Investors need to prepare for changes to Regulation 28

Opinion piece by Daniel Malan, Investment Director of RE:CM

Despite the Financial Services Board (FSB) announcing that it would grant retirement funds and retirement fund members an exemption from complying with the investment limits in the revised regulation 28 of Pension Funds Act for six months after it comes into effect on July 1, RE:CM says that it is still important for investors to prepare for these changes, which have significant implications for pooled retirement savings. It is therefore crucial for trustees, consultants and members of these funds to understand the changes in order to ensure that they take advantage of the new opportunities and guard against the risks presented.

Key change 1: Direct commodities

Previously one could invest 10% of a fund in Kruger Rands (i.e gold). The market for Kruger Rands for large investors can be inefficient due to illiquidity and consequently this option was never really a viable investment alternative. While the commodity maximum exposure stays at 10%, one can now use any exchange traded commodity (such as copper, silver, lead, wheat, orange juice or pork bellies). Very interestingly gold is still the exception at a 10% maximum; any other single commodity will be limited at 5%. The barbarous relic strikes again!

Key Change 2: Hedge Funds and Private Equity Funds

Previously one could invest a maximum of 2.5%of a fund in so-called ‘Other Assets’. The industry classified both hedge funds and private equity funds inside this band and managed accordingly. This has now increased to 15% in total, with a limit of 10% in either. Considering the relative scale of the savings pool this is a very substantial change that will disrupt the fund management industry for some time to come. A lot of savings capital could potentially shift from the hands of traditional long only fund managers to these alternatives. The fund management industry notoriously enjoys zero barriers to entry – anyone with a laptop and a shingle could potentially lay a claim on managing these assets. It will be up to trustees and consultants to figure out the wheat from the chaff, and fast, because if they don’t the market will do it for them, with potentially damaging consequences for their retiring and retired savers.

Key change 3: Unlisted shares

Previously one could invest a maximum of 5% in unlisted shares. This limit will increase to 10% and opens up opportunities to allocate more meaningful fund capital exposures. This has its issues no doubt, including pricing and associated costs as there is no readily available share price. From the perspective of the fund manager/analyst, investing in unlisted businesses brings to bear a whole range of considerations, including Board and/or management involvement of the underlying investments, which is a skillset that is rare, time consuming and potentially stressful.

Key change 4: Mid Cap and Small Cap Equity

Companies with market caps of between R2bn and R20bn: A single fund can now own a maximum of 10% of the investee company - down from 15%.

Companies with market caps of less than R2bn: A single fund can now own a maximum of 5% of the investee company - down from 10%.

These two changes may appear harmless, but where there are large single funds with exposures that are in breach of the revised legislation it could mean they become forced sellers of very illiquid securities – with the potential to dislocate market price from business value. The limitation implies that there will be less capital hunting for investment opportunities in the listed mid cap and small cap equity minority universe, which we would welcome. This will in time of course be countered by the increased pool of capital available to control buyers such as private equity funds. Here’s to hoping they take a while to get going, but that’s wishful thinking given the economies on offer.

A final regulatory change – increase in offshore limits

A seemingly small other legislative allowance is the increase in offshore limits for Regulation 28 funds from 20% to 25% upon approval, with an additional 5% in African markets outside South Africa. This is another step towards the further relaxation of exchange controls, implying further flexibility in terms of our investable universe. It is very interesting to us that Botswana enforces no foreign exchange control limitations on their institutional savings industry. In our view this is the way it should be; please give us a good reason why not to include the worlds’ best businesses and other asset class opportunities in your investible universe.