Q&A: State Super's alternatives makeup shifts towards private debt

The Australian pension fund joins other asset owners in eyeing private credit opportunities in the Asia-Pacific region, although liquid defensive assets retain a majority of allocations.
Q&A: State Super's alternatives makeup shifts towards private debt

State Super, one of Australia’s oldest superannuation funds founded in 1919, is shifting the makeup of its alternatives investments from infrastructure and property to alternative risk premia, private debt and Asian high yield.

A majority of the A$44 billion ($33 billion) the fund manages belongs to the defined benefit portion of the fund, which has largely been phased out in the industry. The remaining A$8 billion comes from the defined contribution section, which is most comparable to the other superannuation funds in Australia.

Charles Wu

Of this A$8 billion, exposure to alternatives has held steady between 24% to 36% over the past few years, but the makeup has shifted away from infrastructure and property, Charles Wu, who became chief investment officer in December, told AsianInvestor.

Asian private debt is of particular interest to the fund “as part of our broader opportunistic credits”, he said.

“We could start seeing non-bank lenders begin to bridge the financing gap for middle-market companies which cannot access traditional financing, ultimately mirroring the trend that has already taken place in the US and Europe,” he explained.

His views are shared by institutional investors across Asia Pacific that have spotted private debt opportunities in China and India as private capital assets in the region are expected to grow to $6 trillion by 2025.

European insurers such as Allianz have increasingly found opportunities in Asian private credit as they search for investment yield.

Asked how the fund manages risks that have been associated with private credit, Wu quipped: “I know if a business goes under… I'm gonna get my money back before an equity investor.”

John Livanas

“The other thing is we diversify a lot. [Private credit] is not a majority of our portfolios by any stretch of the imagination, they play a role within a particular asset class within a particular risk category,” chief executive John Livanas added.

Indeed, liquid defensive assets still take up a large portion of 27% to 47% of the super fund’s balanced strategy. In May, State Super introduced a new income sector to its portfolio in response to its ageing member base and a low-yield environment.

“The base case is that yields will stay low for much longer, at least anchored at the lower end, over the next three or four years,” Alice Tjahja, senior investment manager for debt, capital markets and alternatives said.

“We had a really amazing journey of where fixed income and cash has been for the past four decades, but then now it's a very different environment. The supply of negative yielding debt is massive. It's about $12.4 billion US dollars, about 20% of the global market index. And so that's a very different landscape now relative to before, and also you see the velocity of money supply that's really dropped to record lows,” she said.

CIO Charles Wu expands further on how the makeup for the defined contribution portion of their assets under management is evolving.

Q How much exposure does your fund have to alternative asset classes today?

State Super’s strategic exposure to alternative assets ranges from 24.5% to 36% across our Conservative to Growth options within the Defined Contribution scheme. This constitutes all assets that are not represented by equities or liquid defensive (fixed interest, income and cash).

Q How has your receptivity towards alternative asset classes evolved over the past three years? 

While our allocation to alternative assets has not changed materially over the past three years, the makeup has changed as we continue to look for new sources of alpha and beta to diversify against equity risk and manage liquidity requirements from member switching and exits. We have had meaningful allocations to infrastructure and property assets; however, over the past three years we have enhanced the alternatives portfolio with the introduction of alternative risk premia, expansion of our corporate lending and private debt assets from local into the US and Europe, and introduction of Asian high yield. We also have allocations to other more liquid alternative assets including multi-assets, opportunistic credits, loans, high yields, and Emerging Market debts to bring together the portfolio.

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Is your internal managers’ investment performance better than external ones or the other way around? Which areas do you outsource managers, and which do you prefer to keep internal?

We run primarily an outsourced model. Where we do get more involved, the performance has been on par or slightly better e.g., our overlay strategies. The measure is whether these strategies are in line with design including risk mitigation, not just return. The reason is because we can tailor make these strategies by taking the entire portfolio into consideration. For example, we may put in a sleeve of strategy that returns positively during market downturn (long convexity) which allows us to take on additional equity risk.

Q Asia has traditionally lacked depth in local currency fixed income asset classes. Has this been similar for private debt and infrastructure debt assets and required a more international mindset? 

Asia is indeed an underrepresented region across fixed income. It constitutes 35% of world GDP and is on the trajectory to grow even further; yet it only represents 12% of the Barclays Global Aggregate index and much less in other major global bond indices. There is strong home bias in Asian bonds, with the majority of buyers of the asset being local players. We view this as an attractive feature of Asian bonds, as a strong local investor base shelters the asset class from large outflows of capital in stressed events.

Asian private debt is an area we are considering as part of our broader opportunistic credits. The Asian bond market continues to grow in market size and whilst the appetite for bank credit has remained sticky with it constituting a large ~80% of market share; we could start seeing non-bank lenders begin to bridge the financing gap for middle market companies which cannot access traditional financing, ultimately mirroring the trend that has already taken place in the US and Europe.

Q The depth of liquidity flowing into alternative assets appears set to continue growing, which could cause an inflationary impact on prices. How much of a concern is this for you? 

There is a lot of dry powder for alternative assets with investors searching for higher and diversifying yields. It is true that many General Partners have found difficulty putting the capital to work (at least not immediately). Whilst it may drive up prices in the – short term, the pipeline of deals are starting to recover post COVID-19 as we have seen in the recent months.

At present, almost every asset class (not just alternatives) looks expensive on a pure valuation basis. However, yields on property, infrastructure, and private and public credits remain significantly attractive relative to cash and bonds. We expect that premium (whilst it may reduce) to remain attractive on a relative basis. Ultra-low cash and bond yields are here to stay until some form of sustainable inflation and full employment have been achieved and until we see an unwinding of monetary policy and fiscal support.

However, it is our view there will always be winners and losers as a result of thematic and technological disruptions and evolving macroeconomics. This is significantly more so for alternative assets which are highly idiosyncratic in nature.

Q ESG has been gaining a lot of traction. How do you overlay ESG considerations onto alternative asset investments? 

Our investment belief is that ESG factors may materially impact investment risk and returns, particularly over the long term. ESG is therefore fundamental within our investment processes, and we integrate this through both screening and engagement.

We apply an exclusions list to our managers including companies or subsidiaries that are involved in the production of tobacco and controversial weapons. We also exercise a right to veto deals within some of our credit mandates based on ESG considerations.

On engagement, these vary from asset to asset. Within our directly held real assets to provide an example, we enforce ESG as part of the key performance indicators and engage with management to improve ESG outcomes. These include ‘Environmental’ factors through consideration and monitoring of energy and carbon emissions, water and waste, and biodiversity; the ‘Social’ factor through workforce health and safety; and ‘Governance’ through employee diversity. We also utilise external data and ratings such as GRESB to monitor progress on ESG impact.

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