AIST Background Paper No 7 Listed Unlisted debate revisited March 2009 The valuation of unlisted assets held by super funds has again come under media scrutiny. A number of recent articles in the business press have kept the debate raging with high profile journalists raising concerns about the following: • that the valuation of unlisted assets will fall in 2009, and that the fall should approximate the fall experienced in the listed assets, leading to underperformance of funds holding these assets; • that the valuations are irregular, and/or infrequent, meaning that funds have been carrying unlisted assets at inflated prices; and • that the valuations are not reliable for various reasons. Given the severity and duration of the current crisis, it is to be expected that unlisted asset valuations will come under pressure. However, our view is that the important questions are not whether unlisted asset values decline, or when those write-downs take place, but rather whether funds have robust valuations methods in place, and whether investment in unlisted assets is in the best interests of fund members. Perspective Most Australians do not regularly switch investment options in their super fund. Indeed, most super fund members have only the most rudimentary understanding of their fund’s investments, and rely on their trustees to establish, monitor and review investment strategies. Trustees are keenly aware of this fact and their investment strategy is informed by it. They invest their default option in a diversified portfolio to best serve their members interests. In order to assess the appropriateness of a trustee’s decision to invest in unlisted assets, the performance of the fund must be compared with alternative strategies over the long term. In light of this, it makes no difference whether unlisted assets are written down before, or after, falls on listed markets – the key issue is the performance of the portfolio over the long term. In short, market timing may be an issue for the tiny number of super fund members who are prepared to switch investments to arbitrage differences in valuation timings, but it is of no consequence to the vast majority who will remain in their fund’s default option. AIST Background Paper No 7 Listed Unlisted debate revisited March 2009 Page 2 Comparing apples with oranges With regards to property and infrastructure, the unlisted sector is lagging behind the listed sector because the unlisted sector generally operates at a much lower level of gearing and relatively transparent structures. The listed sector in its quest for market share, geared their portfolios to questionably high levels. This in turn, increased the pressures on business models, eventually leading these vehicles to become ‘forced’ sellers of their assets. Listed security analysts aggressively sold the listed assets down. In most cases, the selling overshot fundamental value, but in other cases, was warranted, as many businesses subsequently ended up on life support. Most finance courses include the question of value and what is fair value. Valuation 101 lists the several types of valuation that exist; we will focus on two here, fair value and fire sale value. Unlisted assets, as we all know, are not priced on an exchange; value is determined via internationally-accepted principles, including Discounted Cash Flow (DCF) models and comparable sales, to name two. The key issue that is often overlooked by commentators concerned with the disparity between unlisted and listed asset valuations is that most of the sales within the listed property sector have been ‘forced’ sales and therefore should be accorded less weight as an indication of value. This point is further highlighted by reports that fund managers are beginning to target these distressed assets. Cleary, value is to be had. It’s a well established fact in real estate circles that you don’t advertise foreclosure. Behavioural economics tells us that if a buyer is aware that an asset seller is forced, the buyer is less willing to offer their best price in the hope that the seller’s desperate circumstances will work to their advantage; with the seller having to accept the highest bid, or in some cases, the only bid for an asset. The DCF model, on the other hand, has been used for over 70 years and has become the cornerstone of modern finance; it is used in the valuation of all assets which produce a cash flow into the future. Infrastructure Infrastructure assets are unique and the use of comparable sales is less relevant than in the case of property because infrastructure assets are usually of a monopolistic nature. Typical infrastructure assets include airports, hospitals, power stations, toll roads and ports, to name a few. Infrastructure valuations therefore tend to rely more heavily on the DCF approach. In recognition of the valuation risks that may be inherent in the DCF model, the infrastructure and private equity industry has, in collaboration with international managers, investors and valuation firms, developed guidelines for the valuation and disclosure of assets. Such a valuation approach typically involves a detailed analysis of the business and a comprehensive forecast of the businesses cash flows for the next 20 years. In some cases, the more pertinent assumptions is that the models may be subject to scenario testing, therefore producing a range of likely results, with the highest probability result adopted as the valuation. AIST Background Paper No 7 Listed Unlisted debate revisited March 2009 Page 3 Given the complexity of such an approach and the costs involved, it is appropriate that the asset be valued on a less than monthly basis. As stated, the assets involved are usually of a monopolistic nature with secure cash flows, and as such, their underlying assumptions will rarely change within valuation periods. Even so, most funds’ constitutions will require that the assets are valued by an independent valuer on a regularly basis, usually quarterly. Super funds & valuation methods With respect to superannuation funds it is uncommon for the fund to hold assets in unlisted asset class directly. In most cases the assets are held via an investment in a unitised trust structure. Within the constitution of such a scheme it is not unusual to find a requirement that the assets of the scheme are valued regularly, at a minimum once a year, given that such schemes are subject to an annual audit every year. It is difficult to envisage a scenario where a scheme will undergo an audit and the accounting firm will not undertake a reasonableness test of the valuation of the assets and confirm the scheme’s unit price. Unlisted assets are valued by independent valuation specialists. Usually the valuation company has been appointed for a fixed term and rotated on a regular basis. The valuation specialists are drawn from the relevant industries and are typically separate from the trusts auditors. Portfolio Diversification Modern portfolio theory is based on the assumption that a portfolio is considered to be efficient if no other portfolio offers a higher expected return with the same or lower risk. The means by which a portfolio is constructed is to determine the correlations of the various assets with one another, the objective being to combine negatively correlated assets together in order to diversify risk. The low and negative correlations of listed share markets to direct property, unlisted infrastructure and private equity make these assets an excellent addition to diversify risk and make a portfolio of assets more efficient. The 6 per cent performance differential for balanced options between industry funds and master trusts last year 1 vindicates these arguments and is testament to the prudent diversification decisions that the not-for-profit sector has undertaken to insulate returns from share market volatility. The evidence shows that funds which invest in property and infrastructure solely via a listed vehicle as a means of diversification, are not in fact diversifying away their systemic risk, because listed trusts tend to track overall listed market indexes. 1 Industry funds outflank all, Australian Financial Review, 11 February 2009 AIST Background Paper No 7 Listed Unlisted debate revisited March 2009 Page 4 Conclusion Unlisted assets are an integral part of an efficient portfolio. The persistent questioning of their valuations and comparison to their listed counterparts is not warranted as unlisted assets do not import sharemarket volatility into a portfolio. The dramatic falls in value that have besieged the listed sector are in large part as a result of excessive gearing and related party structures. The flawed business models that were employed by these vehicles have been widely published, their highly structured, opaque arrangements have collapsed, and in the process they have destroyed value. Comparing the fire sale values that have been realised through the rushed and urgent sale of the underlying assets of these flawed structures to the values of a portfolio of assets of an unforced seller is like comparing apples to oranges. Yes, the value of unlisted assets may fall, but - unless we see a dramatic worsening of the global financial crisis – it is our view that any such falls would be far less severe than those already experienced in the listed sector.