Does Private Equity have a role in superannuation portfolios?

Does Private Equity have a role in superannuation portfolios? By Dr Kar Mei Tang, the Australian Private Equity and Venture Capital Association Abstract This paper looks at whether private equity (PE) has a role to play in meeting retirement savings needs. In theory, the PE asset class seems well-suited to superannuation investment given its longterm profile and high returns targets, and can offer diversification to more liquid or volatile asset classes. This paper looks at the historical evolution of pension allocations to equity, and the empirical evidence on PE investments in pension funds. The Australian experience is discussed, particularly in the context of the challenges posed by this asset class in modern superannuation portfolios. Introduction This paper looks at whether private equity (PE) has a role to play in meeting retirement savings needs. In theory, the PE asset class seems well-suited to superannuation investment. PE funds typically have a ten-year lifespan, and target higher returns than public equity markets by investing in unlisted companies with strong growth or turnaround potential. The reasoning is that tapping the much larger pool of investment opportunities in the unlisted market should result in higher riskadjusted returns that outperform comparable public market investments over the long term. Pension allocations to private equity Investors in PE funds are called Limited Partners (LPs) because, much like shareholders in a corporation, they are only liable on any debts incurred by the funds to the extent of their investment. LPs are mainly pension funds, endowment funds, family offices, and sovereign wealth funds. In the US, the earliest recorded instance of a public pension investment in PE was in 1981, when the Oregon state pension fund invested alongside Kohlberg Kravis Roberts & Company to buy the retailing business Fred Meyer. 1 Because PE has traditionally been a high-performing asset class, and because pension funds need to generate excess returns above the market benchmark in order to meet their members' retirement funding needs, many pension funds globally have steadily increased their allocations to the asset class over time. In addition, the high volatility and losses experienced by many pension funds with high levels of exposure to the listed equity and bond markets during the global financial crisis of 2007-08 saw many pension plans in the US looking at suitable alternative asset classes, to further diversify and enhance returns to their members. 1 Davidoff, S.M., "Wall St.'s odd couple and their quest to unlock riches", The New York Times, 13 Dec 2011. 1

The US GAO reports that 92% of large US defined benefit plans were invested in PE as of 2010. The average PE allocation of US state pension plans more than doubled from 3.9% in 2001 to 8.2% of assets in 2011 (Wilshire Consulting, 2012). Allocations were even larger among the biggest pension funds (those with assets over US$5b), with an average target allocation of 9.7%. The figures are similar in the UK, and only slightly lower in continental Europe (Figure 1). In Australia, the typical allocations to PE are much lower. Domestic super funds are estimated to have $17.6b allocated to PE, constituting only 1.2% of total superannuation assets. 2 Of this, $9.3b (i.e. around half of total allocations to PE) of super monies are committed to domestic PE fund managers. 3 Of the super funds that do invest in PE, we examine 43 super funds ranging from $318m to $52b in assets under management, for which data is available from Preqin. The average allocation to PE is 5.6% of assets under management. However, this is highly skewed by a single fund with an unusually large PE allocation. Excluding this outlier brings the average (median) allocation to 4.7% (4.0%) of assets. Recent research by Deloitte Access Economics also confirms that the average exposure of local super funds to PE is much lower compared the US and UK, where some funds invest as much as 50% in PE (Deloitte Access Economics (2013)). Figure 1: Average PE allocation (% of assets) of pension plans, by country/region Sources: Bain Global Private Equity Report 2013, Mercer European Asset Allocation Survey 2012, Preqin, AVCAL analysis. "Large pension plans" are defined as those having >$5b in assets (for US plans), > 2.5b (for UK and European plans), and >AU$2.5b (for Australian plans). Australian data excludes one outlier. 2 Based on superannuation PE allocation data from Preqin, as of 31 May 2013. 3 Australian Bureau of Statistics 5678.0. 2

The academic evidence Do the returns from PE investment adequately compensate for the costs and risks inherent in investing in this asset class? Early studies have primarily used Thomson Venture Economics data, and generally find that average risk-adjusted PE returns perform no better than the public markets (Kaplan and Schoar (2005), Phalippou and Gottschalg (2009)). However, subsequent studies have found that these results are highly sensitive to the choice of data provider, as shown by Stucke (2011) and Harris, Jenkinson and Kaplan (2012) who find systematic biases in the Thomson data used in earlier studies. Gottschalg (2010) finds, using actual transactions data for over 4,000 deals obtained directly from a large PE fund-of-funds, that PE deals between 1977-2009 delivered on average a positive alpha of 7.1% over public equity investments even after adjusting for timing, sector and leverage effects. Robinson and Sensoy (2011) also find, using a sample of 542 buyout funds from 1984-2010, that buyout funds outperform the S&P 500 on a net-of-fee basis by an average of 18% over the fund's life. Higson and Stucke (2012) examine over 1,000 funds representing 85% of all capital raised by US buyout funds, and find that for almost all vintage years since 1980, US buyout funds significantly outperformed the S&P 500. Fully liquidated funds from 1980-2000 delivered excess returns of about 450 basis points per year. Adding partially liquidated funds up to 2005, excess returns rose to over 800 basis points. They find that over 60% of all funds performed better than the S&P 500. Phalippou (2012) revisits Phalippou and Gottschalg (2009) using better quality data and finds, using a sample of 392 funds, that the average buyout fund actually outperforms the S&P 500 by 5.7% p.a. (although this changes to an underperformance of -3.1% if the public benchmark is changed to small and value indices, and is levered up). However, Harris et al (2012) analyse 598 US PE funds and find that the average PE fund beat the S&P 500 by more than 3% p.a., and by 20-27% over the life of the fund. Acharya et al (2013) similarly finds that the abnormal performance of buyout deals is positive on average, after controlling for leverage and sector returns. The industry experience One of the primary reasons given by LPs for investing in PE is its attractive long-term returns. The evidence by industry benchmark providers generally affirms this view: According to Cambridge Associates (C A), global PE and VC delivered an annualised return of 13.8% (net of fees) over the 30 years up to December 2012, outperforming the MSCI World Index by 440 basis points and the S&P 500 by 300 basis points. A 2013 review by Preqin of over 150 pension funds across North America, the UK and Europe finds that PE was the best performing long-term asset class across the sample, with a median return of 11.5% over 10 years up to 30 September 2012. 3

Mature pension PE programmes often bear the results that demonstrate the value in taking a longterm view of the asset class. For instance, the California Public Employees Retirement System (CalPERS) the US s largest public pension fund had 14% of its assets in PE in 2012, up from 12.5% of assets at the end of 2010. As of end-2012, CalPERS' PE programme had an annualised 10-year return of 6.86% compared to 2.92% on fund's public equity portfolio, and had generated US$23b in profits since 1990 for its 1.6 million members. 4 Many emerging market pension funds are also increasing their exposure to this asset class in an effort to diversify their sources of returns. In 2012, the National Council for Social Security Fund (NCSSF), which manages China's RMB850b (US$135b) national social security fund, announced that it would raise its RMB19.5b PE allocation significantly over the next three years, after PE accounted for up to 70% of its total return in 2011. 5 In 2011, the Montana Public Employees Retirement System (MPERS) which has invested in this asset class since 1988 demonstrated to its board members a model of what its pension fund portfolio would look like without PE. 6 If MPERS had allocated each PE drawdown since 1994 to its domestic stock portfolio instead, the fund would have been US$220.8m poorer by 2010: equivalent to 7% of the fund's $3b assets under management at the time. This suggests that a public employee who accumulated $500,000 in her pension over that period would have had only $465,000 if the fund had not invested in PE, but had invested that allocation in the domestic stock portfolio instead. This provided a compelling illustration of the long-term benefits of the PE programme where superior returns were accrued over several economic cycles, not just a selected short-term period of positive performance. A similar analysis by the Private Equity Growth Capital Council found that over a ten-year period to June 2011, a $1 investment by pension funds into PE would have resulted in a return of $2.3, compared to $1.4, $1.9 and $1.9 for public equity, fixed income and real estate respectively (PEGCC report, 2012). The value proposition Superior returns? The Australian experience As of December 2012, the C A Australian PE Index had a 10-year annualized net return of 9.67% in AUD terms. Over the same period, the S&P/ASX 300 Accumulation Index had an annualised gross return of 9.05%, aided by significant growth in the resources sector. Because PE investments are drawn down over time rather than at a single point in time, a better comparison with listed markets would be with the Public Market Equivalent (PME) first proposed by 4 Source: http://www.calpers.ca.gov/index.jsp?bc=/investments/assets/equities/pe/private-equity-review/peperform-review/home.xml# 5 Sources: Preqin and "Asian Pensions & the Road to Alternative Investments" by Citigroup, 2012, p.5. 6 Memo on "Pension Fund PE Investments" in Montana Board of Investments meeting materials, 14 July 2011. Prospective estimates are based on expected annual arithmetic investment returns for each asset classes as published in the December 2010 Teachers Retirement System (TRS) Asset/Liability Study conducted by the Montana Board of Investment s consultant. 4

Kaplan and Schoar (2005) and now increasingly widely used by LPs as a benchmarking metric. 7 This shows Australian PE outperforming a portfolio of index shares (built using an equivalent cash flow pattern) by 504 basis points even after fees, expenses and carried interest, over the 10 years to December 2012. Figure 2: Returns of Australian PE vs the S&P/ASX 300 Index as of 31 December 2012 1 year 3 year 5 year 10 years C A Australian PE Index (AUD terms) 6.77 8.19 3.96 9.67 S&P/ASX 300 Acc. Index 19.74 2.8-1.81 9.05 S&P/ASX 300 Acc. PME 20.12 2.89 0.66 4.17 Source: Cambridge Associates. C A Australian PE Index returns are net of management fees, expenses, and carried interest. Despite the relatively young domestic PE industry, a number of local super funds have over time built up a strong track record of investing in this asset class to meet their investment goals. Not-forprofit funds (i.e. industry and public sector funds) are particularly strongly represented. The Future Fund, set up to help to meet the Commonwealth Government's unfunded superannuation liabilities, has grown its PE allocation from 0.002% of total assets in 2008 to 6.8% in 2013 (still short of its target allocation of 8%). It explains the reason for this: "Our private equity strategy is predicated on our view that private equity fulfils two functions within the Fund s investment portfolio. The first is to invest in high alpha opportunities, where we believe we can earn a significant premium over similar but more liquid equity investments. Most of these investments would fall in the buyout or secondaries categories. The second function is to expose the Fund to investment themes that it cannot readily gain exposure to through other more liquid investments. In the second category we would include such themes as exposing the portfolio to innovation (venture), companies in financial difficulty that require capital to undertake financial restructurings and/or operational turnarounds (distressed opportunities), and funding idiosyncratic growth within small companies, particularly in sectors or geographies where alternative funding options are scarce (growth equity)." 8 Affirming this investment thesis, Cummings and Ellis (2011) find that not-for-profit Australian super funds with more illiquid investments recorded higher risk-adjusted returns (which the authors suggest are the return premium for investing in these illiquid assets) from 2004-2010. 7 The PME is calculated using actual PE cash flows for all funds to see what would have been achieved had one invested the same cash flow pattern in the listed market index (in this case the S&P/ASX 300 Accumulation index). PE cash inflows are treated as purchases of the index portfolio at that point in time, and PE cash outflows are treated as sales of the index stocks. For example, a PE fund investing $50m in March 1997 and realizing $100m in March 2000 would have generated an annualised IRR of 26%. However, an LP would have been better off investing in the S&P 500 because $50 million in the S&P 500 would have grown to $103.5m over that period. 8 Future Fund Annual Report 2011/12. 5

Volatility smoothing Furthermore, despite some perceptions that PE tends to be a volatile asset class, the evidence indicates the opposite. The quarterly and annual volatility of the C A Australia PE Index is markedly lower than that of the S&P/ASX 300 Index (Figure 3 and Figure 4). 9 Figure 3: Quarterly returns of Australian private vs public equity indices % 15 10 5 0-5 -10-15 -20-25 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011 Q1 2012 Q1 Cambridge Associates AU PE and VC Index Return Volatility of quarterly returns: PE & VC Index stdev: 4.9% S&P/ASX 300 Index stdev: 8.1% Freq. of positive returns: PE & VC Index: 71% S&P/ASX 300 Index: 58% S&P/ASX 300 index return Sources: Cambridge Associates, S&P, AVCAL analysis Figure 4: Annual returns of Australian private vs public equity indices % 40 30 20 10 0-10 -20-30 -40 Volatility of annual returns: PE & VC Index stdev: 14.4% S&P/ASX 300 Index stdev: 17.9% Freq. of positive returns: PE & VC Index: 75% S&P/ASX 300 Index: 67% -50 9/30/2001 9/30/2005 9/30/2009 Cambridge Associates AU PE and VC Index Return S&P/ASX 300 index return Sources: Cambridge Associates, S&P, AVCAL analysis Diversification A 2012 report by Rice Warner Actuaries indicates that most default funds tend converge to a mix of 70-80% in equities and 20-30% in debt assets, with peer influence appearing to play a role in their similar asset allocation decisions. An analysis of the growth options of 59 super funds in the Chant West database indicates that the average returns of the top and bottom quartile funds for the 10-years ending December 2012 differed by only 2.1 percentage points (Figure 5). The best-performing fund in the sample earned 7.6% on an annualised basis over 10 years, while the worst-performing fund earned 5.0%. The narrow spread of possible returns across the super fund universe suggests that there is currently little diversity in the standard investment options offered by most funds available to Australian superannuants, particularly disengaged ones. It is estimated that this cohort likely includes almost all people under the age of 40 and perhaps half of older Australians, making up more than 75% of all super members and about half the industry's assets (Rice Warner, 2012). This is one area where alternative asset classes such as PE can offer diversification benefits and provide an avenue for super funds to strategically differentiate their offerings to members. 9 This is supported by Blackburn and Augustine (2012) and Schali and Demleitner (2012), who show that not only have US and European PE outperformed public markets over time, they have done so while experiencing less volatility, as measured by standard deviation. The authors suggest that PE can be a particularly attractive asset class in times of high economic uncertainty. 6

Figure 5: Spread of superannuation fund returns as of 31 Dec 2012 Sources: Chant West, AVCAL analysis. For the Growth options of 59 superannuation funds. Challenges for super investors Superannuation funds as PE investors face particular challenges because they are fiduciaries of their members' interests, and a regulated industry in their own right. Some of these challenges are outlined below. Liquidity Success in PE requires patience. LPs must remain committed for the lifetime of the fund as PE investments cannot be redeemed on demand. 10 Distributions only flow through when an underlying investment is exited through a private sale or an IPO. This illiquidity can pose particular challenges for defined contribution schemes where members' funds have greater portability. For instance, a PE fund can make a capital call at any time during its investment period (usually within the first five years of the fund's life, or as defined in the fund's constituent documents), as suitable deal opportunities arise. LPs have to ensure they have appropriate provisions to meet these capital calls as they arise. Superannuation investment managers manage their liquidity risk in several ways, including through their internal risk management framework, due diligence, and the negotiation of management agreement terms. For example, most super funds impose internal limits on their allocations to illiquid assets, such as the Commonwealth Superannuation Scheme (CSS) which limits its target exposures to private assets (whether equity, debt or real assets) to 25% of the fund. 11 The Australian Prudential Regulatory Authority (APRA) acknowledges that while "unlisted assets are attractive for superannuation funds due to their long-term earnings and smoothed volatility profile", 10 Opportunities for exit via sales of LP commitments to secondaries funds do exist. However, this is a very illiquid market. 11 http://www.css.gov.au/investment-and-performance/investment-options/css-investment-options 7

RSE licensees need to carefully consider the liquidity implications of investing in these assets. 12 These considerations include assessing the likely impact of the cash flows of these investments on the fund, ensuring that the liquidity assessment is made at the investment option level (rather than whole of fund level), and ensuring appropriate stress testing to manage liquidity risk. 13 Long-term focus and manager selection LPs need to consider the tradeoff between PE's relative illiquidity and lack of opportunities for shortterm realisations, against expectations of higher long-term returns and less portfolio volatility. To illustrate how PE can affect the short and long term returns of super fund portfolios, Figure 6 juxtaposes the net returns from the C A Australia PE Index (which includes the whole spectrum of PE fund performances) against the net returns from a sample of super funds, over a range of investment horizons. PE's characteristic long-term profile is demonstrated here where, although the C A Australia PE Index can underperform a diversified portfolio significantly over shorter horizons, over the longer term horizons it significantly outperformed the net performance of all super funds in the sample. Figure 6: Australian PE funds' net returns vs Super Funds' for 1-, 3-, 5- and 10-year horizons ending 31 Dec 2012 Accountants Super Growth AMP FD Balanced 16 12 % 8 4 0-4 1-yr 3-yr 5-yr 10-yr return return return return AMP RIL Balanced Asgard SMA Balanced Aust Catholic Super & Ret Balanced AustSafe Balanced BT MM Balanced BUSS (Q) Balanced Growth Catholic Super Balanced CBUS Growth Aon Balanced Auscoal Growth AustralianSuper Balanced AXA SD Balanced BT Super For Life 1960s Lifestage CareSuper Balanced Catholic Super Mod. Aggressive CFS FirstChoice Balanced CFS FirstChoice Growth Commonwealth Bank Group Super Mix 70 EISS Diversified ESSSuper Growth GESB Super Balanced Growth HOSTPLUS Balanced IOOF MultiMix Balanced Growth JANA Moderate LGSS Balanced Growth Media Super Balanced Mercer Growth Equipsuper Balanced Growth FSS (NSW) Diversified HESTA Core Pool Intrust Super Balanced JANA Assertive Legal Super Growth Maritime Super Balanced Media Super Growth Mercer Growth Plus MLC Growth MLC Horizon 4 MLC Moderate OnePath OptiMix Balanced Plum Pre-Mixed Moderate RecruitmentSuper Growth NGS Super Diversified Optimum Growth QSuper Balanced Sources: Cambridge Associates, ChantWest, AVCAL analysis. Super funds data for Growth options only. All returns are net of investment fees and tax. REST Core Russell Balanced Suncorp Growth Sunsuper Growth Telstra Super Balanced Vision Super Balanced Growth REI Super Trustee Super Balanced REST Diversified Russell Balanced Opps Sunsuper Balanced Tasplan Balanced UniSuper Balanced C A Private Equity Index 12 APRA Insight Issue 1, 2013, p.22. 13 "Liquidity stress testing for alternative investments", infinance, Aug 2011. 8

This outperformance is even more marked when one considers just the top two quartiles of PE funds managers; that is, when LPs are able to exercise sufficient manager selection skill to invest in the top two quartiles of the best performing PE funds every vintage year (Figure 7). This illustrates how even selecting the top 50% of PE fund managers can make a large difference in the net returns achieved by the LP's PE portfolio. Similarly, consistently poor manager selection will see a corresponding downward drag on the LP's returns. Figure 7: Australian top two-quartile PE funds' net returns vs the top two-quartile Super Funds for 1-, 3-, 5- and 10-year horizons ending 31 Dec 2012 16 Accountants Super Growth AMP RIL Balanced 12 8 % 4 0-4 1-yr 3-yr 5-yr 10-yr return return return return Asgard SMA Balanced AustralianSuper Balanced BT MM Balanced BUSS (Q) Balanced Growth Catholic Super Balanced CBUS Growth Auscoal Growth AXA SD Balanced BT Super For Life 1960s Lifestage CareSuper Balanced Catholic Super Mod. Aggressive CFS FirstChoice Balanced CFS FirstChoice Growth Commonwealth Bank Group Super Mix 70 Equipsuper Balanced Growth FSS (NSW) Diversified HESTA Core Pool Intrust Super Balanced JANA Assertive Maritime Super Balanced MLC Horizon 4 NGS Super Diversified Plum Pre-Mixed Moderate RecruitmentSuper Growth REST Core Russell Balanced Suncorp Growth Sunsuper Growth Telstra Super Balanced Vision Super Balanced Growth ESSSuper Growth GESB Super Balanced Growth HOSTPLUS Balanced IOOF MultiMix Balanced Growth JANA Moderate MLC Growth MLC Moderate Optimum Growth QSuper Balanced REI Super Trustee Super Balanced REST Diversified Russell Balanced Opps Sunsuper Balanced Tasplan Balanced UniSuper Balanced C A Private Equity Index - Upper 2 quartiles Sources: Cambridge Associates, ChantWest, AVCAL analysis. Super funds data for Growth options only. All returns are net of investment fees and tax. As LPs cannot themselves liquidate their existing commitments to rebalance their PE portfolio on demand, appropriate manager selection is crucial. 14 PE funds tend to exhibit a high degree of heterogeneity compared to public equities funds. For example, the top half PE funds earned 12% on an annualised basis over the 10-year horizon to December 2012, while the bottom half PE funds lost -5%. This wide spread of possible returns is because a typical PE fund invests in only about half a dozen companies and then takes an active role in their board of directors and strategic direction over the next 3-7 years, compared to a typical equities fund which spreads out its investment in much larger portfolio of listed companies and is generally a relatively passive investor. 14 Except where they are able to sell their existing commitments to a secondary fund/another investor. However, this is a highly illiquid market and such transactions are relatively infrequent. 9

Fee measurement The remuneration structures of PE funds are set up to reflect their investment profile. They constitute the resources and incentives required for the long-term commitment and active management needed to achieve their higher target returns. For LPs whose primary goal is minimising management fees, PE will likely not appear to be an attractive low-cost option. PE management fees can range from 1.5% 2% of total fund commitments. This fee usually remains steady during the investment period (typically the first five years of a fund s life), i.e. it is a fixed dollar fee over this period. During the remaining years, this fee will typically decline according to a schedule as negotiated and documented in the fund deeds. The fee may decline by a descending scale of, say, 0.25% per year from the sixth year onwards. Or it may be rebased to 2% of the remaining capital invested. There is also a performance incentive referred to as the "carried interest" where the fund's proceeds are split 80/20 between the LP and the PE fund manager if the fund exceeds the "preferred return" (i.e. outperforms the performance high-water mark agreed upon beforehand with the LP). In comparison, listed equity and fixed income managed funds typically charge management fees of 0.7%-2% of the investment balance. 15 This differs from the PE fee structure in that the amount of fees paid will vary with the investment account balance, instead of being fixed based on the investor's specified investment commitment. The fund manager will get higher fee revenues if the value of the investment goes up (reducing the net after-fee return to the investor), but risks being potentially under-resourced through lower fee revenues if the investment does badly. Some managers also charge additional performance fees. On top of that, the cost of brokerage, accounting and other fees related to holding direct shares could be an additional 0.5% p.a. 16 Given these different fee structures, the calculation of annual management expense ratios will likely not accurately capture the true cost of PE investment vis-à-vis other asset classes. A true cost comparison can only be done over the entire lifecycle of the PE fund. In practice, the cost of a PE programme can be reduced for LPs that have the ability to negotiate better fee terms and that can exploit economies of scale in their internal management processes (Dyck and Pomorski (2012), Cummings (2012)). Balance between low fees and optimal asset allocation Many experienced LPs generally recognise that access to high-performing fund managers will not be low-cost. A 2011 report by the US Government Accountability Office on the challenges faced by pension plans when investing in hedge funds and PE states that, "despite these fee structures, pension plan officials we contacted cited attaining returns superior to those attained in the stock market as a reason for investing in hedge funds and PE. One plan official noted that as long as hedge funds add value net of fees, they found the higher fees acceptable." 15 Source: Australian Investors Association. 16 http://www.moneymanagement.com.au/opinion/investment/benefits-of-managed-funds-warrant-closeanalysis 10

This is supported by the empirical evidence. Robinson and Sensoy (2013) find that PE managers that receive higher compensation do earn it in the form of higher gross returns. PE investment management fees (inclusive of the carried interest of performance fee) as measured by the MER do typically tend to make up a high proportion of total management fees for LPs. For this reason, some super trustees and investment managers may not have the appetite to invest in PE as the implementation is seen to be problematic and difficult relative to the its weight in the overall portfolio (in Australia, typically around a 4% allocation). Anecdotally, Australian super funds are seen to be at the forefront of the fee debate, and appear to be more price sensitive than their US and European peers (Superfunds, July 2011, pp 20-21). To a large extent this has been driven by the Government's recent Future of Financial Advice (FoFA) and Stronger Super reforms. The former bans conflicted payments given to platforms, distributors and advisers. The latter requires all large superannuation funds to focus specifically on the costs that might be incurred in relation to their investments, and includes the introduction of low-cost MySuper products and increased focus on the public reporting of management expense ratios (MERs). Figure 8: Fees by superannuation segment - year to 2011 Sector Segment Operating Investment management Advice Total Fees 1 Wholesale Corporate 0.3 0.47 0.05 0.82 Corporate Super Master Trust (large) 0.25 0.58 0.05 0.88 Industry 0.43 0.66 0.04 1.13 Public Sector 0.22 0.56 0.04 0.82 Retail Corporate Super Master Trust (medium) 0.87 0.71 0.25 1.83 Corporate Super Master Trust (small) 1.04 0.77 0.39 2.2 Personal Superannuation 0.84 0.6 0.43 1.87 Retail Retirement Income 0.62 0.67 0.45 1.74 Retirement Savings Accounts 0.6 1.7-2.3 Eligible Rollover Funds 1.95 0.45-2.4 Small Funds SMSFs 0.33 0.52 0.15 1 TOTAL 0.45 0.58 0.17 1.2 1. Components may not add up to totals due to rounding Source: Rice Warner Actuaries Superannuation Fees report The reduction of unnecessary and unproductive fees is imminently desirable. But one concern is that continued downward pressure on total Investment Management costs could work against members' long-term interests. One of the key aims of MySuper is to charge trustees with "a specific duty to deliver value for money as measured by long-term net returns, and to actively consider whether the 11

fund has sufficient scale". 17 However, achieving this through long-term asset allocation decisions is much more difficult to quantify than through cost reductions, which are immediately measurable and hence easier to justify. Anecdotally, there has been consequently been an increased focus on "low costs" as a powerful marketing theme by funds to attract new members or customers. It can be seen from Figure 8 that Investment Management costs already tend to be relatively competitive across the broad spectrum of super funds. By comparison, Operating Fees and Advisory Fees across different funds exhibit a much higher degree of divergence: suggesting further room for cost reductions. Will a continued focus on total fee reduction have a detrimental impact on super funds' ability to invest appropriately for the long term? At some point, it seems likely that there will be a tradeoff between low cost and diversification/long-term net returns, and the pressure on total fee comparisons could ultimately lead super funds away from optimal asset allocation decisions. Conclusion The weight of the global evidence suggests that due consideration of PE should be part of the fiduciary duty of any superannuation fund trustee who needs to consider how to best achieve better retirement savings outcomes for its members. It may be argued that the real concern is not whether PE makes it difficult for super funds to manage their liquidity risks and management expense ratios. With the right framework, these risks can be successfully managed, as seen by the track record of large global pensions with mature PE programmes. The greater concerns should meeting unfunded superannuation liabilities, and planning for how workers are to fund their retirement in the years ahead. For example, total Commonwealth unfunded super liabilities stood at $144b as of June 2013: one-tenth the size of the entire super industry. 18 For defined contribution funds, the challenge lies in ensuring that super investment strategies today can meet their members' future retirement needs without placing increasing pressure on the age pension system (the cost of which is estimated will rise from 2.7% of GDP today to 3.9% by 2050 (ASFA White Paper, 2013)). ASFA also estimates that the number of retired Australians will rise from 13% of the population today to 22% by 2050. With the ratio of workers to retirees also expected to nearly halve from 5:1 today to 2.7:1 by then, the necessity of ensuring adequately funded superannuation has never been more important. This, in turn, suggests that super trustees and investment officers need to seriously consider the empirical evidence on the full range of asset classes available to them including PE as part of their obligations to deliver value to their members. 17 http://strongersuper.treasury.gov.au/content/content.aspx?doc=publications/government_response/key_p oints.htm 18 Australian Government, Dept of Finance and Deregulation. 12

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US Government Accountability Office, "Plans Face Challenges When Investing in Hedge Funds and PE", GAO-11-901SP, 31 Aug 2011. Rice Warner Actuaries, "Asset allocation for MySuper", April 2012. Robinson, D. T. and B. A. Sensoy, " Private Equity in the 21st Century: Liquidity, Cash Flows, and Performance from 1984-2010", Ohio State University Working Paper, July 2011. Robinson, D. T. and B. A. Sensoy, "Do Private Equity Fund Managers Earn Their Fees? Compensation, Ownership, and Cash Flow Performance", Ohio State University Working Paper, May 2013. Schali, S. and F. Demleitner, "Understanding private equity's outperformance in difficult times", Partners Group report, January 2012. Stucke, R., "Updating History", December 1, 2011. Available at SSRN: http://ssrn.com/abstract=1967636 or http://dx.doi.org/10.2139/ssrn.1967636 Wilshire Consulting, "2012 Report on State Retirement Systems: Funding Levels and Asset Allocation", 2 March 2012. 14