Private equity – a role for KiwiSaver? (Part 2)

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Tuesday, May 12th 2015, 5:36AM

by Pathfinder Asset Management

Last month we looked at the private equity market in New Zealand and opportunities to invest.  We saw that private equity is typically only available to sophisticated investors – and yet its long time horizon and potentially high returns could be well suited to KiwiSaver.  Do you want a piece of this growth asset in your KiwiSaver?

Can private equity sit in KiwiSaver?

The answer is yes and no.  KiwiSaver can have a long time horizon of 10, 20 or more years – which is perfect for private equity.  But there are several stumbling blocks to think through:

•  Asset liquidity:  Investors are entitled to access their KiwiSaver at 65 years and to transfer to another provider at short notice.  That is very tricky if assets in the fund are illiquid and have no traded market.
• Private Equity asset valuations:  There is no market pricing for an up to date and accurate asset valuation.  If an exit takes several years are assets held at cost until that point and then a large gain recognised? If so, an investor just joining the fund would share in the gains equally with an investor who has been in the fund since inception – is that equitable?  Implied valuation methods (such as based on similar transactions) have limitations.
• Private Equity investments can fail:  Their value can go to zero.  That is tough for a KiwiSaver investor – but such possible failure is also a risk for listed (non-private equity) investments.  The risk of a single company failure is “fixed” by diversification across a number of private equity investments and private equity in turn being only a small part of the investor’s overall portfolio.  
• Private Equity fees are high:  Typically a 2% base fee plus 20% performance fee is charged in a private equity fund.  The reality is actually worse as the 2% base manager fee is calculated off committed (not paid up) capital.  Private equity funds call capital as required – this means paid up capital starts low (say 10 cents per dollar) and is called in instalments (say 30 cents a year for the next 3 years).  At the point you have paid the first 2 calls (10 cents and 30 cents) the fund expense ratio is running at 5% p.a. (i.e.  $2 of management fee is charged against $40 of paid up capital).  Private equity fee structures do not sit well with the drive for low KiwiSaver fees. 
• Private Equity investors are active:  Private equity managers are very engaged in a business to add value (rather than being passive shareholders).  If a KiwiSaver manager looks to buy private equity assets directly will they have the management resource and skills to achieve this?  Can they overcome this by co-investing

The drawbacks are serious but not insurmountable - we should try to find a way to make it work. 

Do KiwiSaver schemes currently invest in private equity?

When KiwiSaver was set up it was headlined as providing capital to small and medium sized NZ businesses.  That just hasn’t happened as equity investment by KiwiSaver funds is channeled into listed companies both here and offshore.  But it is unlisted companies that are the lifeblood of our economy and need access to capital.

Many growth KiwiSaver funds contemplate investment in private equity, although actual investment in private equity assets or private equity funds is rare.  Here are some examples: 

It is not only growth funds that could include private equity.  For example Westpac’s balanced KiwiSaver fund has a target allocation of 6% to alternative assets (which explicitly includes private equity) and its conservative KiwiSaver has a target 2% allocation.

There is no shortage of KiwiSaver providers with a mandate to invest in private equity – but choose not to.  In fact Milford Asset Management’s Active Growth Fund appears to be the single exception (also accessible via Aon’s Active Growth Kiwisaver).  

Is direct investment by KiwiSaver funds into PE assets the way to go?

There are two obvious ways that a KiwiSaver fund could access private equity investments – by delegating management to a specialist private equity manager or by direct investment.  Milford invests directly into unlisted companies and current stakes include PartsTrader, Vend and AFT Pharmaceuticals.  Other unlisted holdings by Milford have included Orion Health which was floated in late 2014 and a 50% stake in Perpetual Trust / Guardian Trust (Complectus) which was acquired in March 2014 and sold in July 2014.

As direct holders of PE assets KiwiSaver managers may have a natural value add - they can contribute skills, access and profile to the capital raising process when preparing for an IPO.   (Milford’s investment in Orion Health is possibly an example of this).  This means that specialist private equity managers may have an incentive to co-invest with KiwiSaver fund managers.  Milford’s recent investment in PartsTrader is an example of co-investing – this was a $40m capital raising also involving ACC and Todd Technology. 

Milford have shown that direct investment in private equity assets is a viable option for KiwiSaver funds.  The advantages of direct investment can be summarized as follows:

• Fees:  A layer of fees will be avoided by investing directly.
• Cashflow:  The manager should be able to manage availability of cash for new acquisitions and cash calls (whereas by delegating management this control is lost).

Should KiwiSaver funds invest indirectly via a specialist private equity fund?

The alternative is for a KiwiSaver manager to appoint a specialist external PE manager and so invest in their limited partnership or fund (rather than the KiwiSaver investing directly into private equity investments).  While this adds a layer of fees, it also has advantages:

• Skills:  PE is a specialist asset class and requires skills that a conventional fund manager may not have.
• Diversification potential:  A PE specialist can access larger capital pools than a single KiwiSaver fund and so potentially diversify investments more widely.
• Simplicity:  The KiwiSaver fund is optically simpler with one asset (an interest in a private equity limited partnership) rather than a number of individual PE assets.
• Valuation:  The KiwiSaver manager has no input into the valuation of the private equity assets, avoiding any incentive to inflate asset values.  Investing via a specialist private equity fund does not solve the valuation problem, it is just transferred to the private equity manager.  However because private equity fee structures are calculated off committed capital (not fund NAV), a private equity manager is incentivized to value fund assets conservatively.

Whether KiwiSaver private equity investment is direct or indirect it is critical to manage liquidity and valuation issues by keeping private equity investment as only a small part of the overall KiwiSaver portfolio. 

How much could KiwiSaver commit to private equity?

Morningstar’s December 2014 survey covers just over $25 billion invested in KiwiSaver (this is about 97% of the Reserve Bank’s reported total KiwiSaver size).  Morningstar cover a range of investor profiles - conservative, moderate, balanced, growth and aggressive.  The first issue to think about is should all profiles have exposure to alternative assets like hedge funds, commodities and private equity?    Many would argue that all long term investors, regardless of risk profile, should have some (even a small) allocation to alternative asset classes.

The obvious natural home for private equity is growth and aggressive funds.  27% of KiwiSaver money ($6.8 billion) is parked in growth and aggressive funds – if these committed 5% to private equity this would amount to $340m.  If balanced and moderate KiwiSaver funds (36% of KiwiSaver being $9 billion) allocated only 2% to private equity that would amount to a further $180m. 

Based on these allocations moderate to aggressive KiwiSaver investors could invest over $500m in PE.  This is a significant amount and has the potential to climb steadily with KiwiSaver growing at a rate of over $7 billion per annum.

The future: More private equity in your KiwiSaver?

If Milford’s KiwiSaver fund delivers handsomely from its private equity piece over the next few years, then wider investor awareness and interest will pick up.  It has started well – Milford recently announced that in the year to February 2015 the return from its unlisted private equity investments was 54%. 

But under the current rules it is hard to see many KiwiSaver providers following Milford’s lead and launching into this specialist and illiquid asset class.   The illiquidity of these investments does not sit well with an investor’s right to change providers and to cash out at 65 years.  There are also issues around certainty of pricing the unlisted shares.  These problems are not unique to KiwiSaver – fund providers in the US have also been looking for solutions allowing 401(k) pensions to invest in private equity.

Changes would need to be made to KiwiSaver rules to allow the wider inclusion of private equity investments.  Below are some thoughts on possible changes to KiwiSaver that together would make PE investment easier:

• A fixed term KiwiSaver fund:  allow a private equity KiwiSaver fund with a fixed life of up to 10 years during which withdrawals and transfers out are not allowed.
• Distribution of assets rather than cash:  If investors leave a KiwiSaver fund by transfer or reaching 65 years, the manager could distribute private equity fund/partnership units rather than simply transferring cash.
• Splitting a KiwiSaver account:  To counter the reluctance of existing KiwiSaver providers to invest in PE, investors could be allowed to split their KiwiSaver among more than one provider (i.e. they could then choose a small allocation to a specialist private equity provider).
• Self-select KiwiSaver platforms:  Craigs are heading down the route of a “supermarket” KiwiSaver where the investor can choose from a “self-select menu” of securities and funds. It is possible in the future that PE funds could be added to such a platform.  
• Regulatory direction on KiwiSaver liquidity:  KiwiSaver managers are required to balance competing considerations, such as investment liquidity and diversification.  A law change could help by clarifying that immediate liquidity is not required for all holdings. 

These suggestions are intended to loosen KiwiSaver rules to include private equity investment.   However taken together these are a challenge to KiwiSaver’s basic structure, making them unlikely to be adopted.

Is there a solution that actually works?

Fitting an illiquid asset (private equity) into a savings scheme where managers want liquidity (KiwiSaver) is not an easy one to solve.  In larger offshore markets there are several ways to access private equity,  such as (a) an active secondary market in private equity investments, (2) synthetic private equity investment products and (3) listed private equity entities.  Could any of these work in NZ?

• Secondary market:  Offshore markets have more active secondary markets for PE investments – including funds that focus on buying in the secondary market (i.e. these are private equity fund of funds products).  This can’t be relied on in NZ to provide KiwiSaver managers access to liquidity  – there is simply not enough depth in the market or product available for this to work on the scale KiwiSaver needs.
• Synthetic product:  Synthetic private equity products attempt to replicate private equity performance using public market equivalents or other instruments.  Again this is not the solution – if the wider objective of PE investment is to create employment and grow NZ’s unlisted companies, investing in listed companies will not achieve this – in fact the “replication” investments are likely to be offshore as well as listed (if a KiwiSaver provider wanted this exposure they could simply buy into the US$476 million listed Powershares private equity replication ETF).  
• Listed PE entities:  This is the best place to focus.  What if the PE industry collaborated to launch a NZ listed investment company investing in NZ private equity transactions?  With a listed entity KiwiSaver providers may become more comfortable as (1) there is a route to exit a holding and (2) valuation is more transparent with a daily market price (although listed closed end funds can suffer from the premium / discount pricing issue).  Through PE industry collaboration this listed entity could be certain of seeing opportunities to co-invest and also buy into existing funds through the secondary market. 

For KiwiSaver to embrace private equity a listed PE entity may be the best option.  It is worth noting there is an example of a listed company investing in private equity – Kingfish Limited (a listed investment company managed by Fisher Funds) has a holding in Waterman Capital.  According to Kingfish’s holdings commentary, Waterman “acquires and operates established unlisted medium-sized businesses in New Zealand…. [and] operates in a niche market that is typically not represented through listed market vehicles.”  It sounds like there’s an opportunity here for a listed private equity fund.

Final thoughts

The money invested in KiwiSaver is highly concentrated in very few providers.  Morningstar’s December 2014 survey reported that 94.5% of all KiwiSaver assets are held by only eight providers.   This means if only a few significant KiwiSaver players lead with investment in private equity then the resulting contribution to private equity could be significant.

Currently the only KiwiSaver provider to invest in private equity is Milford Asset Management, whose 12 month  private equity asset return is 54%.  Their approach is to directly hold private equity assets – keeping the allocation small to shield the problems of illiquid assets (you never want to be a forced seller in an illiquid market).  The more direct holdings the better to provide diversification.

Outside of KiwiSaver there are specialist private equity managers investing in companies that need capital.  These NZ private equity managers can help build better companies and so are typically good for our economy.  The long time horizon and potentially high returns could also be good for KiwiSaver investors.  The best way for KiwiSaver providers to access specialist PE managers is likely to be a listed private equity entity formed through industry collaboration.

We need investors to be aware of the investment potential of private equity.  We also need discussion and ideas to find a way for these high returning growth assets to “fit” inside KiwiSaver schemes.

John Berry, Director
Pathfinder Asset Management Limited

Seek advice:  Pathfinder is a fund manager and does not give financial advice.  Seek professional investment and tax advice before making investment decisions.

Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors. www.pfam.co.nz

Tags: KiwiSaver Pathfinder Asset Management

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