In retirement, Australia can’t turn the tap off

Euromoney, April 2008

Chris Condon remembers former prime minister Paul Keating kicking off Australia’s compulsory retirement savings regime in the early 1990s. “He was saying one day we’d reach A$600 billion under management,” recalls Condon, the chief investment officer at National Australia Bank’s fund management arm, MLC. “We were all thinking: we’ll never get to that.”

In fact, savings have almost doubled Keating’s target. According to the Investment and Financial Services Association, the Australian superannuation industry (what Australia calls pension funds) was worth A$1.19 trillion by the September quarter of 2007, with the overall investment management industry bigger still. The actuaries Rice Warner project the size of the super industry should reach $3.2 trillion, in 2007 dollar terms, over the next 15 years.

 This, more than any other element of economic life bar commodities (it’s a very handy time to be a quarry and a breadbasket), is where Australia punches dramatically above its weight. Depending on definitions, it is either the third or fourth largest asset management industry in the world, in a country of just 21 million people, and is growing faster than any nation above it.

These numbers, driven by the so-called superannuation guarantee which since 1992 has compelled employers to put the equivalent of 9% of employees’ wages into superannuation, have a profound effect on many areas of Australian economics and business. They have driven one of the most sophisticated investment management industries in the world – in terms of professional management, institutional skill, and the intermediation of financial advice. They have, by necessity, pushed Australians – from the mum and dad investor to the multi-billion dollar pension fund – into international and alternative assets. The capital flows are big enough to have an impact on the currency. And they have dramatically impacted the priorities of Australia’s banks, pushing some of them into esoteric fields outside their home borders; in some measure one can link Macquarie Bank’s appearance as the largest owner of infrastructure worldwide, from the Hua Nan Expressway to Kilimanjaro airport, to the behaviour and appetites of Australian superannuation money. And with the new government of Kevin Rudd talking about increasing mandatory contributions to 12 or 15%, the wall of money is only going to get bigger.

Consider MTAA Super. This fund, originally formed by the Motor Trades Association of Australia for employees of Australia’s automotive industry, puts its members into some esoteric assets indeed: it has direct holdings, for example, in the UK’s East London Bus Group, and in a port in Gdansk, Poland, alongside numerous domestic airports, properties and utilities. It takes an innovative two-portfolio approach in which just over half the fund is committed to mainstream asset classes and the rest – 42.2% in the fund’s balanced option in 2007 – to something called the target return portfolio, made up of unlisted assets such as airports, tollways, ports, power stations, timber, private equity and landmark government buildings.

Such a major allocation to alternatives in a public pension fund is highly unusual on a world scale, but is relatively commonplace in Australia. Westscheme, a super fund originally for Western Australian public sector employees, had 17.6% of its funds in subordinated debt or infrastructure equity as of June 30, 8.8% in private equity and 10.3% in direct property, as well as 24.1% in overseas shares and a chunk in timber. Sunsuper, a Queensland-based super fund, went a step further and took a direct shareholding in the private equity manager Carnegie Wylie in 2005, giving itself the right to be a cornerstone investor (with therefore guaranteed allocation) to any subsequent fund it launches.

Consultants have had a role here, but increasingly it’s the savvy of these once-sleepy industry funds themselves that is driving decisions. “I think we are very sophisticated organisations, and increasingly so on the investment front,” says Paul Murphy, executive director at Unisuper, which manages A$24.3 billion for employees of the higher education sector. “The work that used to be done by [asset consultants] Mercer and Russell is increasingly being done in-house.” Unisuper alone has 27 investment professionals in-house and runs over 100 different investment mandates, while gaining its exposure to private markets through direct investment. Like many, Unisuper has roughly equal allocations to local and global shares, a lack of home bias that would be most unusual in other large markets.

One could argue they have no choice. The volumes gushing into superannuation accounts each year cannot practically be invested in Australia. “Because the flows are so strong and the size is so large, that money can’t all go into Australian domiciled investments,” says Gerard Doherty, Fidelity Investments’ managing director for Australia. “The Australian market won’t grow at that rate and it’s not sensible diversification. So you’re seeing asset allocation trends moving towards global equities, particularly among institutional funds.”

Local managers welcome the shift. “Superannuation funds have led the way in Australia as enlightened thinkers in portfolio construction,” says David Deverall, the chief executive officer of Perpetual, the largest fund manager in Australia not to be owned by a bank, with A$33.2 billion under management as of February 29. “They have really embraced global equities, and alternative assets in all their guises, onshore and offshore.”

Groups like Perpetual are making the same shift to boost expertise in international assets. Three years ago Perpetual broke off a long-standing outsourcing deal with Fidelity for international equities, and decided to take the responsibility for those portfolios in-house, poaching a team from Bank of Ireland Asset Management in Dublin to do so. “The money coming into the superannuation market will be seeking new homes outside of Australian equities, and obviously global equities is the big one that’s been soaking up the large flows,” says Deverall. “That’s how we believe it will continue for 20 years.” Other home-grown managers, notably Platinum Asset Management, have demonstrated that global product can be run out of Sydney; almost all of Platinum’s A$18.71 billion under management is in global equities.

At the same time, foreign managers have flocked to Australia, drawn by the scale of assets. All the biggest names, and numerous boutiques, are here offering some combination of retail and wholesale funds and institutional mandates. Fidelity itself, after ending its tie-up with Perpetual, launched 10 different funds for retail investors in a single day to complement the institutional mandates it already served; it sees great potential in serving Australian clients. “One of the key differences about this market is that it is sticky,” says Doherty. “The money flows into the system at 9% of wages, and you can’t get your hands on the capital until you’re 60 – and even then the majority won’t take most of it out then because of the tax advantages of leaving it in. If you’re in the US and have a 401K you can ring up next week and say: turn off the tap. Here it’s in the system forever.”

Australian banks saw the opportunity created by wealth and investment management early on, but it certainly didn’t come without pain. A few years ago, Commonwealth Bank of Australia’s ownership of Colonial First State – the country’s biggest fund manager – and National Australia Bank’s of MLC, represented a drag on earnings and a source of continual barracking at AGMs. That was nothing compared to Westpac, which in addition to purchasing BT Funds Management in Australia was also trying to integrate a three-way merger in its funds management division in the middle of a flagging stock market.

But that seems a long time ago now. “We’ve found the earnings growth out of it [BT] over the last five years has been nothing short of phenomenal,” says Phil Chronican, group executive (and former CFO) at Westpac. “It’s been well ahead of anything we might have expected at the time.”

Part of the reason for this is that in Australia, it’s not just about funds management. Australia has arguably the greatest level of financial intermediation, both in terms of the role of financial planners and of investment aggregation platforms like mastertrusts and wraps, in any major market worldwide. “I don’t think it’s appreciated how diversified a business BT was,” says Chronican. “One of the key features that made it attractive to us was that they were an early developer of the wrap platform, and that business has gone from strength to strength independent of the asset management activity itself.” Platforms allow banks to sell much more than just funds: life insurance, accident insurance, tax advice and margin loan support, among other things. “It’s an integrated wealth management services business.”

At St George Bank, Patrick Farrell, general manager in the wealth management division, expects a dent to wealth management business from the recent market turmoil, but a modest one. “On the whole, if you normalise the earnings stream, it’s been quite significant across the profitability lines and that’s not going to change,” he says. “A market correction will have an impact but the wealth industry in Australia… is not going to fall by the wayside.”

Another interesting development, which can arguably be traced to the scale and behaviour of super funds, is Australian institutions going offshore to find assets for those super funds to buy into. “One of the virtues of being the third or fourth biggest funds management industry in the world, with an externally enlightened super fund base, is that they are now allowing national champions to develop like the Macquaries and Babcock & Browns of the world,” says Deverall. “They are effectively going offshore with this money from the Australian super fund base [who are saying]: we want international property exposure, global infrastructure exposure, and we want to work with someone we’ve worked with for a long period of time. That has helped spur the growth of our industry on a global stage.”

Macquarie is the obvious example here. By the start of this year it had specialist assets under management of A$166 billion, including infrastructure (A$124.8 billion of it), real estate and private equity. It has listed funds in Australia, Canada, the USA, Korea and Singapore and unlisted funds in Hong Kong, South Africa, Europe and the Middle East besides. 79% of Macquarie’s specialist assets are outside Australia and the infrastructure alone covers 116 assets in 25 countries.

More are likely to follow. “It’s difficult for a fund to put $100 million into an infrastructure transaction, but it might want to put 10 to 15 million in to diversify,” and can do so through these funds, says Donald Hellyer, head of insurance and fund manager relations at nabCapital, part of National Australia Bank.

Macquarie is by a distance Australia’s most international bank – expect it to list in London before too long – and the big four commercial banks have arguably been put off major overseas expansion by some miserable past acquisitions by the sector. But all of them have some international presence (ANZ, for example, has widespread activity in Asia and is in the process of securing local incorporation in Vietnam) and most accept they will need to do more in the region in future. “We recognise that if we’re going to grow it needs to be outside Australia to an increased extent, and we’re focused very much on those sectors where we think we have a competitive advantage,” says Ian Saines, executive general manager at Commonwealth Bank of Australia. These include areas such as project finance and structured asset finance, including infrastructure, aircraft and ship lease finance. In another interesting area, the bigger banks are boosting their presence in the US private placement markets to help their issuers secure North American institutional funds (see box).

The sophistication of the super fund industry is noted on a world scale and is increasingly taking the expertise of domestic banking and funds management with it. There is, though, an argument whether the enlightened thinking of these funds is necessarily all that sensible. “There is a worrying trend I call the excessive granulation of investment strategy,” says Condon at MLC. “There are lots of aspects of this: alpha/beta separation, hedge funds, thematic funds, water funds, infrastructure funds…” He believes that both retail and institutional trustees are “caught on a wave of wanting to be innovative. But you shouldn’t be innovative unless you can put the resources behind that.”

BOX DEBT CAPITAL MARKETS

A strange thing has happened in the Australian debt markets this year: people have been issuing in them. “It’s actually quite intriguing,” says Peter Christie, executive manager and head of corporate securities origination at the Commonwealth Bank of Australia. “There’s been A$16 billion done in the first quarter, and that would tell you we’re on track for an almost record year.” The record, in far more agreeable market conditions, is A$67 billion; last year the total was just A$42 billion.

This apparent good health is a little misleading: the range of issuers is dramatically less and pretty much hits a wall at a credit rating of AA. In brighter markets, Australia boasts a diverse market of corporate, asset-backed and hybrid debt; today, only the most highly rated names are getting a look in.

Typically half of all issuance in Australian dollars comes from the kangaroo market: non-Australian issuers, in Australian dollars. While the proportion of recent issuance has faded, the market is certainly still open: it accounts for around A$5 billion of issuance this year, mainly from AAA-rated names. Gilles Planté, managing director at ANZ, refers to a “surprising resurgence” of the kangaroo market in 2008. “For conservative, quality names there is demand in the Australian market.”

Correspondingly the issuance lists for 2008 are dominated by a handful of recurring names: IFC, EIB, KfW. “Supranationals have had very strong issuance: a flight to quality plays to their strengths,” says Mark Garrick, managing director and global head of capital markets origination at nabCapital, part of National Australia Bank. Curiously, though, most of the buyers have not been Australian. “Investor appetite has been driven almost exclusively by offshore investors: Japanese investors in particular, and offshore central banks,” Garrick says. “The Australian investor base have not been big buyers at all.”

For a buyer like a Japanese institution, there is much to recommend a highly rated supranational name in the Australian currency. “If you look at the currency, the yield differentials, the pick-up to government risk – it’s a no-brainer,” says Garrick. Australians, in the meantime, are “very much caught up with the credit crunch. They have no incentive to commit to a sector now they think is going to get cheaper next week.”

An interesting counterpoint to the kangaroo market is the experience of Australian issuers venturing overseas. Global debt markets don’t seem to have shut for Australian banks: Westpac and NAB (twice) have issued bonds of Eu1 billion apiece so far in 2008, while both of those and ANZ have issued deals equivalent to more than $700 million in yen. The banks are also frequent fixtures in the sterling and Swiss franc markets.

But according to bookrunners, the market giving Australian issuers the most attention is one that won’t show up in the league tables: US private placements. “Australian borrowers have been regular visitors to this market, and it never closes for them really,” says James Waddell, director of capital markets origination at NAB Capital. “The key reasons being the familiar legal systems and accounting practices, language, culture, even the ANZUS military alliance. All those things come together: US lenders like lending into jurisdictions where they don’t have to get accounts translated and where they speak roughly the same language.”

It used to be the norm that Australian banks would strike joint ventures with partners in the US in order to bring Australian issuers to this market, using the US houses for distribution. But 18 months ago nabCapital and Royal Bank of Scotland dissolved their alliance. “For both organisations it was absolutely the right move,” says Waddell. Garrick adds: “The received wisdom was that you needed them for the distribution, that an Australian house couldn’t do that. I think we’ve proven you can do that.” nabCapital claims a 25% share of this market in 2007.

More recently, Commonwealth Bank of Australia came to the same conclusion, axing a tie-up with Merrill Lynch. “Because there are a limited number of investors in that sort of paper, it’s a distribution task we can take on,” says Ian Saines, executive general manager at Commonwealth Bank. “It doesn’t rely on an army of sales people in the US.” He adds: “The reason it was interesting for US banks to have joint ventures was because we understood the credit of these guys. We think credit is the hard part: distribution is more manageable.”

Flying in the face of fashion in the North American capital markets, Commonwealth Bank has been hiring, adding two people to the New York private placement team as local houses have cut headcount. “Some quality individuals became available,” Saines says.

Domestic issuance in Australian dollars is open for the top names but has all but closed further down the curve, with asset-backed paper in a particular bad state. “Lots of issuers are saying: ‘pricing is crazy, we’re not going to issue,’ says Garrick. But sooner or later they’ll have to: all Australia’s big issuers of asset-backed paper have warehousing facilities but typically they have 364-day durations; the credit crunch has already been going for more than half of that period. “Progressively these standbys will reprice along with the current market,” says Garrick. “At what level, we’ll have to wait and see.” There is, though, the advantage that Australian mortgages are considered among the most high quality in the world: according to the Reverse Bank of Australia, mortgage quality has actually improved marginally in recent months, although rising interest rates will put that to the test.

Like any country, Australia has had its fair share of collapses and routs: the ones that have rocked the markets (both debt and equity) in recent months have included the property group Centro, the finance company Allco, and even severe pressure on a preschool centre franchise called ABC Learning. In all cases, it’s been fears about refinancing that have driven the stocks down, but some believe the fears are overblown. “For every one of those names, there are 20 corporations that are successfully refinancing,” says Garrick. “Everyone knows when maturities are looming, it’s all about whether the banks have trust in the corporations, and highly geared entities clearly don’t generate trust. For the vast majority of Australian corporates the banks are open and willing to lend.” 

BOX: THE AUSSIE

What happens to your currency when all your pension funds start investing offshore?

Today the Australian dollar, underpinned by commodities and Chinese demand, is powerful and people are routinely talking about parity with the US dollar. Currency, in fact, is a big issue for funds investing overseas, given that most offshore assets are declining in value relative to the Aussie dollar: nabCapital managing director and head of insurance and fund manager relations, Donald Hellyer, recently put out a paper on this theme. “Your decision on how much you hedge has been way more important than which manager you give an equities mandate to,” he says.

There’s also a macro effect. “It  is interesting because as you are a net exporter of capital, there is going to be a continual purchase of foreign assets by the Australian dollar, so the hedging component will be quite important as to whether it has an impact in the currency.” It hasn’t yet – the resources boom has seen to that – but over time the sums could be so great that it dents currency performance.