17/02/2011 - 00:00

Size does matter when performance counts

17/02/2011 - 00:00

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The post-GFC financial services world has forced Westscheme’s hand.

THE decision by Westscheme to merge with its giant industry fund colleague Australian Super signals the early part of another tectonic shift in the financial services sector that will work against Western Australian players.

As a $3.4 billion fund, Perth-based Westscheme has admitted it simply doesn’t have the grunt to keep up with the big boys in what remains a very fragmented industry.

With the writing on the wall, Westscheme jumped before it was pushed, into the arms of AusSuper, which will become a $40 billion fund. That sounds huge but, amazingly, it represents just 3 per cent of the total sector.

Westscheme claimed its decision was not related to performance but simply to the difficulty in cost-effectively providing services to members in what has been a challenging environment and, due to regulation, is expected to get more so.

I am not completely convinced that performance wasn’t a part of the decision.

The markets have exposed industry super funds since the GFC. For much of the decade, they hammered the airwaves with advertising about how much they outperformed retail funds.

A lot of that was on the back of infrastructure investment, often geared. Retail funds were hurt badly by the GFC but their focus on equities has resulted in something of a rebound, while industry funds have staggered under the weight of illiquid and heavily indebted infrastructure investments.

Westscheme had its fair share of these.

If you look in the 2008 accounts (the 2010 version has a lot less detail) two of its biggest individual investments were Brisbane Square office tower and Loy Yang power stations.

At that stage Brisbane Square was the largest single investment the fund had made. At June 30 it was valued at $440 million, up around $75 million for the year, a revaluation that represented half of the 4.6 per cent growth in the fund’s total investments.

After the market’s collapse, the fund claims it did pretty well. It sold the building last year for $300 million, claiming an equity component of $106 million, from $54 million originally invested. That is an average rate of return of 12 per cent, but doesn’t include the interest paid on debt during the period.

Nor does it include the risk of being the developer, something Luke Saraceni has discovered lately.

It’s not just Brisbane Square. The Loy Yang coal-fired power stations, in which Westscheme has held an interest, have been a constant source of bad news in recent years.

Low wholesale electricity prices are hampering returns currently, but that is nothing compared to the concern last year that some of the power station entities would default on their debts because funding was unavailable due to the uncertainty of emissions trading laws.

Financing remains a big issue, with the problems relating to climate change policy exacerbated by tight debt markets.

Another Westscheme investment was in the Lane Cove Tunnel in Sydney, another piece of infrastructure with a chequered history.

In the past year Westscheme was prompted by regulatory concerns arising from the GFC to shut down one of its investment strategies – the Target Returns option, which aimed to exceed CPI by 7 per cent, and minimise the possibility of negative investment return. Talk about having your cake and eating it.

This strategy was closed for new business because of the illiquid nature of the investments.

The accounts also show a host of venture capital investments that are high risk.

A lot of these investments seem like hard work for, it has turned out, little if any additional reward.

It seems to me that Westscheme was simply too small to be indulging in a lot of these things and was lulled into a false sense of security by strong performances in a bull market.

The past couple of years have clearly brought some perspective.

According to Super Ratings’ review of the 50 biggest balanced funds, Westscheme’s most popular fund choice, Trustee’s Selection’s unaudited 8.2 per cent return for the 2009-10 financial year, put it at 40th over one year, 45th over three years and 34th over five years. I note the real return was 7.6 per cent, which would have pushed it further down the list.

High finance

The story above about Westscheme has a flip side. Despite all the goodwill messages that industry funds put out, they are not benevolent and, like any business, the infrastructure they invest in is expected to generate significant returns.

In better times, this meant loading up assets with big debts, which could be used to leverage their investment. The paper profits helped show industry funds as market performance leaders.

But in tougher times debt has become expensive and those infrastructure players are now finding it harder to meet the performance of the past – let alone deliver to customers.

A good example is Perth Airport, which is significantly geared and, from what I can tell, pays a high interest bill for what is a rare commodity these days – a high-growth utility. No wonder it struggles to keep the travelling public happy – as a recent Australian Competition and Consumer Commission survey showed.

According to the airport’s annual report for the year ending June 30 2010, it has interest-bearing loans and borrowings of $878.8 million among total liabilities of almost $1.1 billion. Net assets are just $244 million.

Finance expenses, mostly related to primary and subordinated debt, cost $75.8 million last financial year, up from $53.5 million. It would not have helped that around half the airport operator’s debt had to be refinanced last financial year. The notes to the accounts show major refinancing costs were $26.2 million.

Currently the average interest rate was 6.7 per cent, compared to less than 3.5 per cent in 2008-09. That shows how much more expensive it was to refinance when margins blew out from 0.22 per cent to 3 per cent or 3.5 per cent.

The cost of subordinated debt provided by the airport’s owners, including Westscheme, is much higher, with margins of as much as 7.5 per cent on convertible notes and up to 8 per cent on subordinated loans.

Fortunately for the operators around $340 million in debt at lower rates remains in place until 2013 or later.

One thought a former banker ventured to me in discussion was that the big leap in interest costs could have been linked to financiers re-rating property developers. A significant part of the airport’s profits came from property development in the years before the GFC.

They have shut most of that down now.

It would be a little ironic if the airport were paying the price for being a property developer just when it was acting more like a utility operator.

So, next time you are whinging about the infrastructure or service at the airport just think how little room to move the operators have.

• mark.pownall@wabn.com.au.

 

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