Instalment Warrants – Everything youve always wanted to know but

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Instalment Warrants – Everything youve always wanted to know but Powered By Docstoc
					                 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.


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

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
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 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

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.

    Industry funds outflank all, Australian Financial Review, 11 February 2009
AIST Background Paper No 7
Listed Unlisted debate revisited
March 2009
Page 4


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

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.

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