A final point is that many of the assets in this book represent the equity slice of the investment, not the gross value. For example, there are $1.8bn of equity and $3.8bn of property investments that are valued net of debt. It is not clear what the additional ‘off balance sheet’ gearing is in these investments. Needless to say it introduces another layer of uncertainty into the asset valuation process.
To summarise, there is a large pile of assets that:
- Yield high rates of return (so are probably above average risk);
- Are either illiquid, or internally valued, or both;
- Are leveraged >6x on balance sheet with an indeterminate amount of additional off balance sheet debt.
Stable or unstable system?
I should stress at this point that nothing in the above suggets there is anything untoward about the Challenger investment process or accounts from an accounting perspective. The point I am trying to make is:
- All valuation is uncertain;
- The Challenger assets contain lots of asset classes that have more potential for errors in their valuation than others;
- These assets are leveraged, so the impact of any errors is magnified.
Despite these issues, for most parties involved with Challenger, there is a natural tendency (or legal requirement) to try and come up with a specific valuation – both of the assets and the share price. But I would argue that this is the wrong approach. What is needed is an understanding of how stable these valuations are and in what conditions.
As noted above, one hint of this stability is the volatility of statutory earnings due to “investment experience”. Challenger imply that this investment volatility can be ignored – with the focus on underlying earnings – on the basis that the assets will be held to maturity.
But what if this is not the case? What if Challenger becomes a forced seller? In this scenario Challenger will be forced to crystallise the existing experience losses, and also perhaps to recognise some new ones as unlisted level 3 assets are revalued,via sale, into a potentially unforgiving transactional market.