S&P Global’s Peter Alleston says trust in the superannuation industry relies on timely, transparent, accurate and reliable valuations, particularly for unlisted assets.
On 1 January 2023, a new prudential standard for superannuation fund investment governance took effect in Australia, known as SPS 530.
APRA (Australian Prudential Regulation Authority) issued the standard following a consultation in 2021, seeking to enhance asset valuation, stress testing and liquidity management practices in the superannuation industry, and promote better outcomes for members.
Among the key requirements under SPS 530, super funds must establish a valuation governance framework which consists of the “structures, processes, procedures and controls necessary to identify and manage valuation risk of investments”.
Slow valuation adjustments
Concerns about unlisted asset valuations in the superannuation industry were brought to the fore early in the Covid pandemic when super funds were accused of being too slow to adjust their valuations of unlisted assets amid heightened market volatility.
At the time, members were allowed early access to up to AUD 20,000 of their balances, before many super funds had assessed and fully recognised the extent of any write-downs. Questions were being raised about whether unit prices reflected accurate valuations of unlisted assets, and whether losses may have been shifted from those making withdrawals to the remaining members.
In a 2020-2021 review, APRA found that super funds lacked robust frameworks for revaluing unlisted assets, had limited board engagement in the process, and were overreliant on external parties without challenging the appropriateness of their valuations.
Following the review, APRA sought out additional information from super funds about their unlisted asset valuation practices and required them to undertake a self-assessment and develop plans to remediate any deficiencies identified.
The regulator also updated SPS 530, raising its expectations on the valuation of unlisted assets. Draft guidance for the new standard issued in November 2022 says super funds should adopt a “rigorous and active approach to valuation governance, recognising the impact on performance and enabling the equitable distribution of investment earnings to beneficiaries”.
“This is the case for both listed and unlisted investments,” the guidance says, spelling out the key features a valuation framework should entail, covering methodology consistency, the appropriateness of judgments and assumptions, and the regular calibration of valuation inputs, among other areas. The guidance (SPG 530) is due to be finalised in July.
Valuing unlisted assets
A typical ‘balanced’ super fund consists of a number of different types of unlisted assets, ranging from investments in infrastructure, private equity, commercial property, and venture capital and hedge funds. However, obtaining valuations for such assets that are up-to-date and responsive to market shocks can be complex.
A commonly used methodology used for valuing unlisted assets in the superannuation industry relies on the discounted cash flow model, which involves projecting future earnings and applying discount rates to those earnings. The selection of the discount rate has broad implications for an asset’s valuation. The lower the discount rate used, the higher the present value of the future cash flows.
Typically, super funds use the average 10-year bond yield over a period of time (usually ten years), rather than the (higher) actual yield. While this helps to reduce the volatility of valuations, it can also result in artificially high valuations for unlisted assets, causing super funds to overstate performance and potentially disadvantage new members that may overpay to join a scheme.
Similarly, super funds that invest in commercial property tend to assume in their models that a drop in rental income due to vacancies will only last for two years. While this may have been appropriate before the Covid pandemic, it may not necessarily be the case moving forward, given the broad shift across industries towards remote working.
APRA recommends super funds prioritise valuation sources that reflect “quoted market prices of identical or similar investments in active markets”. But some industry insiders have argued that market prices are “largely irrelevant” because super funds are not trying to sell their unlisted assets.
Yet, others argue that fund managers should be forced to take account of market valuations because they are remunerated based on performance, which means they could be resistant to lowering their valuations on unlisted assets. Such conflict-of-interest issues were also raised in APRA’s 2020-2021 review.
APRA’s draft guidance says those responsible for investment decision-making should be operationally and structurally independent from those responsible for valuations.
Some of Australia’s super funds have indeed been setting up separate valuation teams for unlisted assets, but these can be costly as they need to be staffed with highly qualified CFAs and accountants with at least five or ten years of experience, according to Peter Alleston, regional head for Private Equity & Debt Services for APAC at S&P Global Market Intelligence.
“The cost and need for skilled expertise and resources in-house is one thing. But super funds also need to achieve an effective segregation of duties that eliminates the potential for conflicts of interest and even the perception of a lack of independence,” he said.
Pension funds in the US, Canada and Europe tend to use independent valuations and leverage service providers rather than set up large valuation teams internally, and they see this as best practice, Alleston explains. “Australia’s superannuation industry is trending in a similar direction, not only because of SPS 530, but also because of investor pressure for them to have a third-party independent process.”
According to a senior executive at one industry super fund, internal valuation teams would typically only be set up at larger super funds where the cost is justified by the number of assets, while small and midsize funds should appoint external valuers. “If you’re a smaller fund, you’ve got the same obligations and you’ve got less resources, but you’ve still got to execute, so that does become more difficult,” he said.
For most super funds, the choice between internal and external valuation teams not only depends on cost and expertise, but also the number of assets the fund holds, the types of assets, and the various markets the assets trade in.
“Most of the investments in the superannuation sector will be overseas,” the executive said. “There is often home country bias, but more and more capital is being deployed globally. And when you have unlisted foreign assets that are a bit more exotic, you’d want to get external valuers.”
“The valuation firms we use are globally well known and extremely reputable. We also rotate valuers so we don’t have the same valuer on a given asset for more than three years. But there’s nothing wrong with having a hybrid model, where you build internal valuation capabilities for asset types that account for a larger proportion of your fund, and use external valuers for the rest.”
APRA’s guidance leaves it open to super funds to determine whether and where they will seek independent external valuations. But it is a path that can ultimately solve multiple challenges associated with SPS 530’s valuation governance requirements.
More frequent valuations
For instance, the guidance says APRA expects super funds to undertake valuations on at least a quarterly basis, be able to demonstrate why valuations performed less frequently are appropriate, and consider the potential impacts on beneficiaries of selling assets at a “stale price”.
They must also “consider triggers that would warrant more frequent or interim valuations including market volatility and the external operating environment” – which is particularly relevant in the current investment climate following the collapse of several US banks and the rescue of Credit Suisse in Switzerland.
According to the executive cited earlier, his industry super fund had already put in place additional governance structures prior to the new standards coming into effect, but the firm is “increasingly interrogating” the underlying assumptions of valuations and why they are acceptable.
This demonstrates a recognition that there indeed needs to be more scrutiny over valuations, and that more questions are being asked and analysis performed to ensure such assumptions are reasonable and justified.
In addition, the executive said greater attention is being paid to the triggers for revaluation. “In years gone by, it was okay to wait until the end of the quarter and get the midpoint of the valuation. Now, we’re more attuned to market volatility and interest rate rises, for example, and always considering whether we should be getting any individual assets revalued for any reason.”
This indicates a growing recognition that waiting until the next quarter or reporting period is no longer acceptable, especially during periods of volatility. Revaluation now needs to be done on a much more timely basis, to help ensure member fairness around NAV.
In March, APRA general manager of superannuation Katrina Ellis called on super funds to be “much more proactive” given the current state of the markets, and to takes steps to ensure valuations “are not stale”. Super funds that are constrained by policies on out-of-cycle valuations should be adjusting those policies on the expectation that “turbulent markets are going to continue,” she said.
Speaking at the same event, ASIC (Australian Securities and Investments Commission) commissioner Danielle Press said her agency also expected more timely portfolio updates following increased volatility and the recent banking issues, particularly in relation to convertible bonds and commercial real estate such as office blocks and retail buildings.
At the beginning of April, APRA started holding discussions with auditors and trustees to ensure super funds have robust processes in place to value unlisted assets, which now account for more than a fifth of a typical “balanced” fund.
Ultimately, having a clear, transparent and independent process for valuing unlisted assets will help to address the growing pressure from regulators, auditors and trustees.
Moreover, APRA’s guidance places the onus on super funds for knowing when to accept, reject or reassess valuations of investments, meaning they must proactively have an independent in-house view of their external fund managers’ valuations.
Analyst-led independent valuation services, such as those from S&P Global Market Intelligence, are designed to satisfy these statutory and policy requirements of investors, regulators and business managers for consistent, independent calculation of prices for input into net asset valuations and other key portfolio metrics.
“APRA and ASIC have both indicated that unlisted asset valuation practices in the superannuation sector would be a key focus area this year,” Alleston says. “More than that, trust in the industry relies on the timely, transparent, accurate and reliable valuation of assets held by superannuation funds.”
More information about S&P Global Market Intelligence’s Independent Valuation Services is available here.