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Investing in Unlisted Assets – Important Guidance for Superannuation Fund Trustees By Maria Crocker and Paul Cleary | May 2009 Area of Expertise | Superannuation & Managed Investments

Summary The investment by superannuation funds in unlisted assets is now under the microscope, given the liquidity and valuation issues associated with those assets in the current market conditions. In a recent letter to superannuation fund trustees, the Australian Prudential Regulatory Authority (APRA) has given guidance to trustees as to what it regards as prudent practice when setting valuation policies and processes for unlisted assets. To assist super trustees in meeting APRA’s expectations, this TurkAlert summarises APRA’s guidance and sets out what we think trustees ought to consider in respect of investing in and valuing unlisted assets. We have also set out some valuable tips on the internal management of valuation policies and processes by superannuation fund trustees.

Who Does This Impact? Superannuation Fund Trustees, Investment Managers of Unlisted Assets, External Valuers and Asset Consultants.

What Action Should Be Taken? Superannuation Fund Trustees who invest in unlisted assets should ensure that their Risk Management Plans, policies and procedures reflect APRA’s guidance in relation to the investment in, and valuation of, unlisted assets.

Background Given that asset valuations form a significant input into the calculation of unit prices and crediting rates, the robustness and timeliness of the valuations can potentially have a material impact on equity among members, via mispricing of transaction and potential arbitrage opportunities.

APRA’s concern is that superannuation fund trustees may introduce inequities into their funds by not properly and regularly valuing unlisted assets. For example, inaccurate valuations may inflate the unit price of an investment strategy to the benefit of members who exit the fund prior to the realignment of the valuation. This distorts the unit price of the investment strategy to the detriment of existing members. To reduce the illiquidity risk and equity issues among fund members that the investment by the fund in unlisted assets may cause, APRA has urged fund trustees to adopt prudent investment and valuation practices.

What is not acceptable APRA has observed valuation practices by trustees which it considers unacceptable. Some examples include: •

Reliance by the trustee on investment manager valuations with no validation checks

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Investing in Unlisted Assets - Important Guidance for Superannuation Fund Trustees by Maria Crocker & Paul Cleary

Lack of consideration of the valuation policies of the investment manager

Reliance on internal models without verification of assumptions, inputs or results

‘Valuation shopping’ (obtaining several valuations and selecting the most favourable)

Smoothing returns instead of revaluing assets when fluctuations occur

By adhering to a robust Policy Framework and Valuation Policies, superannuation fund trustees will avoid these unacceptable practices.

What APRA Expects APRA expects trustees considering investing in unlisted assets to have:1. the proper skills to understand the nature of the investment; 2. adequate governance procedures in place to govern the valuation process and mitigate the risk of fund illiquidity; and 3. appropriate disclosure practices in place to promote transparency and valid comparisons.

SKILLS APRA’s view is that the outsourcing of a fund’s investment functions does not lighten the fiduciary burden on the trustee. Nor does it reduce the need for the trustee to have a high level of knowledge and understanding with respect to the fund’s investment in unlisted assets. In this respect, APRA requires trustee boards investing in unlisted assets to:1. collectively possess sufficient understanding of the factors that impact the value of unlisted assets; 2. collectively possess sufficient understanding of the complexities apparent in valuing such assets; 3. understand the issues posed by the investment structure by which the trustee invests in the unlisted asset; and 4. understand the issues posed by the asset class of the unlisted investment. A trustee may best be able to meet APRA’s expectations on these aspects by: •

undertaking trustee education on: (i) (ii) (iii) (iv)

the internal governance of the valuation of unlisted assets as supported by the Policy Framework. the valuation issues and complexities that may arise based on unlisted assets generally. the framework and investment structure through which the trustee invests in particular unlisted assets. the issues that may arise in relation to those particular unlisted assets.

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Investing in Unlisted Assets - Important Guidance for Superannuation Fund Trustees by Maria Crocker & Paul Cleary

• •

requiring investment managers of unlisted assets, prior to and during their engagement, to address these matters in their tenders and reports to the trustee; and asking relevant questions and clarifying any issues to their satisfaction with the relevant service providers (including, as applicable, investment managers, external valuers and asset consultants).

GOVERNANCE Policy Framework APRA requires trustees to implement and monitor governance procedures for unlisted asset valuations. The key component is a robust, well-documented and regularly reviewed Policy Framework approved by the Board and communicated to all relevant stakeholders and staff. In our view, this Policy Framework would need to set out: •

for each existing investment in an unlisted asset, the requirement that a documented Valuation Policy setting out the basis and process of valuation of the unlisted asset is in place and a direction to the relevant business unit (eg Compliance) to check for compliance on this aspect;

for each proposed investment in an unlisted asset, the requirement that a documented Valuation Policy is in place prior to the investment being made and a direction to the relevant business unit (eg Compliance) to check for compliance on this aspect;

the review cycle for the regular review by the trustee or delegate (eg Compliance) of the Policy Framework and the Valuation Policies;

the charter and terms of reference of a Valuation Committee or similar group to oversee the Policy Framework and the Valuation Policies and report to the trustee Board;

the requirement that the Policy Framework (and any amendments) are approved by the trustee Board;

the method of communication of the Policy Framework (and any amendments) and any Valuation Policies under it (and any amendments) to relevant stakeholders and staff;

the method of communication of the Valuation Policies and issues relating to unlisted assets to members;

the requirement to segregate staff involved in the asset management process (eg the Investments team) from those who approve the process for the adoption of the valuation under the relevant Valuation Policy (eg the Compliance team); and

a process for ensuring that the potential conflicts of interests that may arise where valuations are received from investment managers of unlisted assets are appropriately addressed; and

where external valuation advice is to be taken on an unlisted asset: •

a process for ensuring that the external valuer has a sound reputation, holds the appropriate qualifications and is

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Investing in Unlisted Assets - Important Guidance for Superannuation Fund Trustees by Maria Crocker & Paul Cleary

adequately resourced and experienced; and a process for checking that advice.

The Policy Framework should reference and be consistent with the trustee’s Risk Management Plan (and vice versa) – see below. Valuation Policies The APRA guidance deals variously with valuation policies, processes, methodologies and assumptions. In our view, for simplicity, trustees should capture all of these aspects for each unlisted asset in a single document called a Valuation Policy. Each Valuation Policy would then sit under and form part of the Policy Framework. In our view, each Valuation Policy should contain at least the following: •

the best valuation source (eg investment manager, independent consultant) based on transparency and appropriateness;

the most appropriate way of valuing the type of unlisted asset, having regard for the robustness of the methodology and the consistency of its application. Trustees may wish to enlist asset consultants or other suitably qualified experts to assist in this regard;

a process for the periodic valuation of unlisted assets that are not regularly traded (ie independent valuations updated regularly - particularly in volatile markets);

a basis for determining the frequency of valuations, including the circumstances where an immediate revaluation is required;

where indexation is used between formal valuations instead of asset value movements, a procedure for monitoring that process;

where valuation models are used, a process for the construction and maintenance of those models and independent validation; and

a basis on which the assumptions which underlie the basis of the valuation are checked for appropriateness

Risk Management Plan APRA requires valuation risk to be addressed explicitly in the trustee’s Risk Management Plan (RMP). In relation to investment in unlisted assets, an RMP must set out the risks involved in valuing unlisted assets as well as mitigation strategies to manage those risks. The RMP should be reviewed regularly in order to avoid the analysis becoming stale. In preparing their RMPs, trustees need to have regard for the legislative requirements and regulatory guidance.

DISCLOSURE APRA’s view is that a trustee investing in unlisted assets should disclose to members the valuation methodology and issues surrounding the exposure to unlisted assets.

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Investing in Unlisted Assets - Important Guidance for Superannuation Fund Trustees by Maria Crocker & Paul Cleary

In our view, the most appropriate place to set out this information is in the Product Disclosure Statement (PDS). In particular, the disclosure should be prominently made in the PDS in two places: (a)

in the section dealing with general risks; and

(b)

in the investment options section for each of the speciďŹ c investment options which invest into unlisted assets.

Implications Superannuation fund trustees need to consider their standard of education, governance and disclosure in relation to the issues involved in the investment in, and valuation of, unlisted assets. APRA has stated very clearly that its supervisors will have regard, amongst other matters, to the manner in which trustees adopt prudent practices. APRA’s view is that the valuations of unlisted assets can have a critical impact on members, given their relative illiquidity and infrequency of valuation.

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Investing in Unlisted Assets - Important Guidance for Superannuation Fund Trustees by Maria Crocker & Paul Cleary

For more information, please contact: Paul Cleary Partner T: 02 8257 5760 paul.cleary@turkslegal.com.au

Sydney | Level 29, Angel Place, 123 Pitt Street, Sydney, NSW 2000 | T: 02 8257 5700 | F: 02 9239 0922 Melbourne | Level 10 (North Tower) 459 Collins Street , Melbourne, VIC 3000 | T: 03 8600 5000 | F: 03 8600 5099 Insurance & Financial Services | Commercial Disputes | Workers Compensation | Business & Property

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Investing in Unlisted Assets – Important Guidance for Superannuation Fund Trustees  

The investment by superannuation funds in unlisted assets is now under the microscope, given the liquidity and valuation issues associated w...

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