This contribution is provided by Kosta Sinelnikov, Head of Policy & Research, at Australian Private Equity and Venture Capital Association.
In Preqin’s recent report Australian Superannuation Funds in Alternatives, superannuation funds make up 40% of institutional investors in Australia. The high level of sophistication they bring as international investors, coupled with the significant amount of capital that they can put to work, makes them an integral part of Australia’s financial and economic landscape.
What we are seeing in the private capital industry specifically is that super funds continue to be a key driver of new capital allocations into pooled funds, and alongside that they are also playing a major role as co-investors in new investments made by private equity (PE) and venture capital (VC) managers.
Taking the long-term view
Super funds are the biggest contributors to Australian PE and VC funds domestically. According to AVCAL’s figures from the 2017 financial year period, they accounted for a third of all capital raised by both Australian PE and VC funds. Super funds have been a mainstay of the industry over many years and many investment cycles.
It is often the case that those super fund investors that have managed to deliver the best returns out of their PE or VC investments are those that have the most mature PE investment programs. They have been able to benefit from the strong returns that PE and VC funds have delivered by taking a long-term, conviction-based view on the asset class.
When a super fund, or any investor for that matter, commits capital to PE or VC, that capital is typically locked in for many years. But even though the conventional life of a PE or VC fund is 10 years, the most successful and best-performing fund managers raise many funds over decades. So super funds that are able to commit to a long-term view on the PE and VC asset class can develop an investment program by building relationships with fund managers over multiple funds. A developing secondaries market in the Australian PE/VC environment can provide good outcomes for super funds that are more sensitive to liquidity constraints, and can also allow for fund managers to align themselves with investors that are able to back them over the long term.
Forming a relationship with the right fund manager can also lead to many opportunities for super funds looking to develop a mature PE or VC program, such as making co-investments alongside the fund manager or investing directly in a private business.
Fees and fee disclosure regulation
In its Australia report, Preqin highlights a long-running issue for super funds that invest in alternative assets – fees.
The focus on fees paid by super funds to investment managers has been heightened over the last few years because of regulations related to fee and cost disclosure, namely Regulatory Guide 97, a new disclosure standard administered by the corporate regulator, the Australian Securities and Investments Commission (ASIC). ASIC’s work in this area remains ongoing, while other arms of government have been involved in assessing how super funds have performed over recent years.
The Productivity Commission, the Australian Government’s principal review and advisory body, has been conducting research into the super system and has brought together possibly the best set of data currently available on super fund returns. Further analysis of that data shows that there is a statistically significant positive relationship between active returns generated by a super fund and investment expenses incurred. Each dollar spent on active management was found to produce, on average, $1.60 of additional returns.1
This finding bolsters the long-held argument that paying for some level of active management across a diversified portfolio – as opposed to relying solely on passive investments – is a necessary part of any investor’s toolkit if they are targeting above-average returns.
What the future holds
While some aspects of the interaction between super funds and alternative investments have not changed over recent years, it is worthwhile looking at what the future may hold for super funds as their assets under management continue to grow. The Productivity Commission noted that most projections forecast continued strong growth in super fund assets with between $5tn and $6.3tn under management expected by the mid-2030s.
Two prevailing forces are driving a shift that large institutional investors around the globe will need to grapple with in coming years and decades.
Firstly, we are witnessing the accelerating pace of innovation through leaps in technological breakthroughs and novel business models. Businesses are being set up every day that are taking advantage of this technological acceleration, and some of them will be the industry pioneers and corporate giants of tomorrow.
Secondly, there is an ample quantum of capital, whether it be private capital or public money invested through pension funds and sovereign wealth funds, which is looking for high-growth investment opportunities globally. This is heightening the level of competition for many promising deals but also creating other opportunities for investors as the most critical funding gaps for businesses are identified and met, allowing those businesses to continue growing.
The combination of these two forces means that nascent start-ups – particularly those that are able to harness technology in creative and unique ways – can jump into a high-growth phase very quickly.
With the right financial backing, these companies can start generating tens of millions of dollars in revenue in a matter of months. To give an example, US-based electric scooter start-up Bird is touted to be the fastest company to reach a valuation of $1bn, having been set up in September 2017 and reaching ‘unicorn’ status just nine months later, thanks to a number of rounds of investment in the company from VC funds.
Institutional investors cannot ignore these trends. And indeed some super funds have not done so, investing hundreds of millions of dollars in Australia’s VC sector and VC managers in other markets around the world over the last few years.
So we may not be far off from seeing Australia’s super funds taking a broader approach to the early-stage sector by partnering with and investing alongside VC managers directly in start-ups and later-stage high-growth companies as a way of capturing most of the upside in these investment opportunities.
1Productivity Commission Data: Active Management Adds Value, Peterson Research Institute, December 2018.