One of the themes emerging from ASIC’s consultation into the state of public and private markets is that (institutional) super funds can provide a suitable conduit through which individuals can access private markets. We agree and made this point in our submission, as did others.
Nevertheless, success is not guaranteed. Super funds face a number of challenges when investing in private markets. They also need to have appropriate governance and management capabilities in place. This is all set out in our new research thought piece titled Super as a suitable conduit for investing in private markets.
Advantages of super funds operating in private markets
On one level, super funds – especially larger super funds – have the scale to not only invest in a wide range of private markets but also to build the required capabilities such as manager selection and oversight and the ability to invest directly. Super funds are also comparatively well-placed to deal with the opaque and complex nature of private markets.
On another level, super funds invest on behalf of their members as fiduciaries that are subject to a range of obligations and regulatory requirements as well as prudential oversight. From the member’s perspective, they offer a ‘safe pair of hands’, at least relative to grappling with the complexities of private market for themselves, or relying on other agents such as financial advisers, who often will not have access to the full set of private market capabilities of super funds.
Larger super funds can bring the following to the table when investing in private markets:
- The capability to manage private asset programs through professional investment teams.
- The ability to address agency risk involved in outsourcing through undertaking manager selection, and overseeing the fees and other costs they charge, scrutinising valuations and possibly appointing board representatives where they have a substantial stake in a private asset.
- Access to private markets via skilled managers and/or attractive investments is abetted by building networks and relationships, possibly supported by opening overseas offices (as per AustralianSuper, ART and Aware Super).
- Ability to accommodate assets with large unit size such as property and (especially) infrastructure while still maintaining adequate diversification.
- Scope to limit fees through direct and co-investment, and occasionally by negotiating with managers.
- Professional operational management of portfolios, risk and illiquidity.
Capabilities need to be built
While the above list of advantages is significant, super funds need to build the capabilities to secure them. Topping the list is hiring skilled and experienced investment staff and establishing processes for managing supplier relationships, especially external managers. Ensuring value-for-money is crucial given the high fees and costs involved in private markets. Securing manager alignment also matters.
A private market program raises exposure to both illiquidity and (often) overseas assets. This places a premium on effective management of liquidity, which involves handling uneven cash flows associated with calls or returns of capital and rebalancing portfolios which are partially liquid. Currency management also becomes more important, for which hedging decisions are central but have additional liquidity implications.
Valuation governance is another important area as it directly impacts on performance measurement and unit pricing, which in turn has implications for member equity upon entry and exit as well as portfolio and risk management.
Frameworks are needed to manage member equity that extend beyond valuations and unit pricing, including the terms under which members may enter or exit options during times of extreme stress, addressing valuation uncertainty and the implications of any liquidity pooling across investment options (e.g. the ‘banker option’, where liquidity is underwritten by the main balanced fund).
APRA examined the governance of unlisted asset valuation and liquidity risk management during 2024 and found that parts of the industry had some material gaps. Some funds clearly have more to do.
Hurdles remain
Super funds face a number of hurdles that can limit the effectiveness of investing in private, even where the capabilities outlined above are in place:
- High fees – Fees create a high hurdle, underlining the crucial importance of ensuring value-for-money by identifying managers that are capable of generating returns that more than exceed their fee. A recent article in the Financial Analysts Journal found many private markets have delivered attractive gross returns, but once fees broadly in the 5 per cent to 8 per cent region are deducted, net returns are often far more pedestrian.
- Limited bargaining power with managers – One consequence of competition for skilled managers is that preferred managers often hold the upper hand in negotiations, allowing them to continue extracting higher fees and potentially capture the bulk of the value-add for themselves. It can also limit responsiveness to requests around more transparency or tailoring of valuation processes.
- Competition for access – Strong competition for access can hamper returns in two main ways. First, competition for opportunities in private markets can lead to them trading at a premium to public market counterparts, making it harder to generate high returns. Second, the most skilled managers are often accessible only to investors with existing relationships.
- Portfolio construction challenges – Maintaining a portfolio with an appropriate risk/return profile can be challenging in private markets due to evolution in the opportunity set over time, lags in buying and selling, and uncertain time frames around capital calls and distributions.
- Constraints on private market weights – Super funds face natural constraints on the extent to which they can prudently invest in private markets, which may limit their ability to extract the maximum benefit. Our notional marker is 30 per cent exposure to illiquid assets (see our research paper Why severe liquidity stress in superannuation is hard to foresee): this is approximately where some larger profit-for-member funds currently stand. Some smaller funds may be constrained by lack of required scale or the capability to invest in certain private markets.
The best that can be said is that the hurdles in private markets are likely to be less impactful on super funds than on the members they represent, and indeed individual investors in general. Success is not guaranteed.
Good governance is the entry ticket to private markets
We have argued that super funds are particularly well-suited to investing in private markets on behalf of their members but need to be structured to perform this role effectively. Key requirements include ability to effectively manage suppliers (especially managers) as well as liquidity and currency exposures, and solid processes around valuations and member equity. These requirements sum to good governance, which is the ‘entry ticket’ to exploiting the potential in private markets while avoiding the pitfalls.
David Bell and Geoff Warren
For further discussion, see our thought piece titled Super as a suitable conduit for investing in private markets, which this article summarises.
