Self-managed super fund trustees have typically been vanilla investors. As the ATO statistics show, Australian shares, cash and fixed deposits, and property still comprise the bulk of their investments at about two-thirds of the $750 billion in these superannuation funds.
That’s not surprising. Fund members understand these asset classes, and the returns they have generated over the years have been competitive with the APRA-regulated funds, especially when markets have been bearish.
But the search for yield and asset diversification is slowly changing their investment habits. The latest 2019 Vanguard/Investment Trends SMSF Report is evidence of this, revealing a growing interest in overseas assets, with SMSFs holding 11 per cent in 2019, a figure estimated to reach 16 per cent in 2020.
There has been far less interest by SMSFs in what are called alternative assets (this article will focus on two – private equity and venture capital). The ATO statistics on SMSF asset allocation don’t even have an alternatives category. But it’s my suspicion this could gradually change.
But before explaining why, let’s first explain the difference between venture capital and private equity. The former typically invests in start-ups or companies that are growing rapidly. In most instances they will be unprofitable, have ambitious, confident owners (if often misplaced), and typically their business model seeks to exploit new technology.
The goal of venture capital – $1.25 billion was invested in Australian start-ups in 2018 – is to rapidly grow companies over a short period of time, knowing that many will fail. As a rule of thumb, a venture capital fund investing in 50 start-ups will expect 2-3 to shoot the lights out, 10 to generate a return, and the rest to fail. For venture capital, it’s a numbers game.
It’s also important to appreciate what venture capital firms don’t do. Their investment is solely in the business – not the owners; they rarely invest in companies with large asset requirements (e.g. transport); they avoid companies lacking the potential to disrupt a market (i.e. restaurants) and they don’t get actively involved in management.
By contrast, private equity – meaning investments in companies that are not listed on the Stock Exchange – is later-stage money. In Australia, it’s estimated there about 40 private equity investors/funds with funds under management of about $35 billion. These funds usually invest in profitable companies with the goal of growing them over three to five years before exiting via a trade sale or IPO. Unlike venture capital, they are not looking for the next world beater, nor for super-sized returns.
A private equity investor will typically have eight deals in a fund and expect to generate positive returns on seven of those deals – a rifle approach to investing as opposed to venture capital’s scatter gun. It makes private equity far more cautious, so, unsurprisingly, its investment criteria include:
- A-grade management team;
- growth rates of between 10% and 30%;
- multiple levers for change;
- acquisition opportunities to bulk up the investment; and
- opportunities to add value by being hands-on.
Private equity also differs from venture capital in the size of the investment, with the former looking for deals where they can deploy at least $20 million. In doing so, they don’t oppose the company’s founders taking cash off the table. However, the fact the minimum cheque size is $20 million puts this investment out of the reach of most private Australian companies.
So why would private equity or venture capital investments be attractive for SMSFs? With venture capital, in particular, the failures far exceed the success stories.
Obviously, there are risks in both these forms of investment. SMSFs attracted to alternatives need to invest time and effort before investing, as well as seek professional advice. It’s not for the fainted-hearted or foolish.
That said, it’s worth remembering the primary goal of an SMSF is to grow assets for retirement. By this yardstick private and venture capital make good sense because they too are long-term, illiquid investments.
For an SMSF member in retirement, such time horizons and illiquidity would most likely be far too risky. For someone in the accumulation phase, time and illiquidity are far less an issue. It also adds another diversification string to the SMSF bow, a string that has the added benefit of being less correlated to events in the listed markets.
For both private equity and venture capital, the returns can often be double-digit. But with that return comes higher risk. For most SMSFs, I suspect venture capital will remain a bridge too far. By contrast, private equity investment has a higher probability of success and therefore are better suited to an SMSF. But either investment requires due diligence, good advice, and steely nerves.
Sean O’Neill is a director of Nash Advisory