The recent sharp share price declines that followed capital raisings by two ASX listed companies (Downer and Collins Foods) is clear evidence that capital raisings have become dangerous for investors. It is our view that the structure of the Australian capital market and particularly the profile of the major participants is the cause of the problem. This is concerning because Australia has purposely built up abundant capital to meet our long-term pension needs. Indeed we have one of the largest national superannuation schemes in the world. However, it should be concerning to all Australians that the interplay in the equity market between intermediaries, hedge funds and large fund managers is today failing to deliver long-term returns.
In identifying the underlying problems, it is important for readers to review the evolution of the Australian capital market over the last 30 years. This provides an insight into the current workings and stresses in the Australian equity market. It helps us determine whether the evolution is working both for Australian investors and public companies (the issuers of capital). If we can identify the problem, then the solutions can be developed.
Some of the discernable and dramatic changes that have occurred since the 1980’s include the following:
- Large and stable institutions that were the providers of patient capital demutualized (1990’s);
- Large bank-backed brokers with facilitation capabilities replaced thinly capitalized stockbroking partnerships (1990’s);
- Investment banks and hedge funds evolved (1990 through 2000’s);
- Australia’s national superannuation scheme has developed with retail funds promoted by Australian banks (1980’s to now);
- Industry funds (1990’s) have evolved to manage massive levels of investment capital ($500 billion); and
- Baby boomers have collectively decided (2000’s) to manage their retirement capital (over $650 billion).
The above developments continue today; arguably, the most significant for the equity market is the massive growth in superannuation assets. The extent of this growth is truly breathtaking, and while there are clear benefits from a national superannuation scheme, there are also downsides. While we have no evidence of dis-economies of scale, which can occur if there is too much capital to invest, there is evidence emerging that some market participants are not behaving ethically in both the intermediation space and in the management of these assets.
These observations lead us to our view that some capital raisings have become dangerous for retail and self-directed investors. Indeed, as Australia’s superannuation assets grow faster than GDP, the risk of unsavory outcomes will increase unless checked by ethical and commercial management. If that does not occur, then stronger regulation may be called for.
The growth in Australian superannuation assets
Our first table below identifies the growth over the last five years in Australian superannuation assets across different categories. The most significant growth is noted in SMSF and industry funds, which have accounted for over 50% of incremental asset growth.
The next chart focuses on calendar 2016 as Australia’s super assets grew to about $2.2 trillion. As at December 2016, SMSFs represented 30% of total assets and are the largest sector. Behind them are the Industry Funds, which are now closing in on the mainly bank-managed retail funds. Industry funds will likely become the second biggest category in the next few years.
The asset growth outlined above (mainly generated by contributions net of pension withdrawals) is extraordinary, and we see this clearly when we compare Australia to the rest of the world in the following table.
While the above table has some limitations, noted in the footnotes, it does show that Australia now ranks second (after Netherlands) in the world on the measure of pension/super assets to GDP. We also rank second (behind Hong Kong) in terms of annual growth over the last ten years. The growth in Australian super assets of 6.9% per annum (over ten years) exceeds the growth in actual gross GDP of about 4.5% per annum.
Australia is indeed fortunate to have such a large national superannuation scheme, but size alone does not mean that it will adequately cover all pension liabilities. Our national scheme is not properly balanced, and it is utilised by many as a tax minimisation arrangement. Despite the overall size ($2.2 trillion), the majority of super balances in pension mode are insufficient to ensure the beneficiaries do not need a part-public pension. Australia, like most of the developed world, does not have sufficient funding for promised pensions for public servants. The latest estimate of unfunded liabilities in Commonwealth and State pension schemes is about $200 billion. The Future Fund in its June 2016 report suggested that it was short of its asset target by about $70 billion. It has four years to close this gap before it has pension drawdowns.
Across the world, the public pension shortfall is acute. In March 2016, Citi published a report titled “The Coming Pension Crisis” and suggested that unfunded pension liabilities (mainly unfunded government schemes) are $78 trillion. Ageing demographics and extremely low bond yields are exacerbating the problem. Looking to the future, it seems inevitable that many countries will be forced to cut public pension payments.
Source: Citi March 2016
These observations beg the question: How large should a national superannuation scheme be? And, Can its true utility be measured by comparing the size of super or pension assets to a country’s GDP?
In our view, it is essential to measure the success of a superannuation scheme by its capacity to ensure that as many people as possible can self-fund their retirement to a reasonable standard. Based on this measure, the Australian superannuation system is failing – despite being highly successful in growing its asset base.
Super-size is affecting capital markets
We opened this edition of The View by noting the recent share price collapses of companies that have raised capital through the ASX. But how are these observations related to the emergence of our large and growing superannuation system? Is it not reasonable to expect that the long-term pool of capital that resides in our superannuation system should act to stabilize our capital markets and asset prices?
The answer lies in the transition (outlined above) of the Australian capital market over the last 30 years. Back then, the Australian market was significantly influenced by the investment strategies of large mutual institutions (both general and life insurers) which managed their reserves by underwriting and/or supporting the capital raisings of the companies in their long-term portfolios. Being mutuals, and with no access to capital provided by shareholders, these institutions had to manage their reserves to achieve growth to support their own business growth. In many respects, it was no different to today’s requirement of superannuation funds to grow and match the growth in their pension liabilities.
Thirty years ago, capital market intermediaries were essentially brokers run as partnerships. Invariably, they had limited capital resources even though they presented formidable corporate connections and normally resided in Collins Street (JB Were or Potter Partners). Even Sydney had powerful broking partnerships such as Bain and Partners and Ord Minnett.
These “thinly capitalised” broking outfits were always in the center of the capital market and they were the first port of call for capital raisings or merger and acquisition deals. While there were cowboy elements in the market and the regulators were particularly weak, there was a stabilizing influence provided by the mutuals who collectively realised in the 1980’s that their balance sheets (reserves) were both essential and were being constantly accessed by fast-talking brokers. The mutuals realised two important things:
- Their balance sheets were worth something, and the financial arrangement between underwriters (brokers) and sub-underwriters (mutuals) had to be restructured. Fees for underwriters went down substantially, and fees for sub-underwriters went up substantially; and
- As the major capital providers, the mutuals wanted a say in the structure and pricing of capital raisings. They were simply not prepared to be offered capital on unfair terms.
During this period, the patient capital provided by mutuals was appropriately rewarded. The balance sheets of mutuals could be accessed by brokers, but they had to pay a commercially sensible fee to access it. Deals were structured to be rewarding to shareholders, and they were not rushed in fear of a short-selling attack by hedge funds.
This “Camelot era” passed as we traversed the nineties when mutuals were corporatised, major Australian broking houses were taken over by large multi-national investment banks with large capital bases, and hedge funds were seeded. It is worth remembering that it was the investment banks that promoted the falsehood that mutuals were archaic entities requiring public ownership to improve their corporate governance, returns and performance. Of course, the major beneficiaries of the conversion were the investment banks themselves and their brokers who received large fees.
The decline of the mutuals resulted in the relationship of underwriter and sub-underwriter becoming muddied, and management of the Australian superannuation industry has not filled the void left by mutuals in determining their place and status in capital markets.
Up until the internet bubble and crash of 2000, a chaotic period ensued where many intermediaries, be they investment banks or brokers, were able to facilitate capital raisings with little concern of a shortfall. Greed was king with sub-underwriters rarely needing to raise capital. Things changed subsequent to the internet crash, but the highly supportive interest rate settings of the US Federal Reserve (“the Greenspan put”) propelled asset markets higher, through to the leveraged, speculative period that led to the crash of 2008.
Since the GFC, the growth in the assets of Australian super funds has been astronomical. As noted earlier, the assets have grown from $1.5 trillion in 2012 to $2.25 trillion today. They have doubled since the GFC and the era of massive Australian super funds has arrived – But what are they doing with this capital to drive out inefficient and unsavoury market behavior in capital markets? There should be no doubt that major industry and retail funds have responsibilities both to their members and the community at large. For their members, they need to generate a reasonable risk adjusted return. For the community, they have a responsibility to drive ethical behaviour in asset markets. Some industry funds claim to be managed on a “mutual basis” for the benefit of their members. However, that does not absolve them from broader responsibilities.
Today, the industry and retail super funds dominate as capital providers. In the intermediation market, we can see the proliferation of large international investment banks operating inside Australian capital markets. These banks have promoted the emergence of hedge funds that have the capital support of industry funds. This support is seen both in terms of capital and stock lending (for shorting purposes).
The interconnection between these parties is arguably leading to a string of poor outcomes in the capital raising market. For instance, when a public company advised by an investment bank raises capital underwritten by hedge funds, then the end result can be unconscionable. The compression of capital raisings into 24 hours, when they could and should be extended over a longer period to permit careful analysis, may suit the intermediaries and the hedge funds but how does it suit longer-term investors?
In our view, the recent failures of some capital raisings is a direct result of underwriting panels being composed of hedge funds (short-term traders) and away from the natural long-term buyers. The excessive uses of index investing combined with the covert arrangements regarding stock lending are other examples of uncommercial activities. Indeed, the funding of hedge funds with pension capital to allow them to trade aggressively against those same pension funds and against public companies is a questionable activity; more so when it is aggressively undertaken.
It is time for Australia’s major superannuation funds to create a code of conduct for the management of their assets. It is time for these funds to take more control over the capital raisings of Australian listed companies. It is time for superannuation funds to ensure that capital raisings are conducted fairly to ensure that Australian capital is utilized appropriately for the benefit of the economy and the long-term pension needs of their clients. It is time for Superannuation funds to require that intermediaries conduct or structure underwritings and placements with investors and not traders.
The above may put the Superannuation funds into conflict with intermediaries but it is a conflict that has to occur. It is the same conflict that happened 30 years ago between mutuals and intermediaries. The Australian superannuation asset base is too large and too important to have it white anted by the activities of entities whom have no real concern with long term capital formation.
The sub-optimal returns of the Australian share market over the last eleven years are a warning sign. Australian companies have not performed in terms of return on capital and this is a consequence of poor management, poor capital management and poor capital structuring. All of these will not rectified until the capital that resides in the superannuation system demands a proper return.