Australian funds move to cut illiquid values

The coronavirus sell-off is prompting big Australian superannuation funds to mark down their allocations to real estate, infrastructure and private equity to ensure defined contribution participants taking out money now to pay bills and cover expenses don't disadvantage those staying put.

The move is the latest iteration of an ongoing fiduciary conundrum: Investing with a medium- to long-term investment horizon while participants retain the ability to move their money to competing funds on a short-term basis, said Nick Kelly, a Sydney-based senior investment consultant with Willis Towers Watson PLC.

The plunge in global equity markets since late February effectively forced super funds to grapple with the prospect of members switching out of funds at "stale valuations" for illiquid assets, benefiting them at the expense of those participants who keep their money parked in those options, agreed Padraig Brown, an Auckland-based principal with Mercer Investments' alternatives business and the consulting firm's head of real estate for the Pacific region.

To address that fiduciary challenge, super funds have sped up the adoption of lower valuations for those asset classes, with a view to treating all participants fairly and equally, Mr. Brown said.

Melbourne-based industry heavyweight AustralianSuper led the way on March 24, announcing an average 7.5% valuation cut for the quarter of its default option parked in unlisted assets. The move resulted in a 2.2% decline in participants' unit values. The country's biggest industry fund managed more than A$180 billion ($121 billion) as of Feb. 7, on behalf of 2.1 million members.

Hostplus, Melbourne, a A$50 billion fund focused on Australia's hospitality, tourism, recreation and sports industries, devalued its 13% allocation to real estate and its 12% allocation to infrastructure by 7.5% to 10%. Executives also lowered the value of the fund's 8% allocation to private equity by 15% on average. Allocations are as of June.

The A$85 billion UniSuper reduced valuations for its default option's modest 7% weighting to illiquid assets in March, a spokeswoman for the Melbourne-based fund said. It cut valuations on its unlisted real estate exposure by 10% and by 6% for infrastructure. The fund focuses on Australia's higher education and research communities.

The Retail Employees Superannuation Trust fund, a A$50 billion Sydney-based super fund, lowered the value of its real estate assets by 8.56%.

Meanwhile, a key element of the government's coronavirus response — an "early access" initiative allowing Australians hurt by lockdown measures to draw down A$20,000 of their super savings — is adding another layer of complexity to managing portfolio liquidity now.

No super fund executive modeling the appropriate level of illiquid assets for their portfolios saw that coming, noted David Bardsley, a Melbourne-based partner with KPMG Australia.

Some industry executives warned the timing of that option could prove problematic. AustralianSuper Chairman Don Russell, speaking at a conference March 30, predicted as many as 300,000 of his fund's members could choose "to take advantage of what has been put on offer," which in turn could constrain AustralianSuper's ability to act on investment opportunities thrown up by the crisis, a spokesman confirmed.

The government expects A$27 billion to be redeemed — a manageable 1% or so of the system's total assets — but funds in sectors facing particularly steep job losses like tourism, hospitality and retail could see their business models tested, Mr. Bardsley said.

In that regard, Hostplus is widely seen as Exhibit A, sources said.

With an average age of 37, Hostplus' relatively young participant base of 1.3 million employees has provided the fund's investment team with competitive advantages, such as being able "to invest in unlisted markets and asset classes that are impacted less by the daily ups and downs of listed market," CIO Sam Sicilia said in a video on the fund's website in April.

Hostplus' sizable investments in direct real estate, infrastructure, private equity and venture capital have been a driving force behind the fund's "podium results" — ranking first, second or third in terms of annualized investment gains — for every time period over the past two decades, Mr. Sicilia noted.

Even so, market veterans say the prospect of a large swath of Hostplus members losing their jobs in the coronavirus downturn while having the new-found option of tapping more than half of their average retirement savings balance of A$37,000 could prove a double whammy for the fund in terms of lower inflows and greater outflows.

In early April, a number of news reports highlighted changes made to Hostplus' more than 200-page product disclosure statement, suggesting they gave the fund greater leeway to delay meeting participant claims for withdrawals.

The broad discretion outlined for its trustees to "suspend or delay unit pricing in extraordinary situations to ensure equity, fairness and balance in investment pricing and transactions in the best interests of all members" is neither new nor unique, said a spokesman for the fund, adding that Hostplus remains committed to supporting the government's policy of allowing members to access up to A$20,000 of their savings.

Meanwhile, analysts said the methods that super funds are using now to arrive at valuation cuts for their illiquid exposures are likely a mixture of art and science.

With equity markets falling off a cliff and the government opening the door for members to tap their savings, "super funds had to move very quickly," said Jennifer Johnstone-Kaiser, principal consultant, property leader with Melbourne-based investment consulting firm Frontier Advisors Pty Ltd. It is tough to have much visibility at this point on how they came up with their assessments, she added.

The funds are likely taking a "mosaic approach," tapping different sources of information, Mercer's Mr. Brown said. Looking at how listed infrastructure and listed real estate funds are trading likely provides them with "one bookend" in coming up with a valuation. However, there have also been significant income losses — such as for airports, ports and toll roads — which "provides you the ability to do a little bit more analytical work on how much income you're going to lose," he said.

WTW's Mr. Kelly said it is easier for the 75% of top industry funds that have brought infrastructure and real estate investments for the Australian market in-house to be more scientific in valuing their holdings. For those relying on external managers, there is still considerable science at work in seeking updates from managers but also "an art overlay," he said.

KPMG's Mr. Bardsley noted that a truly in-depth valuation of an unlisted asset can take six to eight weeks — a complicated and expensive exercise. Super funds moved quickly in recent weeks to protect members but their "provisional revaluations" need to be substantiated in due course by independent valuers, he said.

Market veterans said it is unclear whether the precedent being set in recent weeks will end up being a one-off response to an extraordinary moment for capital markets and the global economy or whether, instead, it could usher in an environment where illiquid assets are revalued more often than the current standard of once every quarter.

Trustees should ensure "that the valuation of unlisted and illiquid assets remains appropriate and consider whether any assets need to be revalued," Australia's two super fund regulators, the Australian Prudential Regulation Authority and the Australian Securities & Investments Commission, said in a letter to trustees on April 1 regarding COVID-19-related developments. That admonition effectively reiterates existing guidelines for trustees.

At the very least, this episode looks set to leave "all asset owners pushing their managers for more frequent valuations," Mr. Kelly said.

Kent Robbins, UniSuper's head of property and infrastructure, said in an email the policy set by his fund for unlisted assets calls for increasing "the frequency of independent valuations in periods of increased volatility." Such valuations could be conducted on a monthly basis over the coming months, he said.

Likewise, Sonya Sawtell-Rickson, CIO of A$46 billion HESTA, a Melbourne-based fund for health-care employees, said her fund's policy calls for valuing unlisted assets more frequently in times of market volatility to help "members understand the current value of their super balance."

In the end, the quantum of writedowns is less important than ensuring the proper governance is in place for trustees to be able to demonstrate — to regulators and their participants alike — that they are following a "reasonable prudent" approach to the problem, Frontier's Ms. Johnstone-Kaiser said.