Venture capital faces a reality check

The reverse has been brutal, with the Thomson Reuters Venture Capital Index, which proxies performance using publicly listed assets, down nearly 50 per cent year to date.

A super bad feeling

Local players are yet to concede a “super bad feeling”. But it is a matter of time, particularly given the proximity of financial year end, when scrutiny is at its highest.

For superannuation funds, the temptation will be to repeat the playbook of early COVID-19. Then there was a widespread reluctance to write down unlisted assets by a realistic magnitude, or to engage with legitimate criticisms that were being raised in terms of investment governance.

We highlighted our concerns in this newspaper at the time, both in terms of the deviation from fair value accounting principles and the prospect of insiders gaming artificially high unit prices.

To be sure, the current episode is narrower in scope, if acute. According to McKinsey’s widely read Global Private Markets Review, private assets under management were nearly $US10 trillion at year end 2021, with venture capital comprising 19 per cent.

Likewise in Australia, unlisted assets can be broadly defined to include private equity (inclusive of buyout, venture capital, distressed), private debt, real estate and infrastructure.

For private equity specifically, the most recent update from the Australian Prudential Regulatory Authority (APRA) puts assets under management at $106 billion. However, this captures only APRA-regulated funds.

Aggregate exposure is much higher, inclusive of self-managed superannuation funds, public offer unit trusts, banks, state-based treasury corporations and the Future Fund.

Home truths

Where this gets testy is that APRA has been busy addressing the shortcomings that were exposed during COVID-19.

The implications are more far reaching than the slap on the wrist that superannuation trustees received from the Australian Securities and Investment Commission (ASIC) in April following surveillance that “found significant deficiencies in their conflicts management arrangements relating to investment switching”.

The centrepiece is Prudential Standard 530 Investment Governance (SPS 530). Following a broad thematic review, APRA published proposed amendments to SPS 530 in September last year, and sought consultation through to February.

The main change is to uplift various sections from Prudential Practice Guide 531 (SPG 531) as pertains to the valuation of unlisted assets. The proposed commencement date is January 1, 2023.

The key difference between SPS 530 and SPG 531 is that the latter is merely a best practice guide. It does not create legally enforceable requirements.

In contrast, APRA will have its full suite of enforcement measures available to pursue a registrable superannuation entity (RSE) that fails to comply with SPS 530.

Substantively, the main changes concern stress testing, liquidity management and valuation governance. It is the reforms around valuation that are most pressing and far-reaching, in our view.

At a holistic level an RSE will be required to have “an adequate valuation governance framework, which consists of the structures, processes, procedures and controls necessary to identify and manage valuation risk of an RSE licensee’s investments”.

Drilling down, there are requirements that extend to valuation methodologies, the validation of valuation outputs and the circumstances in which interim valuations are to be made.

There is much else besides, but these requirements will be among the most impactful for unlisted assets, and for level 3 assets more generally.

Hunker down

The burden will fall largely on RSEs, and there will be a strong incentive to in-house more risk management and valuation capabilities.

Still, the implications will flow through the entire ecosystem, including asset and management consultants, accountants and auditors, and underlying managers.

There is, perhaps, some prospect that APRA’s initiative is watered down. The superannuation sector was very effective in doing so with the portfolio holdings disclosure regime, aspects of which we agreed went too far.

The local venture capital sector also cut its lobbying teeth in the delayed budget cycle of 2020, when it succeeded in persuading the Coalition to reverse its proposed diminution of the Research and Development Tax Incentive.

However, both those episodes were overly political. APRA has made its own running here, and it is constituted as an independent statutory authority, accountable to the Australian parliament.

Parallel reforms in US

It would be ill-advised for the new government to get involved, much less impede, what are overdue reforms.

Importantly as well, there are parallel reforms happening in the US. The Securities Exchange Commission has agreed rule 2a-5 of the Investment Company Act of 1940, which is due to come into effect in September.

This introduces a new framework for fund valuation practices centred around the concept of “good faith determinations of fair value”.

Rather than rail against these changes, the local venture capital sector will be better served by hunkering down and improving its own practices.

It was startling to learn in this newspaper last week that one of the local pioneers has only recently moved to obtain external independent valuation on its material assets.

For asset allocators, the challenge will extend beyond investment governance. With the tide going out so rapidly, there will be questions to answer in terms of the drawdown, and importantly, the data integrity of previous realised returns.

A good place to start is a thorough review of the impact of survivor bias on index returns.

The broader question to be addressed is whether the implementation of fair value accounting regimes will increase the realised volatility of private index benchmarks, to the detriment of long-term risk-adjusted returns.

We fully expect that to be the case. In fact, the reality show is already well under way.