A time of reckoning for those super and other funds offering ready access to investors while holding large exposures to illiquid assets was going to come one day. Most thought it would be when member bases had aged, and money being drawn down was significantly more than money contributed. In which case, super funds felt they would have had plenty of time to prepare.

However, the COVID-19 crisis has bought this forward. The increasing ease with which investors can make switches between investment options in a nervous environment and the government’s recent announcement allowing many Australians to make $20,000 withdrawals from super has accentuated the looming storm. Good policy? Probably not, but you play what is in front of you.

The pain of an investment crisis happens first in listed assets and only later in illiquid, unlisted assets, and sometimes the latter impact is small. Indeed, if the crisis is short and mild those unlisted assets can usually escape largely unscathed. But that’s not likely this time. Of course, the downside in listed assets may also have further to go but clearly significant pain has already occurred. With illiquid, unlisted assets that pain may only just be beginning.

Upcoming dilemmas for funds and investors

The irony is the pace with which funds adjust asset valuation of their unlisted assets will heavily dictate what the rational decisions of members/investors should be. Funds holding high weightings to illiquid, unlisted assets are in a hard place. On the one hand large, near term downward adjustments (including some sales at lower prices) will move valuations closer to the levels implied by the pain in listed assets and theoretically, should discourage some switching and withdrawals. It is also a more equitable situation for remaining investors. However, this will see poorer reported performance in the near term, that could encourage other disappointed investors to switch/withdraw.

On the other hand, being slow to make downward adjustments in valuations can make it quite rational for investors to withdraw what they can or switch to cash or a more conservative or liquid investment option. 

The concern being expressed by some funds (and politicians) is that this policy means investors are getting out of markets at the bottom. Really? Who knows if we have seen the bottom, even in listed assets? Nevertheless, I can see how such an argument does have more validity for portfolios of listed assets only, and picking the ultimate bottom there is always difficult. However, I struggle with such a view when we are talking about funds which might have 20, 30%,40% (or in case of some of the retail managed fund offerings), 50% plus in illiquid, unlisted assets (property, infrastructure, private equity, private debt, some other alternatives) whose valuations are typically still far from reflecting anywhere near the movements and valuation levels in listed markets. Some funds have been more proactive, and I am not suggesting that unlisted asset prices need to match those listed falls, but the current gap is stark.

Investors may therefore be totally rational in considering withdrawing or switching from such investment options, even temporarily, even if one is agnostic on the near-term direction of listed markets from here.

How different are listed and unlisted assets really?

Clearly, large super funds hold some high-quality unlisted assets that will deliver attractive long-term returns, even from current valuations and especially if interest rates remain low. But quality has not stopped similar types of assets being punished in the listed market and unlisted assets should not be immune from large falls in products that provide ready access at what is supposed to the “fair” value of the portfolio for all members/unitholders.

Perhaps the strategic and control value of large stakes in direct assets held by the largest super funds means they should, and will, hold their values much better. But to the extent many funds (especially smaller funds) are gaining their exposure to illiquid assets via institutional unlisted funds I am less confident.

Just because these funds rarely trade as secondaries in normal times doesn’t mean their value relative to NAV shouldn’t be adjusted in more challenging circumstances. Just look at the high discounts that listed investment funds (which may hold illiquid and/or listed assets) can trade relative to NAV in extreme markets. Of course, discounts to NAV (on listed or unlisted funds) are not necessarily a big problem and may provide excellent investment opportunities for existing and new investors.

The illiquidity issues are not just about super funds. Some illiquid/semi illiquid non-super managed fund products that offer regular liquidity to retail investors will be under the same pressure although they may respond differently. Some will likely gate while some have already introduced “temporary” much larger sell spreads partly to discourage current redemptions. (Including on some products whose underlying assets are normally quite liquid, but which became illiquid for a period during the worst of the recent panic).

One of the most common criticisms of listed funds versus unlisted funds and other structures is that they trade on market at a discount to NAV on average. Yet we are now, at least temporarily, in a world where some institutional unlisted asset funds, some retail unlisted funds (via the introduction of high sell spreads) and even some ETFs have been, or will be trading, at a discount to NAV. Further, while listed funds on-market liquidity can be poor, especially in times of panic, investors can still sell at a price and realize cash if they absolutely have to, unlike some unlisted illiquid funds with no natural market or non-super retail funds that are forced to gate.

Then there are some looming direct to investor liquidity mismatch disasters like Mayfair Platinum, which ceased paying redemptions on some products last month and is being sued by ASIC over deceptive and misleading information. When that fully unwinds the scale of losses will shock those “wholesale” investors who thought they were buying a “term deposit like” investment. I wrote about these products in December.

Of course, some super funds seen as especially vulnerable are already publicly highlighting that they have more than enough cash and other liquid assets to pay out any required investor withdrawals. (With some having sold listed assets recently to bolster cash levels). But having enough cash and liquidity to cover estimated withdrawals is only part of the issue here. There is the potential for more switching from nervous investors. And what does the portfolio look like after liquid assets have been paid out, especially if there are more losses in listed assets, both making the unlisted allocations proportionally larger. Of course, contributions will continue to come in, but these will be dented by the harsh economic environment and the potential loss of some members.

Ultimately, I expect many funds will eventually relent and illiquid, unlisted assets (especially those held via fund structures) will be devalued much more aggressively than they have been to date and to levels well below what many in the industry expect. Performance of some funds could be very poor through this period. The low volatility and capital preservation “benefits” of many of these assets will be seen to be largely an illusion.

Learning from experience

Although at a relatively small scale (in dollar terms and as a percentage of portfolios) I have had experience in managing illiquid assets as part of diversified portfolios at Select Asset Management through the GFC and some knowledge of the games that institutional asset holders play with respect to these.

The Select Diversified Funds, which I oversaw between 2002 and 2017 had some modest exposure to illiquid assets through the GFC. Fortunately, we were able to meet all the (significant) redemptions through the period, but the experience highlighted the challenges and decreased flexibility that even a modest weighting to illiquid assets can bring in difficult markets for funds that allow constant redemptions or switches. Asset allocation becomes challenging and at the very time there are fantastic investment opportunities you are constrained from fully taking advantage of them.

Other issues were highlighted some years later when a business decision was made to wind-down those Select Diversified Funds. At that stage the exposure to illiquid assets was modest (around 10%) and with an orderly wind-down over an extended period we could afford to be patient in seeking secondary buyers for two quite well rated institutional agricultural and infrastructure funds which were already widely held by several superannuation funds or other institutional investors.

The problem was very few, if any secondary transactions had occurred in these assets since their inception. Still, after patiently looking at all avenues, we were able to negotiate the sale of these funds, albeit at high single digit discounts to NAV. It should be noted this was in a good overall economic and investment environment. In my view that transaction price represented the fair market price for those assets at that time involving a willing but patient seller, and willing and knowledgeable buyers. But how many other institutional investors holding those funds adjusted the carrying of those assets to those transacted fair market sale values at a discount to NAV? I can confidently say zero. Indeed, the buyers were salivating at the chance to immediately write the purchase value back to NAV thereby providing a nice “risk free” return on that portion for the month.

Today’s valuation dilemmas

This brings us to today. What is the real value of vast number of illiquid unlisted assets held (both directly and through institutional funds) by super and some managed funds? Some have begun to write down assets by 5 to 10% and up to 15% for private equity. Some justify only small adjustments by saying their unlisted valuations never reached the peak valuations that listed assets did. Even if this were true for some assets, with falls in listed property, listed infrastructure and listed private equity/debt of as much as 40-50% at recent lows, there is still likely a massive disconnect.

Then there is a contrary view that suggests the chase for unlisted assets in recent years for their “low volatility” and yield benefits had resulted in illiquid asset valuations rising above listed equivalents and above what could be justified rationally. In years past, institutional investors sought these illiquid, unlisted assets for their so-called illiquidity return premium but in recent times many seemed to chase them for their “lower volatility”, yields or simply because other large investors held them. This arguably led to a lower expected return from some unlisted illiquid assets versus listed assets, even at recent peaks. This is certainly the case currently given the large falls in listed assets and minimal falls in unlisted asset valuations to date.

What is determining those new, modestly adjusted illiquid valuations which are still a fraction of the move in listed assets in the same asset classes? Are they just back of the envelope transaction reflecting simplistic valuation measures and small changes in valuation parameters? When it comes to fund structures that are beginning to be valued by some at discounts to the latest NAV, how is such a discount determined? Are they more based on what the fund can tolerate from a performance impact while trying to do enough to discourage more switches and withdrawals?

Are any such transactions happening at those current valuations or lower levels? I suspect very few so far, although this will increase. However, to the extent there are, and will be, sales why aren’t all funds that hold those assets forced to change valuations to reflect those latest transactions.

If, as in the case of the Select fund sales, the argument is that such transactions are “forced sales” that don’t apply to other holders, then how do we determine who is and who isn’t a forced seller? In the current environment where almost all growth oriented investment options could face a period of net redemptions one could argue that all are forced sellers of their diversified portfolio and all assets in that portfolio should reflect the realisable value in the current market as best as this can be determined.

In this crisis I believe that is where we will eventually get to, although it may take some time. There will be much more pressure to value these assets lower and at discounted sale prices that at least partly reflect the current market environment. If funds don’t do this, they are just advertising to their investors to take a rational decision to exit to switch to cash or other lower risk options or cash out what’s possible at least until those adjustments are made. Only truly closed end institutional funds like the Future Fund or some defined benefit funds will have a strong case to ignore these dynamics.

Of course, some super funds may resist the increasing pressure, gamble that the crisis will be short lived and mild and sell off their liquid assets and hope that their illiquid assets can ride through without the need for sale or significant devaluation of their unlisted assets. But obviously that means the illiquid component becomes larger and the fund overall even more illiquid. If they are wrong these funds will be the ones that will be struggling to maintain a sensible investment program and may be desperately seeking a merger partner.

In the retail non super managed fund space, we will likely see poor performance, some fund gatings and a return to investor caution on semi-illiquid structures offering regular liquidity that applied after the GFC. Having said this, gating in the retail space may be accepted by many investors who don’t want underlying assets sold into a poor market and may not be a problem if it is only a small portion of a client’s portfolio.

The future

Recent days have seen considerably more discussion on the dilemmas facing super and other funds with large exposure to illiquid assets. Perhaps the more important focus should be considering what will change as a result of these pressures and how the industry can become more robust and capable of handling extreme scenarios.

The possibility of the RBA helping to facilitate liquidity for super funds in the current environment has been raised, especially if the $20k withdrawals are greater than the $27Billion originally expected by the government. Perhaps such involvement could temporarily allay some of the concerns I have raised but I fail to see how this is a good long-term solution contributing to financial system stability in the future.

Amongst changes I see as possible as a result of these pressures are.

  • The trend to larger funds with fewer small/mid-sized funds via mergers will accelerate.
  • Potentially, only the largest of funds will be able to invest significantly in illiquid assets and most of this will be via direct strategic holdings in assets rather than via institutional funds. (not good for the institutional illiquid asset management industry).
  • A possible cap on the amount of illiquid assets (direct and funds) that could be held by super funds (and even non-super retail managed funds) offering regular redemptions/switches.
  • Funds may place greater constraints on switching/redemptions, at least for investment options that hold illiquid assets. (we are already seeing this).
  • Some super funds, especially remaining smaller ones, will, over time, have significantly less exposure to unlisted assets, and especially if listed assets continue in a bear market, and become cheaper.
  • Listed closed end funds, such as LICs and LITs will become a preferable and accepted vehicle to hold illiquid assets, especially for retail investors, despite the high volatility and large discounts they are periodically subject to.
  • Investors and the industry will become even more sceptical of volatility of return as a sensible measure of risk.
  • Overall, investors will become more risk averse as a result of their current investment experience and the more uncertain economic situation over coming years. Much of the money leaving growth-oriented investment options won’t be coming back any time soon.

Perhaps we see a clean-out and simplification of the super and investment industry. It almost certainly will mean less jobs but that is an outcome that will apply to many industries in response to this crisis. Consumers may ultimately have less investment choices but greater transparency on those choices. Of course, many bad investment choices will still be made by investors/consumers along the way. But that’s the nature of every major financial crisis. The next year will be a challenging but fascinating one.

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Jerome Lander

Do you think the behaviour of these funds is fitting for fiduciaries? Is it equitable to clients, or appropriate, or ethical, not to mark down the assets to reflect fair value. Do we condone or accept this sort of conduct as an industry? It has the short-term benefit for the fund of making the investment performance appear artificially better than it is, for a while - a clear case of agency risk. Furthermore, it obviously incentivises the informed to sell and get out, as you rightly point out - at the expense of those remain.

Anthony Golowenko

Thanks Dominic for your insights in this article. Many points well made. In this current debate on unlisted illiquid investments, I believe context is important - particularly investment time horizon. In undertaking a 5-year unlisted investment, the manager has (or should have) certainty of capital committed, which therefore drives the illiquidity premium. Where the current debate seems somewhat contentious is in determining fair value (NAV) and equating this to observed daily share prices. I'll use the example of Elanor Commercial Property Fund (ASX: ECF). Recently migrating from an unlisted past, the listed Fund's 'market price' has collapsed to circa $0.95 (from a $1.25 issue price). ECF's ASX release of 25th March 2020 provides appropriate context on the underlying fund attributes, including distribution guidance. Valuing these cashflows in an unlisted setting over a 3- to 5-year investment horizon - based on underlying assets, tenancy profile, occupancy, gearing, etc - would very likely NOT result in a fair value (NAV) adjustment to $0.95, the observed share price in fearful listed market environment. As your article illuminates, portfolio composition, the role of each underlying strategy component, and alignment with investor's objective(s) is central to this discussion - appropriate diversification across a range of dimensions. My comments seek to provide some balance to this debate, where an unlisted investment's role to 'provide a foundation of regular income' over a medium-term investment horizon need not be swept up in (fearful) daily pricing. (Disclosure: Recently purchased, Elanor Commercial Property Fund (ASX: ECF) is held in my SMSF)

Matt Christensen

Great article. Your truth-telling on IPO Wealth has no doubt helped many with their lifesavings and deserves huge huge praise. I found your 2 alternative funds example to be most enlightening. Agree with Jerome Lander. Unethical for investors to not mark down assets to the latest transaction price (where a true change of economic interests has occurred), assuming they had a chance to bid higher and did not. In these instances, the lower transaction price surely should prevail for valuation purposes. In the often grey and opaque unlisted space, a lot comes down to where the valuer/owner sits on the spectrum of conservative to aggressive. For unlisted project investing (mainly property); I've seen carrying-values calculated using as high as 35% discount-rates, and others as sharp as 5%. For 10-20 year projects, varying input rates will change present-value calculations enormously. I think added disclosures supporting valuations, that outline the primary method/assumptions backing valuations is pivotal. Also believe it is safest (that unless stated otherwise), best to assume all Net Asset Values have not been calculated using liquidation pricing (with brokerages + cost of crossing spreads factored in). This liquidation differential is obviously more relevant on high esoteric and low liquidity names.

Michael Whelan

Dominic - great article. A big issue is the Asset Consultants 'directed' many, many funds to get into illiquid, unlisted infrastructure.....and here we are, for better or worse (mostly worse). Anthony - I think, in effect, Matthew has answered your question with his 'Comments'.