Less prescriptive guidance on illiquid asset valuations will mean RSE licensees will continue to need to make nuanced judgement calls on valuation processes
12 min read
APRA has released for consultation its draft Prudential Practice Guide (Investment Governance) (SPG 530), which updates its existing guidance (now nearly a decade old) on how RSE licensees should practically implement updated Prudential Standard SPS 530 (SPS 530). The release of the draft SPG 530 arrives just in time for the commencement of the updated SPS 530 on 1 January 2023, which is discussed in our earlier Insights (November 2021 and July 2022).
In this Insight, we discuss the key (and, in some respects, novel) aspects relevant to superannuation investments teams, investment and valuation committees, and boards of RSE licensees.
- Internalisation of investment functions: APRA proposes to formally express an expectation that RSE licensees that have internalised (or are considering internalising) their investment functions should not do so unless they have determined their systems, resources and processes are comparable to an external investment manager providing similar services.
- Valuations: RSE licensees will be expected to satisfy themselves of the quality of valuation information available to them regarding each unlisted investment; and where they cannot obtain sufficient comfort on valuations, should reconsider the merits of being exposed to such investment. APRA’s acceptance of a sample or rotational approach to the testing of investment valuations appears limited – there’s an expectation that all private market assets (regardless of materiality) will be subject to an RSE licensee’s documented valuation methodology, including the valuation hierarchy.
- Blackout periods: APRA has raised the possibility that RSE licensees consider imposing a blackout period for members transacting in investment options exposed to illiquid investments straddling asset revaluation periods.
- ESG: APRA expects RSE licensees to understand not only the risks imposed by climate change on their investment portfolios but a broader range of ESG risks and opportunities (and to be able to demonstrate how they will affect members’ returns and risk objectives).
Internalisation of investments
APRA considers that ‘where an RSE licensee operates or is considering operating some, or all, of its investment functions internally, it would be able to demonstrate that it has systems, resources and processes that are commensurate with expertise and scope of service provided by external service providers’. This extends to an expectation that RSE licensees can demonstrate they have the personnel, experience, systems, data, operations and policies comparable to that of an external investment manager undertaking an equivalent activity.
Bearing in mind this expectation is only guidance – and, to a degree, aspirational – it appears RSE licensees will be expected to have a substantiated plan supporting their internalisation programs (with commensurate benchmarking against external managers). We note there will be potential limits in undertaking this analysis, such as a lack of appropriate comparators (having regard to the relative size or stage of an internalisation program), or difficulties in obtaining access to confidential or propriety information of external investment managers (many of whom are unlisted and not subject to extensive disclosure laws). The updated guidance indicates that APRA will look closely to ensure RSE licensees that have already internalised parts of their investment functions have done so with appropriate expertise and resources.
On the topical debate of valuation of illiquid private market assets, the revised guidance avoids providing a definitive methodology for valuing illiquid assets and instead builds upon the valuation governance framework required to be established by RSE licensees under SPS 530.
Focusing on those aspects of the guidance that go beyond SPS 530, the new SPG 530 will articulate more clearly APRA’s expectations that:
- RSE licensees apply their valuation methodologies and assumptions in a consistent manner (unless, supported by a documented process, the view is formed that the methodology must be updated to achieve a more accurate valuation);
- where an RSE licensee relies on valuations undertaken by external managers, it will be able to demonstrate:
- how its initial due diligence and ongoing monitoring supports its ability to rely on the valuations (particularly where the RSE licensee is unable to influence the valuation methodology); and
- how the external manager’s valuation methodology, hierarchy of sources of information and frequency of valuations, in normal and stressed circumstances, are consistent with the RSE licensee’s expectations;
- where an RSE licensee cannot satisfy itself about the quality of valuation information regarding each unlisted investment, it should reconsider whether the investment should be made or continue to be held;
- where an RSE licensee offers an externally managed investment option, it should ensure the investment manager’s valuation policy is appropriate and consistent with its own valuation policy (which we assume can be undertaken on a holistic basis); and
- an RSE licensee would consider seeking regular independent valuations across asset classes, either on a sample or rotational basis.
The draft guidance is less prescriptive than some in the industry may have been anticipating. It doesn’t seek to provide a granular view on how certain assets should be valued. It also doesn’t seek to provide detailed guidance on how the valuation framework might be structured for each illiquid asset class to accommodate different valuation characteristics or the availability of external valuation data points – other than setting the general expectation that trustees should be able to demonstrate how they have determined the most appropriate valuation approach for each asset class (including sub asset classes or instruments). This includes sources of valuations, the hierarchy applied and the inputs and assumptions to the valuation methodology (and access to relevant data to support the approach).
APRA has also stopped short of setting clear guidance regarding the use of, and reliance on, independent sources of valuations. Trustees are largely left to make their own determination (within the broad parameters of the guidance and prudential standard) of the circumstances in which they will seek independent external valuations for illiquid market assets, and strike the balance in weighing up the cost, reliability, availability and materiality of independent valuation sources to test (what, in some cases, may be thousands of) private market investments.
Member equity considerations
Mitigating member equity risks has received heightened attention in the revised guidance. These risks can materialise when members are switching investment options, or new members are onboarded (eg through a successor fund transfer or voluntary transfer from another fund).
APRA has suggested that RSE licensees may consider enforcing a blackout period for members transacting in the relevant investment option around expected asset revaluation periods, relative to underlying asset liquidity.
The draft guidance also includes an expectation that RSE licensees establish processes for the monitoring and quantification of member equity impacts arising from events such as interim valuation of assets, liquidity provider arrangements and transacting members.
The proposed blackout periods reflect a significant shift in guidance. APRA has traditionally been of the view that RSE licensees must meet their obligations to members in satisfying switching requests and managing liquidity. There are some limited circumstances where leeway is provided to trustees to suspend (or delay) transfers and rollovers in respect of illiquid assets under the portability rules in the Superannuation Industry (Supervision) Regulations 1994 (Cth); and there is some existing regulatory guidance on unit pricing, detailing the circumstances where it may be appropriate to suspend it. That said, such determinations cannot be made without considering (and this is not an exhaustive list!), the general duties under the Superannuation Industry (Supervision) Act 1993 (Cth) and the Corporations Act 2001 (Cth); obligations under the constituent documents of the fund in relation to the issue, redemption, rollover or switching of interests; consideration of what has been disclosed to members in product terms; and, to the extent a blackout period is proposed, what associated updated member disclosure obligations would be triggered.
While the imposition of a transaction blackout on one or more single asset class options might cure a perceived member equity issue for members in that investment option, member equity risks will still be present where other members are indirectly exposed to that asset class via a diversified asset class option that would not be subject to such blackout.
ESG and stewardship activities
ESG risks and opportunities
The draft guidance confirms that APRA expects RSE licensees to be considering broader ESG opportunities and risks, beyond those arising from climate change and discussed in Prudential Practice Guide (Climate Change Financial Risks) (which we explored in our previous Insight). In particular, APRA’s expectations are:
- RSE licensees to understand ESG risk considerations, and articulate how they will affect a portfolio and be reflected in terms of return and risk objectives;
- when pursing ‘additional’ ESG-based investment objectives (eg environment or social impacts), RSE licensees must be able to demonstrate that the additional objectives are consistent with the members’ best financial interest test; and
- RSE licensees should seek evidence to demonstrate how the relevant ESG opportunity aligns with the overall investment strategy and meets the investment objectives.
The draft guidance also reveals that APRA expects an RSE licensee would be able to demonstrate an understanding of ESG opportunities, as well as of risks.
In canvassing the scope of ESG opportunities, does this open an ever-expanding realm of expectations, such as:
What is clear is that APRA expects RSE licensees to assess and consider ESG factors throughout the formulation, implementation and oversight of their investment strategy. Where RSE licensees are considering engaging in ESG investments, APRA expects them to have the financial imperative, and the qualitative and quantitative data, to support making such investments.
The draft guidance also acknowledges that RSE licensees may consider engaging in stewardship activities as part of the prudent management of investments, provided that they can demonstrate:
- the value creation over time;
- the activity being appropriate in the context of the RSE licensee’s operations, resources and investment mix;
- how the activity is publicly disclosed (and, in doing so, RSE licensees will need to consider the various confidentiality issues that may limit the ability of licensees to disclose stewardship activities); and
- the activity is being undertaken on a cost-effective basis.
Taking a step back, somewhat unexpectedly the draft guidance on stewardship does not go much further than the existing best interests and sole purposes obligations on RSE licensees. The guidance merely articulates that APRA considers stewardship is reasonable where it is in the best financial interests of members and consistent with the investment strategy.
Member disclosure considerations
The draft guidance also discusses APRA’s expectations as to particular areas of investment governance that should be subject to enhanced disclosure to members, including that RSE licensees:
- consider how to articulate investment risk objectives to enhance member understanding of investment risk, including how risk appetite tools and qualitative statements support traditional quantitative metrics (eg no more than x negative investment returns in a period of y years);
- clearly communicate to members how they screen proposed investments and the potential effect of these screens (in the context of articulating investments risks to members);
- consider how significant deviations in asset allocations are disclosed; and
- publicly disclose how they use their voting or investment power to generate value in investments to engage in stewardship activities.
The enhanced disclosure expectations remind RSE licensees to be cautious in ensuring their communications regarding investment governance are accurate. Public communications that are not consistent with the RSE licensee’s operations, or with what has been agreed at the underlying investment level, risk being misleading or deceptive, which could be seen as greenwashing. These risks are explored in greater detail in our previous Insight.
Board involvement in investment strategy and supervision
Although it’s well understood that an RSE licensee’s board is ultimately responsible for ensuring its investment governance supports effective investment decisions that are consistent with the strategic direction of the RSE licensee, the draft guidance reinforces that boards must be effectively overseeing operations and regularly updated by their delegates. This includes:
- ensuring liquidity provider arrangements are subject to periodic review and regular oversight by the board;
- performance of investment options being reported to the board on at least a quarterly basis; and
- the board providing input on and challenges to the development and consideration of the plausible, but severe, scenarios most relevant to the RSE’s investments in the stress testing methodology.
Of particular note is APRA’s expectation that an RSE licensee’s board be able to demonstrate that it itself has an appropriate mix of investment skills and expertise. The existing SPG 530 stated ‘a prudent RSE licensee would have in place, or have access to, appropriate skills, expertise and resources’ – the distinct change in the guidance suggests that there is an expectation the board itself have an appropriate mix of investment skills and expertise (not merely access to external expertise and resources).
SPS 530 will commence on 1 January 2023, before the draft SPG 530 is finalised. APRA has confirmed that it expects RSE licensees will comply with the updated SPS 530 despite this timing gap (and, in doing so, they will need to carefully consider the extent to which they should now begin operationalising some of APRA’s guidance in the draft SPG 530, given that it may change before the final guidance is issued).
Therefore, it is important that superannuation funds are agile and fully understand their responsibilities under the updated SPS 530. Namely, that RSE licensees will need to:
- update their board-approved liquidity management plans to address the more prescriptive requirements set out in the new SPS 530 (particularly in relation to liquidity stress testing; the roles and responsibilities of the board, board committees and management; and reporting to the board);
- uplift their valuation governance framework, including having a board-approved valuation policy that addresses the various matters specified in the new SPS 530; and
- ensure their stress-testing program is approved by the board and addresses all the prescribed requirements set out in the new SPS 530.
Stakeholders are invited to provide feedback on draft SPG 530 before 17 March 2023, with the final version expected to be released in the second quarter of 2023.