If they can find investments that earn close to double-digit returns with reasonable reliability, they’re happy to scale up – which is precisely what they’re doing.
Once a year, billionaire Anthony Pratt’s Visy and The Australian Financial Review host a gathering of policymakers, super funds and bankers.
The purpose is to explore ways for the $4 trillion pool of superannuation to provide more debt capital to Australian businesses and projects while also providing members with stable, reliable returns from the earned interest. In essence, it is to promote the growth of direct lending or private credit.
On Tuesday, Pratt will again hold court, alongside former prime minister Paul Keating, Reserve Bank governor Michele Bullock, and the chairman of the Australian Prudential Regulation Authority, John Lonsdale.
The chief executives of big banks, super funds and sovereign wealth funds will again be in attendance with ideas on how the financial system should be reshaped, and how it should not.
The overseas guest is Michael Milken, the creator of the junk bond, or high-yield, market in the 1980s that three decades on is a well-established and reliable source of capital markets funding.
Private credit is certainly heading that way, and super funds are getting on board. At the first roundtable in 2017, the feedback from super funds in attendance was that it was a great idea, but only in theory.
Big super funds were indeed embracing private assets, but because they were illiquid, there was a limit to how much of their portfolio could be deployed outside public stock and bond markets.
In a low-interest world, the returns from investing in private equity, infrastructure and real estate were far more compelling than the 5 per cent returns available from lending to big and small businesses.
A new world
That calculus has changed dramatically. With base interest rates between 4 per cent and 5 per cent, private lending can earn anywhere between 8 per cent and 12 per cent.
That’s about in line with the total return delivered by super funds over the past 12 months, and one that most members are satisfied with. If super funds can find investments that earn close to double-digit returns with reasonable reliability, they’re happy to scale up, which is precisely what they’re doing.
In the past year or so, the titans of the pension industry – AustralianSuper, Cbus, REST, UniSuper, Hostplus and Australian Retirement Trust – have all announced mandates and intentions to scale up their private credit exposure. Cbus and Hostplus have allocated about 7 per cent of assets to private credit, while AustralianSuper’s 4.5 per cent is set to grow, according to Morningstar.
The Future Fund, too, has been directing more dollars towards the asset class because it presents a compelling opportunity. The sovereign fund has about 10 per cent of assets invested in high-yield credit, of which about a third is in private credit.
They’re all playing private credit in slightly different ways. Some funds have built their own lending teams, others are partnering with banks to lend alongside them. Others are allocating to Europe to finance large private companies, and in the United States in the so-called middle market. Some prefer risky loans, others are opting for safer exposures.
It is proof that while super funds tend to act similarly to each other on big decisions such as asset allocation and currency exposure, their size, member composition and investment approach means they’re not entirely uniform.
All about liquidity
The evolution of the high-powered roundtable shows that the biggest consideration for super funds in deciding how much to invest in the sector is that so-called illiquidity budget.
Super funds can afford to invest only so much in private assets – which are difficult to sell on short notice – and be certain they can handle an unexpected run on a fund. They also have to be aware that if public market valuations fall sharply relative to private exposures that are valued less frequently, they risk leaving members overexposed.
So far, private credit stacks up against private equity, where most pension funds are waiting impatiently to get repaid before they write new cheques.
As HESTA chief investment officer Sonya Sawtell-Rickson told Super Review in April, private credit is diverse, and while it makes sense to direct marginal dollars to that asset class right now, this might not be the case in the future.
What is clear is that how capital is allocated across the economy and by super funds in Australia and around the world is determined by assumptions about liquidity.
These assumptions have reshaped the banks, and regulators have forced them to be prepared to meet a short-term run by depositors by holding a sufficient amount of easy-to-sell assets such as government bonds, and by penalising them for taking deposits from flighty savers.
Super funds, meanwhile, may be making bets with a long time horizon, but they still have to be prepared for members to switch to another fund or to change to another option that would require them to sell an asset.
These constraints on banks and super funds are enforced by regulators with a view to preventing a repeat of previous financial crises.
Ironically, super funds’ efforts to diversify bets beyond Australia and protect investors from adverse moments in foreign exchange place a further constraint on their ability to invest in illiquid assets.
Super funds engage in multibillion-dollar currency hedging strategies, which effectively are long the Australian dollar so that the appreciation of the local currency doesn’t reduce the value of their overseas investments.
But when the Australian dollar falls, even though these hedges are in the red, super funds have to keep their counterparties happy by raising cash against these positions.
How to manage these hedges, and the liquidity constraints they create, is a key area of focus for Australia’s largest super funds. As their pool of assets swells, and they continue to divert more marginal dollars to foreign markets, the currency hedging constraint is going to increase and become an even bigger focus for super funds.
These liquidity constraints are real and only likely to grow, so it makes sense to examine the costs. The limited liquidity budgets are effectively an insurance against failing to cash out members in time, and at a reasonable cost.
The issue of liquidity constraints is one that super funds and regulators are all too aware of.
There’s an argument that too much insurance in the form of underinvestment in illiquid assets that will provide solid returns over the long run leaves a superannuant prepared to agree to less frequent switching worse off.
But then, of course, there’s the point that the value of these illiquid assets is questionable and results in unfair transfers of value between members.
One of the most contentious issues for regulators of super funds to contend with is the accuracy and frequency with which to value illiquid assets. In a system that allows members to switch options or funds at short notice, a consistently fair and timely valuation is vital for the integrity of the system.
The issue of liquidity constraints is one that super funds and regulators are all too aware of. But another issue confronted by the chief investment officers of super funds is the value of the liquidity they’re giving up when they buy private assets.
That is, what is the extra return they should extract from a private illiquid investment relative to a public market equivalent?
Investors of all sizes, including super funds, have been guilty of under-pricing this premium because of the illusion that the investment is more stable when, in fact, it is simply being valued less frequently.
The sooner investors can recognise the true value of liquidity and price it accordingly, the better it will be for asset classes such as private credit to flourish sustainably.
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