Australian allocations

Superannuation funds have made a major contribution to the development of private equity in Australia. Now, they face a new challenge: to diversify their portfolios internationally. Andy Thomson reports.

Australia is a good place to grow old. In 1992, having faced a crisis in pension funding similar to that experienced in many other countries around the world, the Canberra government decided to take drastic action. It forced every Australian business to channel three per cent of each employee's salary into a superannuation (i.e. pension) fund. This contribution was increased in stages to nine per cent by 2002, the level at which it has remained ever since.

One (albeit indirect) consequence of this has been a steadily increasing flow of capital into the country's private equity funds. A recent survey conducted by the University of New South Wales and sponsored by Swiss fund of funds manager Adveq, canvassed the attitudes of 40 superannuation funds with a total of AU$120 billion ($92 billion; €76 billion) under management, accounting for just over onesixth of the total AU$700 billion currently pooled in all the country's superannuation funds. These funds are by far the most dominant force in terms of institutional investment in Australian private equity.

The survey found that 75 per cent of funds canvassed had some kind of exposure to private equity, and allocations to the asset class were on average between 4 and 4.5 per cent of total assets. This compares very favourably with pension and insurance company investors in the German, Nordic and Swiss markets, according to previous studies conducted by Adveq. In those markets, says a spokesman, between 35 per cent and 45 per cent of respondents had a private equity exposure and the amount was typically between one and two per cent of total capital.

However, Australian enthusiasm for private equity has a distinctly parochial flavour. The survey found that the domestic market accounts for some 74 per cent of the funds' total private equity allocation (see chart, page 76). One reason for this is the market's relative youth. “Private equity is a new asset class for a lot of Australian investors, even though a small core has been committed to it for a long time,” says John Brakey, head of alternative investments at Macquarie Funds Management, the funds of funds and tailored accounts arm of Macquarie Group.

There are other compelling reasons for local institutions to invest in their own backyard. Socalled franking credits result in Australian investors being treated more favourably for tax purposes for domestic rather than offshore investments. In addition – perhaps again a reflection of the relative youth of the industry – LP agreements tend to be highly favourable to investors, with fees (the issue of primary concern for Australian investors, see graph page 76) on average lower than in other parts of the world, whilst terms assisting the removal of under-performing managers are ubiquitous.

But perhaps most significantly – and against a background of strong economic growth – fund performance has been impressive in recent years. Brakey says Macquarie Funds Management has raised three funds of funds in 1998, 2001 and 2004, which after fees had returned 15.6 per cent, 38.3 per cent and 18.7 per cent respectively at the end of July 2005. “We have had key personnel issues and one or two deals that have lost money, but overall we can honestly see good performance across all our funds, in spite of the tech downturn in 2000,” says Brakey.

Macquarie's experience is not unique, and it stems from what has been something of a golden period for Australian buyouts. The sector has benefited from a lack of competition for assets relative to the US or leading European private equity markets, as well as the strength of the country's capital markets. According to the Ernst & Young's Global IPO survey, new issues activity on the Australian Stock Exchange more than doubled in 2004, with 166 deals raising AU$10.2 billion – much of it driven by private equity-backed floats, such as the AU$1.25 billion offering of retailer Pacific Brands by CVC Asia and Catalyst Investment Managers. In addition, returns from Australian IPOs can be maximised by rules allowing 100 per cent selldown of shares on day one.

Given their positive experiences to date, investors lack any obvious motive to turn their backs on the domestic market. What is more, they are showing no signs of losing faith in its ability to out-perform international markets. Respondents to the Adveq survey cited Australian buyouts as the most attractive segment for investment over the next two to five years, out of ten categories altogether (see graph right). More surprisingly perhaps, the Australian venture market – which suffered a similar fate to venture markets globally from the tech meltdown – was nominated as the second-most popular category.

Confidence is one thing, but is it time to begin questioning whether optimism has morphed into hubris? Brakey says that, while proprietary deals that would be the envy of the US or UK still exist in the midmarket, the larger buyout arena is becoming increasingly competitive. With the AU$1 billion fundraising mark having been broached by the likes of Babcock and Brown Direct Investment and Macquarie Capital Alliance Group, domestic funds are increasing in heft.

And that's before you add to the mix the increasing numbers of sizeable pan-Asian funds with their sights set on Australia as a potentially fruitful hunting ground. “There is no doubt there's more competitive pressure and that pricing is increasing as a result,” says Brakey.

In itself, this would cast doubt on Australian funds' ability to deliver the 16.5 per cent average absolute returns expected by the respondents to the survey (together with an out-performance over listed equity of 4.5 per cent per annum). And there are other warning signs. The economy cannot be relied upon to maintain its momentum indefinitely in the face of current worries about high levels of debt, a slowdown in consumer spending and the prospect of a rise in interest rates. This in turn tempts speculation about how management teams used to exploiting the good times will cope when confronted (perhaps for the first time) with a sustained downturn.

There is another very practical reason why superannuation funds should be open to broadening their horizons: they are growing at such a phenomenal rate that they are beginning to outgrow domestic funds' ability to accommodate them. “You can't flood a market and expect to keep getting high returns,” says Brakey. Taking into account government figures forecasting the size of Australia's superannuation funds to increase from AU$700 billion currently to AU$1.7 trillion by 2015, the scale of the flood begins to assume ever more menacing proportions. What is more, they are now competing for access to domestic funds against a greater number of international investors keen to get in on the action.

Therefore, it is no surprise to find the survey respondents indicating their intention to decrease allocations to Australia from 74 per cent to 65 per cent of their portfolios over the next two to five years (see chart, right). During this period, the funds say they will make their first incursions into the neighbouring Asian private equity markets (from 0 per cent to 2 per cent of the total), while increasing allocations to Europe from 7 to 8 per cent and in the rest of the world from 3 per cent to 13 per cent.

This apparent willingness to deepen relationships with fund managers around the world should not necessarily be viewed as a project undertaken with unbridled enthusiasm. Take Asia, for example, where Australian investors have until now absented themselves entirely from the local fundraising scene. For the majority of Australians busily squirreling away cash for their retirement, the future looks secure. But for the Superfunds that have been willing recipients, finding a secure home for the private equity portion of that money has become just a little more challenging.