How can superannuation funds invest in innovation?

This week I spoke at the Ausbiotech conference in Melbourne on the role of superannuation investing in life sciences, proposing the establishment of a Superannuation Innovation Forum.

Following are notes from my speech:

Superannuation and Life Sciences Speech
AUSBiotech Conference, Crown Conference Centre, Melbourne
Tuesday 6 October 11.30am – 12.00pm

Today I want to focus on how we can get superannuation funds to invest in innovation.

This question is directly related to life sciences. But it is broader. If we can establish the right environment, then we will see investment flow to technology companies, advanced manufacturing and other entrepreneurial companies benefit.

There is a ground dog day element to this discussion that as a nation we have never been able to quite address.

The fundamental reason why is that government, superannuation and industry talk at each other – not to each other.

One of the perennial problems is that when talking about innovation, government become besotted with the idea of establishing a venture capital culture in Australia. This is backed by Ministerial tours to Silicon Valley and discussions with venture capitalists.

I am afraid that our policy makers have spent far less time talking to the heads of superannuation funds – who are literally next door.
So let’s talk about the obstacles that are preventing capital flowing to innovation.

Government

Part of the problem is that the Governments own rules make it difficult.

Superannuation funds have been required to manage liquidity in order to meet redemption requests and member choice requests.

This is one of the real costs of the choice of fund that we all individually are able to access. My ability to transfer assets within a couple of days anywhere in the system means that superannuation funds can only ever invest a tiny proportion of investments in unlisted assets.

There has been discussion on the need for liquidity facilities and special rules that could enable super funds to invest more in illiquid assets – but unfortunately we have not seen progress on this issue in the recent Financial System Inquiry.

Venture Capital

The second issue is the venture capital model.

Venture capital is at its heart an investment structure. One of the problems with venture capital is that it is not ideal for superannuation funds. The key issues are:

1. Investment volatility
2. Fees
3. Flipping

Again we need to understand the impact of one arm of government policy – which requires disclosure of fees and has established low cost accounts – MySuper. Venture capital is more expensive and for a system that has been designed to be fee sensitive this is an issue.

Returns from VC have also been volatile, which is again not suited to a system where individuals carry investment risk.

Where super funds do invest in VC one of the problems they encounter is the flipping culture. If superannuation funds do take risks on illiquid investments they have no incentive to sell to realise a short term capital gain. They have an interest in holding for the long term.

Superannuation

The third issue is the superannuation industry itself. A key factor that supports investment is knowledge. In the case of infrastructure investment, we have built up knowledge over the last 20 years. The result of this accumulated knowledge is that superannuation funds feel more comfortable allocating to infrastructure. This same level of knowledge does not currently exist in sufficient depth in innovation.
How do move forward?

The first thing I am advocating is the establishment of a Superannuation Innovation Forum – an independent group funded by Government, industry and stakeholders – whose job it would be bring the superannuation industry, government and industry together to develop solutions.

One of the functions of such a group should be to develop investment models that enable superannuation funds to invest. This could involve collaborative models and may require changes to regulation.

The forum should involve all stakeholders, including the ASX – which will remain the major source of capital flow from superannuation funds and which is already a major source of capital flow for small cap stocks.

What kinds of outcomes could we see?

One thing I would like to see is the emergence of a series of Autralian Innovation Companies that are listed on the ASX with the major shareholders being superannuation funds. The purpose of these companies would be to invest in our entrepreneurial companies – including life sciences. When investments succeed the Australian Innovation Company would not sell – it would use the cash-flow to fund future investments with the aim of building a company that in the end has global scale.

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Innovation and investment – time to think wider than VC

Language is important. When it comes to talking about innovation and investment in the same sentence the focus invariably turns to venture capital.

Long term asset owners have had a mixed experience with venture capital to the point that CALPERS, the Californian public sector fund, has decided to no longer allocate to VC.

But innovation is not just about venture capital. The Oxford Dictionary defines the word innovate as to ‘make changes in something.’ The key word here is change.

Change is fundamental to investment. It is a beast that is hard to control, and much of the investment processes we use are designed to strip out different elements of change in an attempt to tame them.

The one thing that is certain is that the world does not sit still. In fact the pace of change is such that I struggle how to answer my kids’ questions. The olden days – that mystical time that used to refer to knights and castles, now goes all the way back to the era before the ipad was invented – yes, all the way back to before 2010. Our kids are growing up in a world where they think rapid change is normal. The last question I had was ‘Dad, did you have electricity when you were a kid?’

One of the anxieties that Australians have is that we are somehow not an innovative society. We worry endlessly about whether we can create a venture capital industry to rival Silicon Valley.

I think it is time we got rid of this innovation anxiety. Venture capital is at the end of the day just a structure. There is a very good question as to whether it is the best structure for long term investors. VC returns are volatile, which doesn’t suit a system that is measured on short term performance. VC funds are also illiquid and have high due diligence costs. The model of exiting an investment just as it starts to get started is also questionable for long term investors.

If we do want a VC industry in Australia then we need to look at different structures. We can’t ignore the ASX, which provides the governance and daily pricing that superannuation funds need. What we need to see is a series of listed innovation companies that build a portfolio of growing businesses.

Rather than selling a successful business once it reaches the first stage of maturity we need to be keeping these businesses and taking them to the second stage of development. It will only be in this way that we will develop the next generation of large cap Australian companies operating globally.

Investing in innovation through capital markets aligns to a superannuation system that has restrictions on liquidity, but which is rapidly outgrowing the investable opportunities within the ASX. The pathway forward is for start-up companies to collaborate to establish larger innovation companies. The sharing of governance, human resources and debt makes a lot of sense and is likely to be attractive to superannuation funds that have strong taxation and currency incentives to invest in Australia.

The good news is that there is no need for innovation anxiety – except when it comes to explaining the olden days to your kids.

Pension and Superannuation Fund Investment in Innovation

Superannuation Fund Investment in Innovation

Melbourne Financial Services Symposium

Thursday 7 March 2013

Today I wanted to talk about why it is important that the superannuation industry work collaboratively to address the challenges that we currently have investing in what may be called innovation assets.

In my presentation I will be specifically focusing on the role that the ASX plays in providing opportunities for superannuation funds to invest in innovation companies. Young, start-up companies in areas such as Biotech, Clean Technology and Technology already look to the ASX as a means to raise capital.

To start let’s have a look at where the superannuation system is currently at.
According to the APRA December Quarter statistics the system has $1.51 trillion.

What is of particular interest is the rate growth. Over the last twelve months the value of superannuation investments has increased by $192.2 billion. In the last quarter alone we have seen we have seen $21.9 billion contributed to APRA regulated funds. Total contributions in 2012 were $92.2 billion up from $83.8 billion in 2011.

We can expect that the system will continue to grow. Deloitte estimates that by 2028 the system will have $7 trillion in assets.

I want to look at what this may mean for future asset allocation by superannuation funds.
In particular I want to look at the ASX where super funds invest a significant portion of new monies. The market cap of the ASX is around $1.38 trillion.

There are 2,183 companies in the ASX but 95% of the value of the market is in the ASX 200.
Superannuation funds roughly allocate 95% of their investments in ASX to the ASX 200.
The 5% that super funds do invest outside the ASX 200 is still significant, making up over $21 billion.

But here is the problem. The superannuation industry is rapidly outgrowing the ASX 200.
The continued strong cash flows each month into superannuation mean that funds must invest.
If we assume around $80-90 billion of annual contributions on a typical asset allocation we could expect that funds will invest up to an additional $20 billion into the ASX each year.

This equates to 20 $1 billion companies. Given that 92% of the market is made up of companies with a market cap less than $1 billion this indicates the size of the challenge.

There are already a number of implications of our growing size. Super funds for instance are increasingly drawn to dark pools because the size of some of the larger funds in particular means that it can be hard to execute in the lit market without moving the market.

But the more significant question is where does the super industry turn to for future investment?
The challenge that we have is that outside of the ASX 200 the market is illiquid and concentrated.
While liquidity is largely a function of size there are very good reasons why outside the ASX 200 more than half the market is mining and resources related.

We may think this is due to the all the ore that we have in the ground but in reality it is due to the regulation of the market, in particular the Joint Ore Reserves Committee that has meant that Australia has become an attractive place to list for international mining and resources companies.
There are over 200 ASX companies that solely work in Africa. We also have 15 mining companies based in Mongolia. One of the reasons we have such presence is that ASX has actively sought listings by putting people on the ground in Mongolia to recruit companies.

One option of course is for superannuation funds to seek investments outside of the ASX – and this is happening already. However it makes sense for the superannuation industry to consider how the whole of the ASX could be made a better place for future investments.

There are a number of ways the superannuation industry can work together to create more opportunities in the ASX.

The first thing is to understand that markets are a regulatory construct. The codes that have been developed for the mining industry have supported the development of mining and resources companies. The question is can we use similar codes in other areas to support the development of other sectors. One example is the Code of Best Practice For Reporting by Life Science Companies which is currently being reviewed. We know that there are US biotech companies that are now attracted to list on the ASX because of this Code. Are there ways that this could be further supported?
The second area we can concentrate is for the superannuation industry to collaborate to explore how we can support the development of the ASX. This could take a number of forms including establishing a working group that explicitly focus on this end of the market.

The size – and continued growth – of the superannuation system means that it is in our best interests to address the challenges in the ASX.

To finish it is worth asking the question does this is all matter. Is it a problem if super funds simply increase their allocations to global markets and diversify away from ASX?

It is worth delving for a moment into the economic history of one of the great economic empires of the modern era – the Netherlands. Kevin Phillips in his polemic book Wealth and Democracy examined the decline of the Netherlands which had been a significant merchant power in the 1600’s but by the 1740’s consisted of a divided society with a wealthy Dutch upper class and growing unemployment in towns that had once been thriving places for industrial production. Phillips attributes the decline of the Dutch empire in part to the fact that the Dutch upper class preferred to invest in economies other than their own, a fact that was not seen to be a significant issue at the time. In fact there were elements of Dutch society that advocated that the increased size of the finance sector that grew to service the Dutch upper class would more than compensate for the loss of domestic industries. This did not prove to be the case and the Dutch empire gradually faded, its demise accelerated by numerous wars.

Whilst things may have moved on over the last three hundred years the reality is that the superannuation industry and the economy are interlinked. Our contributions come from millions of Australians who rely on a strong economy for their future work. For that reason alone we have a responsibility to do what we can to make the ASX are better place for future investment.