in illiquid, unlisted assets, and sometimes the latter impact is small. Indeed, if the crisis is short and mild those unlisted assets can usually escape largely unscathed. But that’s not likely this time. Of course, the downside in listed assets may also have further to go but clearly significant pain has already occurred. With illiquid, unlisted assets that pain may be only just beginning.
The irony is the pace with which super funds adjust asset valuation of their unlisted assets will heavily dictate what the rational decisions of members/investors should be.
Super funds holding high weightings to illiquid, unlisted assets are in a hard place. On the one hand large, near term downward adjustments (including some sales at lower prices) will move valuations closer to the levels implied by the pain in listed assets and theoretically, should discourage some switching and withdrawals. It is also a more equitable situation for remaining investors. However, this will see poorer-reported performance in the near term, that could encourage other disappointed investors to switch/withdraw.
On the other hand, being slow to make downward adjustments in valuations can make it quite rational for investors to withdraw what they can or switch to cash or a more conservative or liquid investment option.
But where’s the bottom?
The concern being expressed by some funds and politicians is that this means investors are getting out at the bottom.
Really? Who knows if we have seen the bottom, even in listed assets? Nevertheless, I can see how such an argument does have more validity for a portfolio of listed assets only, although doubt we have seen the ultimate bottom. However, I struggle with such a view when we are talking about funds which might have 20, 30 per cent, 40 per cent (or in case of some of the retail managed fund offerings), 50 per cent plus in illiquid, unlisted assets (property, infrastructure, private equity, private debt, some other alternatives) whose valuations are typically still far from reflecting anywhere near the movements and valuation levels in listed markets. I am not suggesting that unlisted asset prices need to match those listed falls, but the current gap across some areas is stark.
Investors may therefore be totally rational in desiring to withdraw or switch from such investment options even if one is agnostic on the near-term direction of listed markets from here.
Quality versus opacity
This is not to deny that large super funds hold some high-quality unlisted assets that will deliver attractive long-term returns, even from current valuations and especially if interest rates remain low. But quality has not stopped similar assets being punished in the listed market and unlisted assets should not be immune from large falls.
Perhaps the strategic and control value of large stakes in direct assets held by the largest super funds means they should hold their values much better. But to the extent many funds (especially smaller funds) are getting their exposure to illiquid assets via unlisted funds I would be more sceptical.
Just because these funds rarely trade as secondaries in normal times doesn’t mean their value relative to NAV shouldn’t be adjusted in more challenging circumstances. Just look at the discounts that listed investment funds (holding both illiquid and listed assets) can trade relative to NAV in extreme markets.
This is not just about super funds. Some illiquid/semi illiquid non-super managed fund products that offer regular liquidity to retail investors will be under the same pressure although they may respond differently. Some will likely gate while some have already introduced “temporary” much larger sell spreads partly to discourage current redemptions. (Including on some products whose underlying assets are normally quite liquid, but which became illiquid for a period during the worst of the recent panic).
Of course, some super funds seen as especially vulnerable are already publicly highlighting that they have more than enough cash and other liquid assets to pay out any required investor withdrawals. (With some having sold listed assets recently to bolster cash levels). But having enough cash and liquidity to cover estimated withdrawals is only part of the issue here. There is the potential for more switching from nervous investors. And what does the portfolio look like after liquid assets have been paid out, especially if there are more losses in listed assets, both making the unlisted allocations proportionally larger. Of course, contributions will continue to come in, but these will be dented by the harsh economic environment and the potential loss of some members.
Ultimately, I expect many funds will eventually relent and illiquid, unlisted assets (especially those held via fund structures) will be devalued much more aggressively than they have been to date and to levels well below what many in the industry expect. Performance of some funds could be very poor though this period. The low volatility and capital preservation “benefits” of many of these assets will be seen to be largely an illusion.
The final write down
The question for funds today is this – what is the real value of vast number of illiquid unlisted assets held (both directly and through institutional funds) by super and some managed funds? Some have begun to write down assets by 5 to 10 per cent and up to 15 per cent for private equity. Some justify only small adjustments by saying their unlisted valuations never reached the peak valuations that listed assets reached. Even if this were true for some assets, with falls in listed property, listed infrastructure and listed private equity/debt of as much as 40-50 per cent there is still likely a massive disconnect.
Then there is a contrary view that suggests the chase for unlisted assets in recent years for their “low volatility” and yield benefits had resulted in illiquid asset valuations rising above listed equivalents and above what could be justified rationally. In years past, institutional investors sought these illiquid, unlisted assets for their so-called illiquidity return premium but in recent times many seemed to chase them for their “lower volatility”, yields or simply because other large investors held them. This arguably led to a lower expected return from illiquid assets versus listed assets even at recent peaks. This is certainly the case currently given the large falls in listed assets and minimal falls in unlisted asset valuations to date.
What is determining those new, modestly adjusted illiquid valuations which are still a fraction of the move in listed assets in the same asset classes? Are they just back of the envelope transactions reflecting simplistic valuation measures and small changes in valuation parameters? When it comes to fund structures that are beginning to be valued by some at discounts to the latest NAV, how is such a discount determined? Are they more based on what the fund can tolerate from a performance impact while trying to do enough to discourage more switches and withdrawals?
Are any transactions happening at those current valuations or lower levels? I suspect very few so far but to the extent there are why aren’t all funds that hold those assets forced to change valuations to reflect those latest transactions.
If the argument is that such transactions are ‘forced sales’ that don’t apply to other holders, then how do we determine who is and who isn’t a forced seller? In the current environment where almost all growth oriented funds could face a period of net redemptions one could argue that all such funds are forced sellers of their diversified portfolio and all assets in that portfolio should reflect the realisable value in the current market as close as this can be determined.
In this crisis I believe that is where we will eventually get to, although it may take some time.
There will be much more pressure to value these assets lower and at discounted sale prices that at least partly reflect the current market environment. If funds don’t do this, they are just advertising to their investors to take a rational decision to exit to switch to cash or other lower risk options or cash out what’s possible at least until those adjustments are made. Only truly closed end institutional funds like the Future Fund or some defined benefit funds will have a strong case to ignore these dynamics.
Of course, some super funds may resist the increasing pressure, gamble that the crisis will be short lived and mild and sell off their liquid assets and hope that their illiquid assets can ride through without the need for sale or significant devaluation of their unlisted assets. But obviously that means the illiquid component becomes larger and the fund overall even more illiquid. If they are wrong these funds will be the ones that will be struggling to maintain a sensible investment program and may be desperately seeking a merger partner.
In the retail non super managed fund space, we will also see poor performance, fund gatings and a return to investors caution on semi illiquid structures offering regular liquidity that applied after the GFC. Having said this, gating in the retail space may be accepted by many investors who don’t want underlying assets sold into a poor market and may not be a problem if it is only a small portion of a client’s portfolio.