As debate over valuation practices around unlisted assets is heating up, TCorp’s Tanya Branwhite points to the danger of mistaking valuation infrequency for stability.
Unlisted assets, including infrastructure, property and private equity, have a number of benefits for institutional investors. Often they are less correlated with public equity, the dominating risk factor in most investment portfolios, and so they offer a level of diversification.
These assets also provide a level of stability to portfolios because they are usually owned by sophisticated institutional investors and, therefore, not subject to the mood swings of return-seeking retail investors that public markets experience from time to time.
But the fact these assets are infrequently priced doesn’t mean their most recent valuation is an adequate reflection of their current value, especially in times of market stress. Tanya Branwhite, Head of Portfolio Construction at TCorp, says investors need to remind themselves that infrequent valuations are not the same thing as stable prices.
A naive approach to say that just because the valuation mark on an unlisted asset happens once a year, that the valuation volatility is a reflection of only that one year mark…, I actually would argue that we should have learned that out of the global financial crisis, because property in particular, particularly in this country, had some very significant challenges
“We do try to de-smooth the … behaviour of unlisted assets and there are a whole range of quantitative and technical techniques that you can apply. And there are some benchmarks that are very helpful in that space that gives you a better understanding,” Branwhite says in an interview for the [i3] Podcast recorded earlier this month.
“A naive approach to say that just because the valuation mark on an unlisted asset happens once a year, that the valuation volatility is a reflection of only that one year mark … I actually would argue that we should have learned that out of the global financial crisis, because property in particular, particularly in this country, had some very significant challenges.
“And to the extent that some of the assets throughout COVID were at risk of potentially needing cash injections … as do the listed markets, through capital raisings, but I think sometimes in the unlisted space maybe the risk of the requirement of additional cash from shareholders is perhaps not thought about.
“So I think it is interesting to observe that unlisted assets aren’t as stable in pricing terms as the regularity of the valuation mark might suggest.”
The lockdown during the coronavirus pandemic rapidly changed the operating environment for many companies and some business models struggled to adjust to the unprecedented circumstances.
Yet, infrequent valuation practices often meant these changed circumstances were not reflected in the valuation of privately held companies during the height of the volatility.
It caused the Australian Prudential Regulation Authority (APRA) to express concerns over the frequency and methodology of valuation practices among superannuation funds in Australia.
The prudential regulator’s main concern focuses on the problem that assets might be noted down in the books at a much higher price than they are currently worth, which creates an unfair position for members looking to buy into the fund. Since many superannuation funds use a daily unit price, this price might be artificially inflated by the infrequent assessment of price movements.
Retirees who are looking to cash in their savings, on the other hand, would receive an unfair advantage over new members joining the fund as they would receive a higher unit price than would be warranted.
To address these issues, APRA updated its Prudential Standard SPS 530 Investment Governance and opened it up for consultation in November last year. The consultation period is set to end this week.
I think the other interesting observation was from one of our clients, given that they were very aware of their fiduciary obligation of money that may be transactions through that period, actually asked for valuations of their unlisted assets to be done more regularly
In the draft, the regulator proposes under paragraph 111 that valuations should take place at least once a quarter or explain why a lower frequency is appropriate. It also states in the prudential guidance that it expects funds to consider increasing the level and frequency of
reporting and valuation oversight during times of heightened market volatility.
Quarterly valuations are certainly not common practice currently for assets such as unlisted infrastructure and private equity.
TCorp is not subject to scrutiny from the regulator and so SPS 530 doesn’t apply to it. But the asset manager keeps a sharp eye on the needs of its clients. TCorp manages a number of portfolios for a diverse range of clients, each with their own set of liquidity requirements. Some portfolios have cash outflow requirements that must be met.
Branwhite says some of its clients were taking proactive steps to get a better understanding of the impact of the pandemic on their portfolio.
“I think the other interesting observation was from one of our clients, given that they were very aware of their fiduciary obligation of money that may be transactions through that period, actually asked for valuations of their unlisted assets to be done more regularly,” she says.
Despite the challenges around valuations, many institutional investors are looking to increase their holdings of illiquid assets for the diversification benefits they bring. Branwhite also emphasises these assets have an important role to play in TCorp’s portfolios.
“Illiquid assets, not just unlisted assets, but illiquid assets can provide benefits. A good example is an investment that we hold in the portfolio: it is a series of hydroelectric dams in Canada,” she says.
“We were very fortunate to, under a bilateral arrangement, purchase a half share of that set of investments from a Canadian investor who was looking to reduce their exposure there.
“That [investment] obviously has its own series of risks, but primarily it is a hydrology risk. They are set up to sell the electricity into the electricity grid of Ontario. So if there is no water in the dam, then that is a risk.
“But that is a risk that is different. It is not correlated, generally speaking, to economic risk and so that is an example of a part of the portfolio that has provided us with a high degree of resilience through the last few years.”
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.