Australian pension funds: Indecent disclosure?

When the letter hit David Russ' desk, the University of California Regents' Endowment Fund had just under $650 million - or 1% of its total portfolio - invested in VC vehicles run by Sequoia Capital. Their relationship stretched back 22 years. But the missive from Michael Moritz, a partner at the VC firm, brought it to a swift close.

Sequoia was dropping the University of California from its latest fund, Moritz told Russ, the university's treasurer, citing "the spate of Freedom of Information Act requests with which your office has been bombarded."

With plaintiffs queuing up to demand the endowment release performance data for funds in its private equity portfolio, and several judges deciding disclosure was a good idea, Sequoia concluded that its privacy was worth more than the University of California's continued custom.

Responding to the court ruling that triggered Sequoia's rejection, Russ noted that he wouldn't be able to replace the fund positions with similarly productive investments because they weren't available. "This decision is going to cost the university hundreds of millions of dollars," he added.

It was one of numerous actions, all of which took place more than a decade ago, that set the terms of certain US venture capital firms' relations with investors that endure to this day. Public disclosure of fund performance by LPs is frowned upon to the point that it can be a deal breaker.

Blast from the past

Sequoia's exchange with the University of California has now resurfaced in an Australian context. Last year, the federal government passed legislation requiring superannuation funds to publish full details on their portfolio holdings on a look-through basis - in a PE context, not only identifying the funds but also the assets that each fund is invested in - on a publicly-available section of their websites twice a year.

Disclosures made by US public pension funds, the closest the industry has to a "global standard," do not extend to the specific contents of PE managers' portfolios. The standard reason is that revealing the value of unlisted assets could have a detrimental impact on investment performance.

It is feared foreign PE firms will respond to the Australian regulations by refusing to do business with superannuation funds, thereby potentially denying members the opportunity to invest in the top-performing managers.

The new disclosure system was supposed to come into effect on July 1, 2013 and is now nearing the end of a 12-month deferral. Following the change in government last year and a reopening of the consultation process, it is hoped the regulations will be amended to something nearer the global standard.

Several superannuation funds declined to speak to AVCJ on the grounds that the situation has yet to be finalized. However, the dilemma facing these LPs is what do they do right now - follow the law or be pragmatic and accept the law is likely to change?

"Although I believe the regime will change, it is not appropriate to make commitments on the assumption that the law will change," says Andrew Major, general manager for investments at healthcare sector superannuation fund HESTA. "Therefore, when we make a commitment, we have to be confident that we can comply with our legal obligations as they currently stand."

Geoff Sanders, a partner at Allens who specializes in superannuation and funds management, warns that another deferral doesn't necessarily rescue the issue. He is advising superannuation clients that are making new commitments to put side letters in place entitling them to disclose the relevant information if and when necessary.

However, a Hong Kong-based funds formation lawyer tells AVCJ that he is advising GP clients to refuse these requests and pass the risk back to the investors.

It is, as more than one industry participant observes, "a real mess" and the sooner the government steps in and offers a degree of clarity, the better for all concerned.

Best intentions

The superannuation portfolio holding disclosure requirements emerged as part of the broad review of Australia's financial services sector in the wake of the global financial crisis. Many superannuation members lost a significant portion of their retirement savings and so the government promised root and branch reform to ensure this couldn't happen again.

The Cooper Report, published in 2010, identified a number of areas in which the superannuation system could be improved, including a removal of the complexity and opacity surrounding investment products.

It advocated "systemic transparency," whereby the trustee would disseminate a wide range of information on a superannuation fund's processes and portfolio holdings via a publicly accessible website. This was meant to go above and beyond the existing requirement that a superannuation fund disclose all investments or combinations of investments with a value in excess of 5% of total assets.

"I don't think anyone would disagree with the fundamental premise of transparency and more meaningful information being put in the hands of end users,," says Yasser El-Ansary, CEO of the Australian Private Equity & Venture Capital Association (AVCAL).

"But this is a case of the pendulum swinging too sharply in the direction of over regulation, which will not deliver the outcome the government is looking for and will actually be detrimental to the interests of superannuation fund members."

Indeed, it has swung past the point of comfort for most GPs. Lawyers attest that domestic managers have little choice but to comply with the new regulations, should they be fully implemented. They are subject to Australian securities laws and therefore bound to provide superannuation funds with information required to meet disclosure requirements.

Offshore GPs, on the other hand, are not obliged to approve the disclosure of their portfolio holdings. Based on their discomfort with any fund information entering the public domain, venture capital firms in the US would almost certainly reject the notion out of hand.

"It would be a serious issue for the US VCs," says Richard Baker, investment director at Blackbird Ventures, who until May 2012 was venture capital portfolio manager at MLC Private Equity. "I know freedom of information regulations in the US meant they didn't accept some institutions that were subject to those laws. It would have a significant effect on the super funds and their ability to access these investments."

Anecdotal evidence indicates that venture capital firms are threatening to exclude Australian investors from their products while the response from private equity has been more mixed, with some of the larger managers reasonably understanding of the situation.

This is in keeping with their respective strategies. While the typical VC manager can be guarded about his investments, a big buyout firm would struggle to keep deals a secret given the need for approvals and the size of supporting infrastructure.

Problems can arise when confidentiality arrangements in the limited partner agreement (LPA) that specifically restrict the disclosure of information have to be renegotiated. If there is no breakthrough with existing GPs, the LP is not obliged to exit the position on the secondary market. Rather, they can employ the "reasonable steps" defense.

"There is a point at which the super fund says, ‘We have taken all reasonable steps to get the information and we can't. It is not reasonable for us to sell the investment because we can't get the information, so we've done what we can do and need to do no more,'" explains Sanders of Allens. "We don't see it being an issue in a practical sense for pre-existing investments."

There is one caveat: the superannuation fund might already be in possession of the information through the GP's standard quarterly reporting. In this context it is questionable whether "reasonable steps" is valid. The fund might be compelled to disclose, regardless of whatever restrictions the LPA tries to impose, simply because the law does not respect confidentiality.

As for new investments, superannuation funds are drawing up side letters. GPs that are unhappy with this arrangement can walk away from negotiations and seek to raise capital elsewhere.

From an LP perspective, two issues have yet to become clear. First, would a trustee be able to make a commitment to a GP in the knowledge that the manager won't budge on LPA amendments? Second, given private equity accounts for a relatively small portion of superannuation funds' overall investments, are they prepared to devote the time and energy required to resolve these issues?

Superannuation funds say they are able to reach satisfactory outcomes with GPs, with one manager describing the default position as "an agreement to agree further." However, there are also cases in which commitments haven't been pursued, in part due to discomfort with GPs' attitudes towards disclosure.

Red tape

In addition to potentially denying superannuation members exposure to top quartile managers, the regulations would introduce a compliance burden beyond anything that Australian LPs have seen before.

To put this in context, the California Public Employees' Retirement System's (CalPERS) 2012 annual investment report, which offers the most detailed insight into its holdings, comprises 296 pages and 14,856 line items.

The bulk of these are public investment instruments, where the individual holdings are disclosed but the identities of the managers responsible for them, where the function is outsourced, are not. Real estate and real estate investment trusts account for 426 line items, infrastructure for nine, and private equity funds - divided up into corporate restructuring, credit, expansion capital, opportunistic and venture capital - for 349.

With $277.2 billion under management, of which $31.2 billion in deployed in private equity, CalPERS is a giant among the Australian superannuation funds. AustralianSuper is the largest, but at A$65.1 billion ($58.5 million) its asset pool is just over one fifth the size of its US counterpart.

In its 2013 annual report, AustralianSuper names 34 external managers for listed equities, 21 for global bonds, 32 for property, 30 for infrastructure, seven for capital guaranteed, absolute returns and cash, and 14 for private equity. Should this or any other superannuation fund be obliged to disclose the full extent of each manager's holding it is estimated the list could run to 5,000-10,000 line items.

"It's a very significant cost burden on superannuation funds and GPs," says AVCAL's El-Ansary. "At a time when we have a new government that has made reducing red tape and compliance costs on business its number one economic priority, this particular reform represents a very straightforward opportunity to stop the implementation of changes that will only serve to impose additional regulatory costs."

Even if the government is comfortable with the compliance costs, there is a broader consideration of whether or not full disclosure actually benefits superannuation members. A balance must be struck between giving end users access to information in the interests of transparency and overwhelming them with so much information that only those with accounting backgrounds will be able to process it.

This point is reinforced by submissions made by AVCAL and other industry associations, including the Association of Superannuation Funds of Australia (ASFA) and the Australian Institute of Superannuation Trustees (AIST), each of which calls for another deferral so the policy can be reconsidered and released in a workable format and with proper guidelines.

"Disclosure of fund assets (on a full ‘look through' basis) will not assist members to better assess the level of diversification and risk in particular products of likely future returns," ASFA states. "Such information will be too voluminous, not standardized and potentially too complex to be of assistance to retail investors."

AVCAL also stress the need for an exemption for unlisted investments from the public disclosure of commercially sensitive information in order to avoid the breach of contractual confidentially arrangements. AIST takes a broader view, arguing that the exemption should apply "where it is in the best interests of members."

The example given is an emerging markets fund that represents an excellent investment opportunity but is unwilling to see its assets disclosed publicly. In the light of the new regulatory requirements, a superannuation fund would either have to decline to invest in the fund or make a "blind" commitment. Both these outcomes could be considered sub-optimal and therefore detrimental to the interests of members.

Educated guesswork

In the absence of detailed guidelines, interpretations of the regulations are varied, particularly how information should be presented on a superannuation fund's website. It is possible to create a scenario, for example, in which disclosures wouldn't reveal much at all about a GP's investment activity.

One pension fund manager tells AVCJ that his disclosures would amount to a company name and valuation - much like CalPERS' policy for public debt and equities. There is no requirement to link the company to a fund manager, in part because four hedge fund managers could have a position in a single company, so the superannuation fund would aggregate its exposure.

As a result, people reading the disclosures wouldn't necessarily be able to decipher an individual manager's holdings.

"To really understand how a company is valued, you need to understand our percentage interest in the partnership; you then need to understand the partnership's percentage interest in the company to get an equity valuation; and then to get an enterprise value you have to look at the debt," the pension fund manager says. "There are a couple of steps to get to any clear valuation of a company using information that itself isn't going to be disclosed."

On this basis, while the disclosures are potentially quite material, once you drill down into the practicalities, the information might not provide a huge amount of insight into GPs' investment strategies. This is just one interpretation, however - the product of a fund trying to establish where it stands on an issue in order to prepare itself for when the government passes judgment.

Fortunately, this judgment, or at least another deferral of the implementation date, might not be long in coming.

AVCAL's El-Ansary believes a compelling case has been made to the government for a proper debate on this reform and a proper examination of whether or not the balance between cost obligations and more meaningful information has been struck. Furthermore, the assistant treasurer is said to regard the issue as a priority and recognizes the importance of providing a clear signal to the industry.

The much-desired compromise solution appears likely, one that addresses the broad transparency imperative yet saves superannuation funds from awkward conversations with GPs in which they offer no definitive answers to questions about carve-outs for materiality and sensitivity.

"I am hopeful there will be some materiality thresholds introduced into the current disclosure requirements, or that there will be recognition that certain information currently required to be disclosed is confidential and proprietary," HESTA's Major adds.

Foreign GPs shouldn't cancel marketing trips to Melbourne just yet.

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