Currency swings compound woes of Australian LPs

Currency swings and hedges gone sour are exacerbating the denominator effect among Australian superannuation funds and draining them of cash, making an already difficult fundraising climate even tougher for private equity and infrastructure funds.

According to Les Fallick, managing director of Sydney-based placement agent Principle Advisory Services, the recent swing in the value of the Australian dollar against the US dollar – from near parity in July to lows unseen since September 2004 – has hit superannuation funds already struggling with the so-called denominator effect, which forces many LPs to be over-weighted to alternatives due to falling valuations in other parts of their portfolios.

“The effect of the currency collapse has increased the value of contingent liabilities held by some pension funds by up to 50 percent,” Fallick estimates.

For example, if a pension fund committed $100 million to a US asset manager when the Australian dollar stood at 96 cents against the US dollar, once the currency depreciated to recent lows of 64 cents per US dollar, the liability rose to A$156 million. This exacerbates the denominator effect and puts added pressure on investors to halt new commitments to alternatives.

“The market has had a significant reduction in appetite and global private equity and infrastructure,” says Fallick.

Worse still, currency hedges meant to counteract these effects are causing a cash drain. Many Australian superannuation funds, which collectively hold some A$1.2 trillion (€600 billion; $800 billion) in assets under management, hedged their currency exposures using forward contracts against which they must hold cash as collateral. As the Australian dollar collapsed, they had to put in more cash in to meet the hedging obligations.

“Cashflows have been used to meet currency movements, so there’s been less cash available for other investments,” said Ken Marshman, head of investment outcomes at Jana Investment Advisers in Melbourne.

Marshman estimates that the typical fund will have 3 percent to 5 percent less cash than it thought as a result of the currency swings, which have triggered margin calls to meet hedging requirements.

“The one thing that softens that a bit is that the funds are still getting money into the fund [from future retirees] and infrastructure and property assets are still paying dividends,” Marshman explains.

Fallick agrees, noting that some super funds, like Australian Super, still have large cashflows and can make allocations. The Future Fund, Australia’s sovereign  wealth Fund, likewise has in excess of $40 billion of dry powder, he says.

Still, in the short term, the denominator effect, exacerbated by currency swings, is likely to put Australian investors under additional pressure.

“From now until mid-2009, people will primarily be making re-ups with existing managers with whom they have relationships,” Fallick says. “There is not a whole heap of new capital available for new managers coming to market.”

AUD Exchange rate: sudden collapse against US dollar Source: VFMC Market Outlook & Analysis, Oct. 2008