As the Future Fund and larger industry funds had already realised before the crisis, however, there are characteristics of private markets for equity and debt that are appealing to investors with long-term investment horizons.
The Future Fund’s chief executive, David Neal, announced his retirement this week to take up the CEO role at IFM Investors, the industry funds’ infrastructure investment manager. Neal has been head of the Future Fund since 2014 and before that its chief investment officer and architect of its investments strategies from its inception in 2007.
From the outset the fund had exposures to unlisted assets, but relatively modest ones.
Last year almost 15 per cent of the $168 billion fund – nearly $25 billion — was invested in private equity, $10.5 billion in property, $11.8 billion in infrastructure and timberland and $22.6 billion in alternative assets. There was also $22.6 billion exposed to debt securities, some of which – probably a large proportion — would be in private and higher-yielding debt.
There are a number of explanations for why sovereign wealth funds and big pension and superannuation funds are comfortable tying up increasing proportions of their assets in illiquid assets.
They have long-term liabilities and need assets with long-term stable cash flows, which are exactly the assets that private equity targets.
It has to be more than that, of course, because the companies that private equity takes over generally come from listed markets – the funds could just as easily invest in them while they are listed.
Companies owned by private equity funds are, however, far more highly leveraged than would be tolerated within public companies, offering higher returns on the equity invested.
They also operate on longer timeframes – five or six years or more – rather than being exposed to the pressure of the bi-annual, or even quarterly, reporting of sharemarket-listed entities. That allows for better longer term decisions, and less distraction from the constant scrutiny of analysts and fund managers.
There’s also a stronger, more direct relationship and commonality of interest and incentives between their managers, who usually have a lot of skin in the game, and the investors.
It isn’t just the lesser scrutiny, or the longer time horizons, or the leverage or alignment of interests that distinguishes unlisted assets from their listed counterparts.
In the early 1990s, the large unlisted property trust sector in Australia imploded as the “recession we had to have”, the collapses of financiers and the damage done to banks destroyed their access to finance. Many shifted across to the ASX.
The appeal of the unlisted trusts was that they seemed to offer better performance than their listed counterparts, even though both were invested in portfolios of similar properties.
The argument of their advocates had been that listed trusts were affected by the broader movements in the more volatile sharemarket – by equity performance rather than the property market. In reality, as with most unlisted investments, the “discount” for listed investments relative to investments in private hands relates to liquidity and valuation.
Listed securities are valued continuously and a sharemarket investor can cash out in a moment.
Investors in unlisted property, private equity, or infrastructure might see valuations of their assets once a year and could have their funds tied up for years. There is an illusion of minimal volatility only because there are no real-time valuations.
The inability to cash out and exit at the investors’ discretion explains why there is talk about an “illiquidity premium” for unlisted investments – investors seeking higher returns for the extra risk posed by the lack of liquidity.
Even without an illiquidity premium, unlisted investments might still appeal to the Future Fund and the industry funds because there are elements of diversification – the illiquidity and the difference between the instant pricing of public markets and the lags in valuations of unlisted assets – that dampen the volatility of a balanced portfolio of listed and unlisted investments.
The Future Fund was created by Peter Costello in 2007 just before the financial crisis developed. The fund was fortunate that it was heavily cashed up, having yet to deploy the bulk of its funds as the crisis developed.
It was able to exploit the distressed state of credit and asset markets to get off to a solid start. Neal’s strategy then seemed to be increasingly focused on private markets as central banks flooded markets with cheap liquidity, the cost of debt plummeted and private market activity soared.
The test for the fund in future will come if interest rates were to rise and the inherent risks in leveraged and illiquid investments became more of a threat to returns. In that circumstance, however, listed markets, inflated by those same low interest rates, wouldn’t provide a refuge.
The Future Fund’s big cash balance helped provide the foundations for its strategy and success. Increases in the allocation to cash and any decrease in private market exposures could provide an early indication that the fund sees troubled times ahead.
Stephen is one of Australia’s most respected business journalists. He was most recently co-founder and associate editor of the Business Spectator website and an associate editor and senior columnist at The Australian.