Some short-term optimism in the global economy has led the Future Fund to increase risk, chief investment officer Raphael Arndt has said.
This is reflected in the portfolio by an increase in global equities, and a decrease in the cash allocation, during the last six months.
The increase in allocation to global equities was split between developed markets, which rose from 14.9 per cent to 18.6 per cent of the portfolio, and emerging markets, which rose from 6.9 per cent to 7.7 per cent. The fund’s cash allocation decreased from 21 per cent to 16.4 per cent in that time.
“The global economy is exhibiting synchronised growth – job creation and economic growth is occurring across developed and developing economies,” Arndt said. “This has led to us recently increasing risk in the Future Fund marginally, in light of the more positive shorter-term economic outlook; however, we remain cautious over the medium to longer term.”
Arndt, speaking at the 15th Annual Private Equity & Venture Forum Australia & New Zealand, said that in the current environment the team was attracted to flexibility and the ability to move the portfolio as its view on value, or the risk outlook, changes. He also said the team was seeking strategies that were uncorrelated with equity returns and focused on genuinely adding value to businesses, not just financial engineering or strategies that involve leverage.
About 12 per cent of the fund’s portfolio is in venture capital and private equity. Arndt said this was an integral part of the fund’s response to macro changes in the economy, including generational change and technological disruption.
“The PE program continues to play an important role in the Future Fund’s portfolio – currently standing at A$17 billion ($13 billion), and having delivered returns in the mid-to-high teens since inception,” he said. “Within this program, we seek to access strategies that invest into innovation and small company growth.”
The Future Fund private equity team of eight uses fund of funds, external managers and co-investments.
Disruption is something the team takes seriously, incorporating it into its process in three ways: offence, meaning investing in disruption; defence, or avoiding certain investments; and application, which means using the lessons from investments in its portfolio to improve how the team operates.
Joel Posters, who leads the fund’s ESG and investor stewardship function, is charged with working with the sector teams to share insights on disruption.
Arndt said all thoughtful investors need to be thinking about the impacts of disruption and generational change.
“Disruption creates winners and losers,” he explained. “Investors who are open to change will be rewarded in this environment and those who fail to engage with the changes that are occurring will risk failing.”
Below is Arndt’s full speech at the conference.
Speech by Dr Raphael Arndt, Chief Investment Officer, at the 15th Annual Private Equity & Venture Forum Australia & New Zealand, in Sydney.
Good morning, and thank you for the opportunity to speak to you today.
My organisation manages five funds on behalf of you – the people of Australia. In total, we currently manage about A$164 billion ($127 billion) on behalf of future generations of Australians.
The largest of these funds, the Future Fund, currently stands at about A$139 billion – and is Australia’s sovereign wealth fund. The fund was established in 2006 to strengthen the Australian Government’s long-term financial position.
Our mandate is to achieve a return of at least inflation plus 4 per cent per annum over the long term, without taking excessive risk.
Let me begin by touching on the Future Fund’s current thinking and positioning.
I have been saying for some time that it is an incredibly tough time to be an investor – over the longer term the real economy faces headwinds from ageing demographics and a significant debt burden, with expensive asset prices supported by interest rates currently at unprecedented lows.
However, interest rates are now poised to begin rising as the world finally works through the surplus capacity created following the global financial crisis.
This challenging longer-term outlook remains – and is compounded by risks associated with growing populist movements across the world that have resulted from wealth inequality arising from the response to the global financial crisis.
In the long run, more protectionism can only detract from economic growth and create uncertainty for business.
However there is some reason for optimism when looking at the economy in the shorter term.
The global economy is exhibiting synchronised growth – job creation and economic growth is occurring across developed and developing economies.
This has led to us recently increasing risk in the Future Fund marginally in light of the more positive shorter term economic outlook; however, we remain cautious over the medium to longer term.
And we saw the return of volatility in early February, reminding us that equity exposure carries risks, particularly at the currently elevated valuations compared with history, and in an environment of rising interest rates.
In the current environment, we are, therefore, particularly attracted to:
- Flexibility – the ability to move the portfolio if our view on value, or the risk outlook, changes – and as such we are currently managing our liquidity closely, and ensuring that any illiquid exposure we do take is well rewarded;
- Secondly, investment strategies that are uncorrelated to equity returns. We have an exposure of more than A$20 billion to hedge funds – and further exposures to venture and growth equity, which I will talk more about shortly; and
- Finally, investment strategies that are focussed on genuinely adding value to businesses – not just financial engineering or strategies that involve leverage. These include:
- Our active approach to Property and Infrastructure, where we have been prepared to back managers to deliver on value adding business strategies and turn the portfolio over once these strategies have been realised; and
- Our approach to Private Equity and Venture that involves growing businesses, rather than just the financial engineering of leveraging and ‘flipping’ assets.
In addition to this backdrop, there are a number of macro-economic changes which are likely to increase in importance over coming years. These are generational change and technological disruption. The world is changing and any long-term investor needs to not just be aware of this, but to respond to it.
Generation Y – the ‘millennial’ generation – will displace other generations in the decades ahead. They are currently one-third of the workforce and in less than 10 years – together with their younger siblings, Generation Z – they will make up two-thirds. These generations work, interact and consume differently to their parents. They are comfortable with technology, and want experiences, collaboration and technological enablement – and are less interested in material possessions and accumulating ‘things’. Technological disruption means that business models must evolve, and businesses and investors can’t rest on their laurels because technology will erode margins and returns unless businesses can reinvent themselves to remain relevant to their customers. The successful businesses of the past will likely not be tomorrow’s champions unless they respond to the changing environment. Investors and businesses that can’t adapt to technological disruption and generational change will be consigned to the dustbin of history. On the other hand, new winners are emerging. If the leading companies of today can’t or won’t adapt then they will be replaced by a new generation of winners.
I will return to how we at the Future Fund think about this disruption in a minute, but let me first outline the role of Private Equity in the Future Fund portfolio, and how it is integral to our response to these changes going on in the world.
The Role of Private Equity
In September 2016, I spoke in some detail about the role of Private Equity and Venture in our portfolio.
I won’t repeat myself – other than to say we see PE and Venture as an important access point to invest in real businesses.
The PE program continues to play an important role in the Future Fund’s portfolio – currently standing at A$17 billion, and having delivered mid-to-high teens returns since inception.
Within this program we seek to access strategies that invest into innovation and small company growth. These strategies do not rely as heavily on the availability of cheap and plentiful credit or economic growth as large buyout strategies.
These venture and growth strategies are focussed on smaller businesses where there is more scope to grow or improve a company rather than just carve it up or merge it with another one – and it is these strategies that we have the largest exposure to within the PE program, with an exposure of more than A$8 billion.
The Future Fund’s Private Equity team of eight – some of whom are here today – use fund of fund, external managers, and increasingly co-investments alongside our managers to access these drivers.
Technological disruption is not new – and is not confined to any particular sector or investment asset class.
Let’s look at the auto industry as a study in disruption – quite topical at the moment, due to the emergence of electric vehicles.
But I am going to look back to a period before “EV” was a commonly used acronym for electric vehicles.
Detroit, Michigan grew from a population of 285,000 in 1900 to reach a peak of 1.9m in 1960.
Since 1960 the number of cars and vehicles in the US – and the world – has increased, significantly.
Despite this, between 1960 to now, Detroit’s population has fallen from 1.9m to 700,000 as auto manufacturers moved out of Detroit over the last fifty years and as manufacturing evolved to be less labour intensive.
This hasn’t just affected those who invested into automotive and related companies.
An investment in property – whether residential, commercial or industrial – in Detroit in the 1960s was a far worse investment than property investment here in Sydney, where population increased from around 2m to more than 5m between 1960 and today.
I hope this helps explain why investors need to think about disruption and its broader impacts.
By their nature, these types of changes are hard to predict, and come on suddenly. And by then it may be too late to change your positioning, especially if your holdings are illiquid.
So let me now explain how we at the Future Fund incorporate thinking about disruption into our processes.
We think of disruption through three lenses:
- Offence – this is investing into disruption, principally through the venture program;
- Defence – thinking about whether there are investments we should avoid;
- Application – are there lessons we can learn from investments in our portfolio that we can apply to how we operate as investors, as we think about our own portfolio and activities. To put this into effect our Sector Teams have responsibility for investments relating to their area of expertise. And Joel Posters – who leads our Investment Stewardship and ESG function – has since last year had responsibility for working with our Sector Teams as a centre of excellence to share disruption insights across the investment team. We can look at an electricity network as a practical example. In this case, our approach to thinking about disruption, means we would seek to fully consider the impact of technological change and distributed generation such as rooftop solar PV if we were looking to invest in a regulated electricity network. It doesn’t mean we wouldn’t look at such an investment, but we would think about the payback period and we probably wouldn’t include an assumption that the experience of the last 30 years continues into perpetuity as our base case. This approach of looking at technological change and disruption could apply equally to thinking about: the impact of driverless cars on car-park assets; the impact of fintech developments on banks; and the impact of changes in the retail sector on shopping centres.
Importantly, in thinking about the impact of disruption, I want to make the point that those of us working in the financial services industry must not be complacent. For the Future Fund, we recognise that, like successful companies in every other industry, we cannot stand still. And we are part way through a significant multi-year journey to invest in our business – investing into new technology and systems that will give us more insight into our portfolio exposures in real time.
Australia’s private equity sector
Just as roles in stockbroking have been replaced by computers and online trading, Australia’s private equity sector won’t be immune from these disruptive changes that are occurring.
To stay relevant and attractive to LPs, you need to be investing in your businesses – and when thinking about the value proposition you offer prospective LPs, you need to be as tough on yourself as you are on prospective investments.
This means knowing where you add value, and being able to articulate that.
We have no interest in supporting managers that simply rely on leverage and a prayer that debt will remain cheap and economic growth will continue for the next decade.
Our very best PE managers are investing in their business. They have developed teams that include dozens, sometimes hundreds, of people with an operational background who go into investee companies and drive real operational improvements.
For instance, we have an example in our portfolio of a manager who has sent in teams of people with an e-commerce background into a traditional bricks and mortar luxury goods retailer that had a pretty basic web offering.
The approach involved optimising their online presence, including installing the ability to combine real-time analytics with a dynamic website to allow each user to experience a tailored landing page.
So a user visiting the website with a history of searching for handbags will see handbags displayed when they visit the website, while someone who has bought shoes previously will see shoes displayed more prominently.
This is in addition to streamlining the purchasing process to create a user friendly experience, including enabling people to purchase using WeChat Pay and other new payment platforms.
To be clear, the experts in this example work for our manager as employees and do this time and time again for their portfolio companies – helping them grow while making returns for their investors.
This ‘operational excellence’ function currently exists in the best PE managers, and the successful PE firms of the future will be those who can invest in their own business by resourcing up with the operational skills required to buy into investee companies and leave them stronger and better businesses on exit.
If the industry can adapt, I am optimistic that we are seeing the beginning of a renaissance for Australia’s private equity sector.
As a significant Australian based investor, the Future Fund seeks to remain active within the local PE community, to support the development of Australian businesses and commercialisation of Australian innovation and ideas.
We do this through our PE investment program, and through our work with AVCAL and the industry to build the capacity of Australia’s PE sector.
With you, we have a mutual desire to see Australia’s PE and Venture industry thrive, and with it, Australia’s small and medium businesses get the capital and expertise they need to reach their full potential.
In August last year the Future Fund and AVCAL co-hosted a day-long workshop with Greenspring Associates, one of the Future Fund’s US based venture fund-of-fund managers, and one of the most successful venture investors anywhere in the world. Greenspring has a successful track record spanning nearly two decades operating in Silicon Valley and the US East Coast, including increasing global activity.
The workshop introduced Australian venture managers to Greenspring, who outlined the standards they look for in venture managers seeking to raise capital – with the intent being to help facilitate the development of Australia’s venture sector to be in a position to raise domestic and offshore capital.
Key insights included:
the importance of GPs specialising by sector or theme – and having real expertise in their area of focus; the role of thought leadership and proprietary deal flow for GPs; and the need for GPs to build relationships with entrepreneurs. And I am pleased to see the Australian venture sector is active and growing.
Following the workshop last year we have been working with Greenspring and the Australian VC community to help promote a world class venture capital sector here in Australia. As part of our mandate with them, we have asked Greenspring to specifically look for opportunities to support Australian VC managers. Greenspring are actively monitoring the market and capital will be allocated as suitably strong opportunities are identified. This program, in bringing one of the world’s leading Venture Capital investors to Australia, is an example of the work the Private Equity team has been undertaking to find ways for the Future Fund to support Australian businesses with their growth aspirations. Of course some businesses mature past the Venture stage. There is no shortage of growing small and medium Australian businesses requiring capital. Their success is important to the development and diversification of the Australian economy, including ultimately our listed market should they go on to IPO. While banks have been the main funders of these companies, they have not been able to support all of the growth opportunities this sector has generated. And these businesses are too small to access debt or equity capital markets.
Given the large size of the Future Fund, and our model, which involves a relatively small investment team, it has always been challenging for us to find an efficient way to invest in these types of businesses. We believe there are attractive investment opportunities in this sector in which the Future Fund can invest. This will have the added benefit of supporting small and medium Australian businesses to realise their growth potential.
We are therefore thinking about how we operate in the Australian market. In doing so we are actively considering ways we can invest in these types of opportunities in an efficient way, and we will hopefully have more to say on this in the near future.
In conclusion, I reiterate the need for all thoughtful investors to be thinking about the impacts of disruption and generational change.
Those allocating capital like the Future Fund must continue to innovate and be open to the changing world we live in and the changing investment environment we operate in.
Disruption creates winners and losers – investors who are open to change will be rewarded in this environment and those who fail to engage with the changes that are occurring will risk failing.
Australia’s private equity and venture industry is well placed to capitalise on the huge changes going on in the world. Indeed Private Equity is one of the few asset classes available for investors to obtain this exposure early in its cycle.
The Future Fund looks forward to working with our managers and the Australian industry as a whole to take advantage of these opportunities.