Unlisted asset valuations can be murky.

Unlisted assets make up a growing and significant portion of many industry superfunds. AustralianSuper had 26.6% of their funds in unlisted assets at March 2022. Australian Retirement Trust’s Super Lifecycle investment strategy (Balanced) is 32.93% at June 2023. Nearly 50% of Hostplus’ Balanced MySuper option is in unlisted assets.

This level of exposure means that unlisted assets have a significant impact on the outcomes for the fund’s members. This will impact both how the funds perform and the volatility of returns. Volatility is particularly important to consider during retirement when there are regular drawdowns.

Funds are increasing their exposure to unlisted assets because they believe that they have a return premium over listed assets. They attribute this to high barriers to entry. In a sense this is true as individual investors do not have the same opportunity to access these assets. They call this return premium the ‘illiquidity return premium’.

The illiquidity return premium

The illiquidity premium is what investors receive as compensation for holding an illiquid asset. The premise is that investors favour liquidity, so they’re willing to pay more for liquid assets which lowers the return because of the high valuations. Investors that are willing to buy and hold illiquid assets over the long-term can purchase those assets for cheaper and therefore earn a premium or higher return.

As mentioned, unlisted assets have higher barriers to entry. The high barriers to entry to unlisted assets are due to a number of factors. Investing in unlisted assets requires large capital outlays and very long time horizons. They also require adequate scale – if you have a portfolio of $1 billion it isn’t prudent to allocate 100% of it in one illiquid unlisted asset.

These factors are intertwined and related to the liquidity premium and combine to potentially offer attractive returns over the long term.

However, it is worth questioning whether this premise is true. During the recent Conexus Financial Researcher’s Forum, a question was posed to the panel of experts*. The question was whether these large, illiquid assets are out of reach for the majority of investors, and whether that meant it would have to trade at a discount to ensure a sale to one of the few buyers that could purchase the asset.

Superguide has compared asset class returns which shows superior unlisted asset returns, i.e. an illiquidity premium.

Asset sector return performance superguide

Source: Superguide

 

These figures should be taken with a grain of salt. Annika Bradley mentioned during the panel that valuations are subjective. These figures are at least in part based on subjective valuations of unlisted assets that will not be realised until they are sold. It is a professional ‘guess’ as to what an asset is worth – and there is room for error.

It’s also important to consider that while there are restrictions on the number of investors that can buy unlisted assets there are very few of these assets available. As more capital flows to unlisted assets, as demonstrated by the size of the allocations from major super funds, the bidding wars may push prices higher and lower returns.

The problem with unlisted assets

According to three experts on the panel at the Forum, the main issues lie with the frequency and transparency of valuations. More on transparency a little later.

The problem with unlisted assets is – well, they are unlisted. This means that there is no way to know the true price of the asset and what it would sell for on any given day. There are rarely comparable sales that will give indications of how much an asset is worth. Similar assets are bought and sold very infrequently so it is hard to know what they will sell for.

Adding to this, many funds believe that they do not need to value assets as frequently since they aren’t planning on selling them for a long time, or ever. This is a spurious argument. If residential real estate prices are falling across the country I wouldn’t argue that my house has not dropped in price because I don’t plan on selling it.

APRA is the regulating body for these funds. They came out in July and said that the expectation is that these funds should price their assets quarterly.

The valuations come from one of two sources – internal valuers or external independent valuers. The panel agreed that an external independent valuation is always the best way to proceed – and frequently.

Annika Bradley, Morningstar’s Director of Research and Ratings believes that funds transact daily, so they should strive to have an accurate price daily. She makes the point that members are able to transact on a daily basis, and it is unfair that members are coming in or out of the fund when it isn’t priced correctly. If we look at AustralianSuper as an example, if 26% of the assets aren’t priced daily, how do you know what price each of these member transactions should be executed?

Say that a 100% unlisted property fund is valued quarterly as guided by APRA. It was last valued on 30th June, with a unit price of $1. A contribution from a member comes in in August and property prices have fallen. The investor would be purchasing in at $1, when the asset value within the fund would have dropped. The investor is effectively overpaying due to infrequent valuations. This is particularly important in super where contributions are coming in regularly, and funds may be revalued irregularly.

She calls out that quarterly valuations just wouldn’t work in scenarios with heightened volatility, such as in June 2022. Members of funds were switching in and out of funds and valuations needed to be current to ensure that they were getting a fair price.

Some members of the industry have argued that revaluing doesn’t really matter if you’re in a fund for the long-term. This is a theoretical argument and doesn’t stand up to the challenge of investors receiving income streams and withdrawing on a regular basis. It also makes any argument about the higher long-term returns with lower volatility. If there is no need to revalue an asset lower in times of financial stress there is no volatility. Returns simply march higher over time even if they pause at a certain level when there is no justification for an increase as the same assets that are publicly traded are falling sharply.

An example is Sydney Airport. It used to be publicly traded and the price bounced around. As COVID hit and air travel stopped the share price fell significantly from over $9 to under $5. In retrospect it is easy to say that COVID was temporary and investors were being irrational. However, it is hard to argue that all the uncertainty about the duration and severity of COVID did not impact an asset reliant on global transport. If the new private owners held the asset at the time and did not adjust the price it is hard to argue the portfolio reflected accurate valuations at that point in time.

How much exposure to unlisted assets should you have?

Annika Bradley believes that there is no optimal level. There are two factors that need to be considered.

1. Illiquid and unlisted assets get crudely bucketed together. The underlying liquidity profile could be different for these assets. For example, there may be exposure to a private credit fund that closes in three years. There may also be exposure to an infrastructure asset that is designed to be held for thirty years. The fund will class these assets into the same bucket. This is why, as mentioned above, transparency is a huge issue.

Morningstar believes that one of the key components to successful investing is understanding what you are invested in. This means that you are able to understand its behaviour, and you’re more likely to make rational decisions. Unfortunately, Australia is one of the few countries in the world that does not require funds to fully disclose their holdings. This is an antiquated notion and not in the best interest of investors.

2. Understanding the demographics of the fund. Most funds have different member demographics. Rest Super, the superfund for retail workers. I joined this fund during my first job at Grill’d. My experience was not unique, and the fund has a very different demographic to Australian Retirement Trust. This is important to funds because they have to think about their inflow and outflow profile. Rest would be getting a lot more contributions, while ART would be getting relatively more redemptions.

This is extremely important when you are investing in illiquid assets. As an investor, consider the exposure to unlisted assets as they usually do not perform well in times of stress. A perfect example is the Global Financial Crisis. Funds that held unlisted assets and faced an influx of redemptions could not liquidise quickly enough. Assets were sold at depressed prices.

This is important for investors to understand – especially if they are reliant on the income or require the capital back in the short to medium term.


*The panel consisted of Annika Bradley (Director of Manager Research and Ratings, Morningstar), Andrew Fisher (Head of Portfolio Strategy, Australian Retirement Trust) and Brad Matthews (Founding director, Matthews Investment Strategies).