AVCAL Alpha Conference
1 September 2016
Dr Raphael Arndt, Chief Investment Officer
Good morning, and thank you for the opportunity to speak to you today. There has never been a more important time for a long term investor to have a meaningful exposure to Private Equity. As an industry I am sure you are pleased to hear that … however it is far from all good news.
In a moment I will explain how Private Equity fits into the Future Fund’s portfolio – why we include it and how we have gone about it. In short – why I think it should be your time in the sun. But first I need to provide some context around the Future Fund’s mandate and the current investment environment.
The Future Fund Management Agency manages five funds on behalf of you – the people of Australia. In total we currently manage around $140 billion on behalf of future generations of Australians.
The Future Fund currently stands at around $120 billion – and is Australia’s Sovereign Wealth Fund. It was established in 2006 with a long term objective to maximise returns without taking excessive risk. Our mandate from Government is to achieve a return of at least inflation plus 4.5 per cent per annum over the long term.
Before I talk in detail about Private Equity, I want to touch on the current investment environment.
It is a particularly difficult time to be a long term investor.
The Global Financial Crisis continues to linger. Interest rates are either below or close to zero across the developed world. More than US$13 trillion worth of bonds are now trading at negative yields. Here in Australia our cash rate is at an historic low, and the ten year bond yield indicates that investors expect it will stay there for a long time.
Global economic growth is tepid, despite the implementation of significant fiscal policy and expansionary monetary policy on a scale never seen before.
The outlook for the global economy is challenged by a number of headwinds, including demographics and unsustainable debt levels.
The world is more indebted now than it was prior to the Global Financial Crisis. This level of debt is a significant challenge to economic growth. If you are focussed on paying down debt, or at least not increasing it, then you will be hesitant to invest in new projects or ideas and hesitant to hire new staff.
Unconventional monetary policy may have increased returns for asset owners by inflating asset values but it has done little for workers. We currently see low nominal wages growth, and in many cases falling real wages – and increasing concern over job security across the developed world. Australia was insulated from this effect for some time by the mining boom. Those days are unfortunately, now behind us.
Rising wealth and income disparity is a real and present danger to a long term investor and cannot last indefinitely. We are now seeing the consequences of this reflected in global politics and increasing risks.
Risks like Britain leaving the European Union with all of the uncertainties attached to that. Risks like both candidates for the US presidency backing away from the Trans Pacific Partnership.
Despite these and many other events in the real economy suggesting that owners of capital should be seeking higher returns to compensate for increasing risks, we are actually seeing expected returns being compressed by ever higher asset values.
Central bank policies are forcing investors to take more and more risk to find reasonable returns – pushing up asset prices and making it difficult to find value investing in traditional asset classes such as public equities and debt.
Private Equity and venture in the Future Fund portfolio
So where does Private Equity fit into the picture I have painted? In a world without the tailwinds of ever increasing and cheaper debt and reliable economic growth, true value creation strategies are more important than ever.
Investments that do not rely on leverage or strong economic growth to achieve respectable returns are very valuable. That is why hedge funds and Private Equity make up a material part of the Future Fund’s portfolio – two strategies that have not found great favour with many of our domestic peers. In my view, the role of Private Equity and particularly venture capital in our portfolio is more important now than it has ever been.
In the Future Fund’s early days we took a conscious decision to build out a Private Equity programme that was focussed on innovation and small company growth. These strategies do not rely as heavily on the availability of cheap and plentiful credit or economic growth as large buyout strategies.Investors – the Future Fund included – are increasingly looking for asset classes that aren’t correlated to traditional equity and debt markets. Venture Capital, in particular, provides us with access to the innovation cycle that shows little correlation to these markets.
Importantly, through our venture programme we also gain insight and economic exposure to disruptive technologies – and we can take these insights away and make more informed investment decisions in other sectors including listed equities, property, infrastructure and debt.
As a result, today around 5% of the total Future Fund portfolio has exposure to these return drivers – mainly through the Private Equity portfolio.
The Future Fund’s Private Equity Programme
It is hard work building a Private Equity programme from scratch and, of course the j curve effect means that start up costs are high and results take some time to see. Today, eight years after the programme commenced it has finally reached maturity.
We have a small but highly skilled Private Equity team of seven, led by Steve Byrom, who is here today. We aim to be thoughtful investors, building a portfolio with purpose. We invest in funds and in co-investments, and will selectively use fund of funds for specific initiatives. We have the skills to meet our managers as peers, and the expertise to openly debate the merits of a deal with them.
The Future Fund’s Private Equity programme is now around $12 billion, or 10% of the Fund. The portfolio is tilted towards venture and small company growth, with over half the capital deployed exposed to this theme. We have a global programme with exposures across developed markets but also dedicated exposures to various emerging economies.
In fact, we have recently been increasing our exposure to onshore Chinese strategies where we can access the “New China” opportunities being generated by an emerging middle class. These are exposures to businesses in healthcare, tourism, agriculture and internet enabled retail. We just cannot get access to these trends through public equity markets as they are heavily tilted to the “Old China” sectors of construction, manufacturing and SOEs.
Relative to many peer funds globally I would characterise our approach as seeking a small number of General Partners – with whom we seek to develop deep and meaningful partnerships.
Around 25% of the programme is in co-investments and this is growing. Through the co-investment programme we can really get to know our managers and gain access to their insights, which we can leverage across our business.
We have built a capability to respond to co-investment opportunities quickly, in real time and to be there at financial close – avoiding the need for expensive or uncertain underwriting. This helps us get access to our managers’ best ideas. Of course, it also reduces the fee load.
What we are looking for
Let me explain what we are looking for in our Private Equity programme.
Over the last couple of decades most investors have benefitted from strong economic growth, increasing debt availability, lower borrowing costs and rising equities valuations. These tailwinds have created the conditions for an impressive track record – especially for highly levered buy out strategies.
In my view those days are gone forever. The focus must now be the application of genuine skill to create value, to improve a company, grow earnings, invest in its future and do this without the benefit of reliable economic growth or cheap debt.
These are the strategies we are focussed on. Hence we view favourably, focused managers with true asset management expertise and a track record in delivering alpha. Our due diligence process strips out free kicks from leverage or rising equity markets.
So how are we doing? Well, as I said, our programme has only just reached maturity. However I am pleased to report that it has delivered high teens returns since inception – including the j curve period. And of course that is net of all fees and costs.
Even more importantly, when measured on a like for like basis against an equivalent public equities market exposure, it has outperformed by over 300bps per annum since inception. In the period since the programme reached maturity this has increased to over 1,000 bps. That’s right – it has delivered an increased return of over 10% per annum net of all fees and costs when compared to public equity returns on a like for like basis.
Fees, terms and alignment
Some investors have adopted a cost driven approach to constructing their portfolios. In my view this unnecessarily tilts the field against strategies like Private Equity, which can deliver strong performance even without economic growth or increasing leverage.
That is why in assessing Private Equity investment opportunities, we focus on net returns and true alignment.
We view unfavourably GPs who see base management fees as a profit centre – and we are uncomfortable with the incentives created by excessive management fees that aren’t tied to performance.
In this context we will pay reasonable performance fees or carry where alignment exists, and where a GP is delivering true value for LPs.
As you would expect, we scrutinise fees closely and will not pay for luck or lazy use of leverage. When assessing track records we study the share of skill based return kept by GPs with that passed through to LPs.
We work hard to secure acceptable LP friendly terms. And we have rejected managers we otherwise liked on the basis that we weren’t comfortable with the fees and terms being offered.
In an environment where returns are being compressed, the focus on fees and terms is only likely to increase, and we have been active in working with the Institutional Limited Partners Association and with our GPs to improve fees and terms for LPs.
In terms of alignment, I want to also talk about the developing secondaries market in Private Equity.
As I explained earlier, risks for long term investors are rising while expected returns are falling. Our response to this has been to reduce risk in the portfolio and increase our flexibility to respond to changing market conditions by reducing portfolio illiquidity.
We have an added challenge that as an Australian dollar investor with a global portfolio we need to deal with the impact of sometimes significant currency movements.
That is why, late last year we conducted a secondary sale of some mature PE positions in the portfolio. This was not a reflection on any of the managers of the stakes we sold – indeed we kept an exposure to almost all of them. Instead it was a rational response by a long term investor to exit well performing but now mature positions. We recycled that capital into new ideas – including new allocations to Private Equity.
Secondary sales are an important source of liquidity for LPs, and a deep and well-functioning secondary market benefits all investors in this sector. GPs who seek to frustrate the secondary market from operating are short sighted and only add to negative perceptions that the industry is not sufficiently customer focussed. In this context, I encourage GPs to facilitate rather than frustrate secondary sales. The right to trade our positions as we see fit is an important element of our consideration of any new commitments we make and I am sure all LPs are watching GPs behaviour in this respect closely.
The Australian private equity industry
I earlier touched on the Future Fund’s objective to maximise returns for future generations of Australians.
It is sometimes suggested that the Future Fund should do more to support Australian Private Equity and Venture GPs.
As an Australian fund we are always actively looking for domestic exposures and, indeed, have several in the portfolio.
In a world where capital is mobile, the Australian industry needs to be able to stand up and be measured against the best in the world. At the Future Fund we measure all Private Equity managers – including Australian firms – against our global opportunities. And that’s how it should be.
The Future Fund’s size means that it is difficult for us to efficiently access meaningful allocations in Australian private equity funds – and particularly Australian venture funds. However we continue to have active conversations with a number of managers who are seeking to establish themselves in this space. It is to all of our benefit that the industry keeps developing.
Any discussion of the domestic Private Equity industry must acknowledge the focus on some poor IPOs over recent years. This has undoubtedly increased institutional investors’ caution about Australian Private Equity allocations.
In this context, we want to be sure that we can exit our positions. We diligence a manager’s exit track record – including the performance of its businesses post IPO. Where an IPO is the exit strategy, we prefer managers to stay involved with a company for a period after listing, as is done overseas. This approach generates better alignment for all concerned.
I also note that several domestic managers are dealing with succession issues for the first time. I encourage you to address these issues openly. We have overseas managers in our portfolio that are led by the third generation of leaders and have successfully moved on from founding partners and corporatised their business. Thoughtful LPs will not commit to a manager for 10 or 15 years without having a clear view on how these issues will be managed.
Venture sector in Australia
Before I finish, I also want to offer a Future Fund perspective on how Australia can best be part of the global innovation ecosystem.
As I mentioned, we are an active investor in Venture Capital with a current exposure of over $2 billion, including in Australia. We access the sector through fund of funds, direct investments into funds and, increasingly, via co-investment directly into the companies themselves.
Venture is very important to us as it gives us access to the current innovation and disruption trend. I am pleased to say that it is working – with the program having returned well over 20% per annum net of fees, one of our strongest performers.
We had early exposure to companies like Uber, Didi Kuaidi, Pinterest, Airbnb, Atlassian and Snapchat – all massive companies today – but we also have exposure to emerging winners like Digital Ocean, Stitch Fix, Coursera, Mongo DB, Elastic and MapR, just to name a few.
In discussing venture in Australia, the first observation I make is that we are a long way from Silicon Valley – more than 12,500 kilometres and seven time-zones.
Despite this we have some advantages – a well-established rule of law, a well-educated and skilled population base, as well as quality universities and institutions – including the CSIRO – that can hold their own against anyone else in the world in generating new ideas.
However we don’t have a deep and well developed venture sector like the US. And nor is the Australian domestic market particularly significant on a global scale.
To be part of the global innovation ecosystem requires significant effort, and we cannot sit in Melbourne, Sydney, Brisbane or Perth and think it will automatically come to us.
Our local companies and investors must take an outward looking approach – seeking to leverage off global innovation hubs such as Silicon Valley or Tel Aviv to take local ideas and sell them to the world.
Let me conclude by thanking you once again for the opportunity to be here.
As I touched on – it is a particularly challenging time to be a long term investor. The real economy is challenged, and asset returns are being compressed.
It is against this backdrop that private equity strategies such as growth, venture and innovation – which genuinely create value – are increasingly attractive to us.
As I said at the start, it’s my view that now is a particularly important time for long term investors to have a meaningful exposure to Private Equity.
Whether this eventuates into a new spring for the industry depends on you – both managers and fund investors like the Future Fund.
If you are a manager you need to consider your investors first – and ensure that you are focussed on true value add, are flexible with fees and terms, and most of all, operate in a transparent way.
If you are a fund investor, you need to truly consider the return drivers in your portfolio – and the diversification that different strategies provide. You need to question whether a purely cost focussed approach helps you achieve investment returns, to make sure it doesn’t preclude investment approaches that might have an important role to play in a diversified portfolio.
Our experience at the Future Fund is that Private Equity has an important role to play.
I, for one, am confident that the industry can and will respond to the challenges I have discussed today – and we will see a stronger, more sophisticated and more mature industry in the future. If this is the case then despite the grey skies in the global economy, the future for Private Equity will be bright.