The time of reckoning for superannuation funds and others offering ready access to investors while holding large exposures to illiquid assets was going to come one day. Most thought it would be when membership bases had aged and the outflows were significantly more than that being contributed. In which case, 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 switch between investment options and the government’s recent announcement allowing many Australians to withdraw up to $20,000 from their super earlier has accentuated the looming storm. Good policy? Perhaps not, but you play with what is in front of you.

Recent days have seen considerably more discussion on the dilemmas facing funds with large exposure to illiquid assets. Perhaps the more important focus should be considering what needs to change as a result of these pressures, and how to get to a more robust industry solution capable of handling extreme scenarios.

The possibility of the Reserve Bank of Australia helping to facilitate liquidity for super funds has been raised, especially if the member withdrawals are greater than the $27 billion currently expected by the government. Perhaps such involvement could temporarily allay some concerns, but I fail to see how this is a good long-term solution that contributes to the stability of the financial system.

Some of the possible changes that could result from these liquidity pressures include:

  • An acceleration of mergers to create larger funds and fewer small/mid-sized funds
  • Only the largest funds being able to invest significantly in illiquid assets via mainly direct investments
  • A possible cap on the amount of illiquid assets held by super funds
  • Constraints imposed on member switching, at least for investment options that hold illiquid assets
  • A gradual reduction in exposures to unlisted assets seen among some funds, especially if listed assets become cheaper
  • More scepticism around the volatility of return as a sensible measure of risk
  • More risk-averse investors

Investment crisis

The pain of any investment crisis usually hits the listed assets first before it affects unlisted assets. And if the crisis is short and mild, illiquid assets can escape largely unscathed. But that’s not likely the case this time. Of course, the downside in listed assets may also have further to go, but the pain for unlisted assets may be only just beginning.

The irony is that the pace that super funds adjust valuations of their unlisted assets will heavily dictate what the rational decisions of members and investors should be.

Super funds that hold high weightings to illiquid assets are in a hard place. On the one hand, large and near-term downward adjustments will move valuations closer to the levels implied by the pain felt in listed assets. This should theoretically discourage members switching and withdrawals and is a more equitable situation for those remaining in the fund. However, this will also result in a poorer performance in the near term which could encourage others to switch or withdraw.

On the other hand, being slow to devalue an asset can make it quite rational for investors to withdraw what they can, or switch to cash or a more conservative or liquid investment option.

The concern raised by some funds and politicians is that it also means that investors are getting out at the bottom. But who knows if we have seen the ultimate bottom, even in listed assets? I doubt that we have seen it yet.

Such an argument does have more validity for a portfolio of listed assets. However, when we are talking about funds which might have 20 to 30 or even 50 per cent in unlisted assets (as is the case for some of the retail managed fund offerings), valuations are typically far from reflecting anywhere near the movements and valuations of the public markets. I am not suggesting that unlisted asset prices need to match the decline in the listed space, but the current gap across some areas is stark.

Not immune

Investors may, therefore, be rational in withdrawing or switching from such investment options, even if one is agnostic on the near-term direction of listed markets from here.

This is also not to deny that super funds do 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 from being punished in the public market and unlisted assets should not be immune from large declines.

Perhaps the strategic and control value of direct stakes in assets held by the larger super funds do hold their values much better. But to the extent that many funds, especially the smaller funds, are getting their exposure to property or infrastructure via unlisted funds, I would be more sceptical.

Just because these funds rarely trade as secondaries in normal times, doesn’t mean that their value relative to NAV shouldn’t be adjusted in more challenging circumstances. Just look at the discounts that listed investment funds that hold both illiquid and listed assets can trade at in extreme markets.

This is not just about super funds. Some illiquid and semi illiquid non-super managed fund products that offer daily liquidity to retail investors will also be under the same pressure, although they may respond differently. Some will likely gate the fund, while others have already introduced temporary and much larger sell spreads to discourage current redemptions.

Of course, those super funds that are seen as especially vulnerable are already publicly highlighting that they have more than enough cash and other liquid assets to meet any redemption. But having enough 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, 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 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 writedown

The question for funds today is this: What is the real value of unlisted assets held both directly and through institutional funds by super and some managed funds? Some have begun to writedown 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 declines in listed property, listed infrastructure and listed private equity and debt of as much as 40 to 50 per cent, there is still likely a massive disconnect.

Then there is a contrary view that suggests that investor demand in recent years for unlisted assets had pushed valuations above their listed equivalents and what could be rationally justified. In years past, institutional investors sought unlisted assets for their illiquidity return premium, but many more recently have bought them for their lower volatility and yields, or simply because their peers also own them. This arguably has led to a lower expected return versus listed assets even at recent peaks. This is certainly the case currently, given the large selloff in listed assets and minimal declines in unlisted-asset valuations to date.

So what is determining those new modestly-adjusted illiquid valuations which are still a fraction of the move of the equivalent listed asset? Are they just back of the envelope transactions reflecting simplistic valuation measures and small changes in the parameters? Are they based on what the fund can tolerate from a performance perspective while trying to do enough to discourage more switches and withdrawals?

And are any transactions happening at those current valuations or lower levels? I suspect very few so far. But for those that 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 and 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 encouraging their investors 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 pressure to devalue their assets, gambling that the crisis will be shortlived. But that would also mean that the illiquid component becomes larger and the overall fund even more illiquid. If they are wrong, these funds will be the ones that will struggle to maintain a sensible investment program and may desperately seek a merger partner.

Dominic McCormick is an investment consultant for DPM Financial Services. This article was first published on Professional Planner.

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