Mergers can benefit superannuation funds: favourable mandate structures, terms and fees can be secured; co-investments or direct investments in unlisted assets can be made; more money to allocate becomes available in a capital-constrained world; and capital-gains-tax credits can be used to offset future profits from domestic stocks.
What can go wrong? Funds don’t agree on how their merger can strengthen their investment strategy or they don’t lay thorough plans to combine portfolios. The cost of failure is daunting.
About 1 per cent of net returns can be lost if a merger fails, according to Ashley O’Connor, senior consultant at Frontier Advisors, which consults on $117 billion in institutional assets. Volatile investment markets can exacerbate losses from such breakdowns. Also, the “limbo effect” of suspending investment decisions in the months or years preceding a merger can curb performance. Following a merger, fund performance can suffer if strategies have not been prepared in advance and are not executed well.
Each merger is different. They involve funds with different membership demographics, investment portfolios, governance policies and organisational cultures. In O’Connor’s experience, however, common principles can be used by merging funds to ensure that investment performance does not suffer amid myriad other tasks – including governance, custody, member administration, regulation and public relations – that funds must also deal with while becoming a new entity.
Equal say
At least 12 months before the merger date, funds should create a steering committee comprising equal numbers of senior people and empower it to make important investment decisions, O’Connor said in an address at the Frontier Advisors client conference on June 15. The group must envisage how the combined portfolios can take advantage of scale benefits and make sure, as much as possible, that members of either fund are not disadvantaged. The committee must have decision-making continuity and be held accountable for results. Clashes over trustee elections must be prevented.
In May, the two-year plan to merge Equipsuper and Vision Super broke down. Before this, in preparation for the merger, Equipsuper became an investor in Vision Super’s existing pooled superannuation trust. The $4.6-billion industry fund placed its cash and fixed income assets, totalling $1.3 billion, with Vision Super. (The government’s temporary withdrawal of capital-gains-tax offsets for merging funds stopped it from transferring equity investments.) The funds then established a joint-venture company, Pooled Super Pty Ltd, to be trustee of the assets, and an investment committee comprising equal numbers of directors from both funds to monitor fund managers (see figure 1).
Fund trustee directors then tasked their investment teams and lead consultants, Kristian Fok of Frontier Advisors and Duncan Smith at JANA Investment Advisors, to determine how the merged entity should invest.
“We took the view that the two asset consultants and internal investment teams should work together to establish a recommendation of what a future asset allocation should look like and what assets should be managed internally,” Danielle Press, chief executive of Equipsuper, a $4.6-billion Melbourne-based fund, said in an interview on July 16. “We said, ‘Let’s work out what the goal is, what the ideal portfolio is and then work out how we get there’.”
The $46.5-billion AustralianSuper, which was formed by the 2006 merger of the Superannuation Trust of Australia and the Australian Retirement Fund and has joined with other funds since then, now assembles staff members and service providers from various fields – investment, operations, member administration, communications, finance, risk management, tax, human resources and legal – to oversee various aspects of mergers. “It’s almost business-as-usual doing mergers,” Peter Curtis, head of investment operations at the Melbourne-based fund, said in a July 17 interview. “We have a team of people that we pull together for the job.”
New characteristics
Merging funds should forecast what the characteristics of the new member base will have and how it will influence investment strategy, O’Connor said. They should discuss the following points: the range of ages, occupations and investment-risk appetites members of the new fund will have; the new volume of contributions; the number of members likely to remain invested in the default investment option; and members’ record of switching between investment options in a market rout.
AustralianSuper, which will grow to $50 billion following its merger with AGEST Super and potentially become the third-largest superannuation provider, considers growth a vital part of its investment strategy.AustralianSuper’s 2011 merger with Westscheme, a $3-billion fund, and it’s current absorption of the $4.6 billion AGEST Super will boost current-member cash flows into AustralianSuper. This steady volume of new funds must be channelled to investment managers and used profitably. “On top of the 9 per cent coming in every day, it cranks up the activity,” Curtis said.
“How can we use size to get better net returns?” Curtis asked. “By being able to look at larger investments, listed and unlisted, and by trying to get first-mover advantage into Asia. By starting to do portfolio management internally, doing unlisted investments more directly rather than through pooled vehicles, and looking for co-investment opportunities.”
As plans for the Equipsuper and Vision Super merger progressed, the funds’ investment teams began working together in Equipsuper’s office at 114 William St in central Melbourne.
Michael Strachan, chief investment officer of the fund, was slated to lead the merged fund’s investment activities. The internal team he oversaw – which manages Australian equities, fixed income and infrastructure assets – would have been allocated more capital to invest.
“Investment management is a scale business,” Press said. “We wouldn’t have added to the internal investment team. It’s a scale business so there would have been cost savings.”
The merger ultimately failed because the two funds could not agree about the future role of the internal team.
Tricky illiquids
The investment philosophy, performance objectives and governance principles of the new fund must be clearly defined. This should include an analysis of potential scale benefits and admission of how seriously the fund will compare itself against the short- and medium-term returns of peers as it seeks to beat inflation over longer time periods.
In this, the funds should decide their tolerance for negative returns that are publicised in league tables. “Sometimes trustees can come from funds with completely different investment philosophies,” O’Connor said. “You don’t want trustees – one year after the merger – to still be discussing investment philosophy.”
The asset classes that the new fund will invest in, and the desired blend of growth and defensive assets, should be decided. Its appetite for private market assets, including direct holdings or co-investments in property or infrastructure, should be gauged. Future liquidity needs may make it necessary to put unlisted assets up for sale.
The contrasting asset mixes of the defined-benefit funds within Equipsuper and Vision Super meant that they would have remained separate. Private equity and infrastructure assets of different maturities were difficult to combine in a single portfolio that benefited both memberships.
Their intrinsic value was difficult to carry into a merged portfolio, Press said. “How do you make it equitable? That was the biggest challenge.” However the two funds’ default options, in which defined-contribution members invested, “were almost identical.” 
AustralianSuper seeks details of its merger partner’s investments. It asks: “What are the underlying assets of the fund that we are merging with: are they held in unit trusts? Shares in a discrete portfolio? How many of the assets are unlisted or held in partnership around the world?” Curtis said. “We work with the other fund to understand what they own and how they have structured their portfolio, and what we need to understand that is unique.”
Existing investment options and tax positions of the merging funds, plus their methods used to calculate unit prices and crediting rates, must also be known.
So far, AustralianSuper has not merged with a fund that has a meaningfully different balanced fund.
Consequently, the asset allocation of its default option, which manages most of the fund’s assets, has not undergone a “significant shift” during mergers.
“Once we understand their investment portfolio, we pick it up and move it into our portfolio on the merger date,” Curtis said. “Once we get the portfolio on board, we due diligence it to decide which assets we’d like to keep or sell over time.”
Combining the unlisted assets of the merging fund can be the most complex part, according to Curtis. They can be very difficult to sell – some are held in private equity partnerships for many years, while others need time and management effort to be sold at a higher price – in order to meet the investment and liquidity aims of the new fund.
Build the portfolio
The long-term strategic asset allocations for all investment options should be set to meet new investment objectives and abide by the new philosophy. This includes deciding the number of member investment choice and sector- specific options, O’Connor said. Policies for reviewing long- and medium-term asset allocations, and for portfolio rebalancing, need to be determined.
The mergers with Westscheme and AGEST have not fundamentally changed AustralianSuper’s investment strategy. This is because the funds are much smaller than their merger partner: they represent about 10 per cent of AustralianSuper’s capital and can be absorbed into its portfolios. “If one of them was a $30-billion fund, there would be much more planning,” Curtis said.
Fund manager line-ups should then be consolidated. This reduces the number of fund managers to monitor and provides opportunities to reset fees and terms with preferred managers. “Managers know that consolidation is inevitable with mergers. So it’s a great time to renegotiate terms,” O’Connor says.
Equipsuper and Vision Super aimed to gain fee discounts this way. “A lot of the gains for members would have come.
