---

CoreLogic has just reported that national dwelling prices rose by 2.3 per cent in May. That's an annualised rate of more than 28 per cent. And with lenders continuing to provide cheap and easy access to credit, and investors showing lots of interest, I don't see the property market cooling off any time soon.

Here at Montgomery, we've always kept a close eye on the property market. By now you should know we believe access to credit ultimately determines short and medium-term property prices. On that front lending data has been strong for some time and housing credit has accelerated. Unsurprisingly, as we have previously predicted, house prices have risen.

Other factors can have a 'micro-economic' effect on prices through the behaviour of buyers and sellers each weekend, but ultimately the meaningful changes in property prices are driven by credit, and immigration in the longer-term.

The Commonwealth Bank of Australia (ASX:CBA) has just published property lending data, which helps paint a picture of the state of the current property market.

According to the CBA economics team, new housing-related lending rose by 3.7 per cent in April to a new record high (excluding re-financing), while lending to owner-occupiers surged by 4.3 per cent and lending to investors was up by 2.1 per cent. Thank ultra-low rates for that.

Interestingly, lending to first home buyers has fallen for three consecutive months and the CBA believes this reflects declining affordability.

Clearly, the Australian property market is booming and the latest lending data suggests there are ample people looking for property with cheque books approved. That will continue to keep property prices supported.

The CBA notes the lending mix, is shifting. First home buyers are declining while investor buying is strong and lending to owner-occupiers excluding first homebuyers rose by 7.0 per cent.

According to the CBA, housing finance data is a strong leading indicator for dwelling prices.  Mind you, the relationship weakened during COVID when the CBA forecast significant house price declines that never eventuated.

Now prices are rising to record levels, houses are selling faster than ever and the proportion of homes exceeding asking prices is also at a record. It's all thanks to cheap, abundant and easy access to credit. The rate of price increases is quite spectacular. CoreLogic has just reported national dwelling prices rose by 2.3 per cent in May. That's an annualised rate of more than 28 per cent.

Despite the surging property prices, or perhaps because prices are rising so fast, owners are reluctant to sell, resulting in listings remaining stubbornly low. According to CoreLogic again, in the three months to May there were approximately 164,000 dwelling transactions Australia-wide. During the same period however only 136,000 new properties were put up for sale. It seems potential sellers fear missing out on further price rises or being locked out altogether. Consequently, the lack of stock, itself a function of rising prices, is fuelling further price rises.

For what it's worth, the termination of the RBA's Term Funding Facility at the end of June should mean bank borrowing costs for three and four year fixed rate mortgages will rise, and so will rates on those loans. That could dampen demand for loans and if it does could slow the rate of price increases for properties, particularly for owner occupiers.

If investor loans and properties continue to accelerate at the expense of first home buyers, it might be possible some macro-prudential measures by APRA could be implemented. This would serve only to slow the pace of property price rises because interest rates remain ultra-low relative to history and employment, wages and economic data continues to improve. While aggregate wages might not be rising, you only need a bunch of IT or digital recruits to switch jobs for a reported 10-15 per cent wage increase to impact what happens at this weekend's auctions and ultimately impact property prices for everyone else.

---

---

In 2019, which seems like 100 years ago, the cruise industry was booming with bookings and pricing both at record levels. 2020 was set up to be a phenomenal year. What could go wrong?

With the onset of Covid the world changed drastically, and the travel sector in particular continues to experience significant difficulties. The cruise lines found themselves right in the eye of the storm with the Ruby Princess in Sydney and the Diamond Princess in Japan making headlines for all the wrong reasons. For approximately 15 months now and counting, ships have been sitting idle and the operators burning through cash. In order to stay afloat literally and figuratively they have been forced to raise significant amounts of capital - both equity and debt.

Moving forward to today, global travel is slowly resuming and more specifically we are seeing an enormous amount of pent up demand for leisure travel. Consumers want to go on holidays and they love to cruise. Using Norwegian Cruise Lines as an example, their booked position for 1H 2022 is meaningfully ahead of 2019 which was a record year and at higher prices. Recently launched new ship Norwegian Prima, with voyages scheduled to begin in August 2022, set a company record for the single best booking day and best initial booking week. It warrants emphasising that this is all being achieved with almost no spending on marketing, further demonstrating the strong demand for cruise travel.

The revenue economics for the major cruise lines are quite straightforward. Prior to covid all ships sail at close to 110% occupancy. The only variable is price as the opportunity cost of an empty cabin is significant. The business model is to get the passengers on board then upsell them with things like shore excursions, dining upgrades, internet, casino, drink packages, etc. Revenue is split roughly 2/3rd ticket price, 1/3rd on-board spending. For this reason, Norwegian is strongly advocating for cruises to be fully vaccinated so that they can firstly fill the ship and secondly the onboard experience will be as close to 'normal' as possible.

In the very short term, the US Centre for Disease controls (CDC), which has been making life hard for the cruise industry by imposing excessively onerous conditions to the extent where Norwegian CEO Frank Del Rio accused them of being and I quote "un-American". His source of frustration is the different rules for every other transportation, entertainment and hospitality venue which are all open to varying degrees. However, in the last few weeks, the CDC has started to ease, providing cruise operators with greater confidence that they will be able to meet their return to sailing timelines.

As any army general will tell you, it is easy to start a war but difficult to end it. This is very similar to the cruise ships and Covid where we have been through lock down and now the path out remains a little foggy. While we don't expect smooth sailing from day 1, for investors that are prepared to take a more medium-term view, we know that cruising will resume in full force and we know that demand is there in abundance.

Keep Calm and Cruise On.

---

Twelve months ago we wrote our second note on Mineral Resources (ASX: MIN) titled "Can Mineral Resources be a $40 stock?". Within seven months our question was answered with an emphatic yes. Like all good sequels that enjoyed debatable success, we thought why not go a trilogy? We realise we may sound a bit like a broken record suggesting parts of the company remain underappreciated but hopefully some of the areas highlighted in this note make it less pointless than the Karate Kid III movie.

As a recap, from our last note we felt the market was: underappreciating the quality and growth potential of Mining Services; behind the curve on iron ore projects; and mispricing lithium optionality. Ultimately some of this boiled down to being under-covered, which appears to no longer be the case with increased broker coverage. This probably brings with it reduced ability for unique insight but we still see a couple of interesting parts of the business that present meaningful upside to market (sell-side) valuations and the share price, including:

• The minimal value attributed by the market for the Southwest Creek project
• The limited value attributed by the market for Ashburton
• The FMG implied iron ore price well above that used by us and the market to value MIN (with the exception of one analyst)
• International deals for NextGen crushers present as meaningful upside
• Mixed approaches by the market in valuing Wodgina and Mt Marion hydroxide optionality
• Energy blue sky

Our updated valuation is presented below with more detail following.

Source: Chester Asset Management

 

Lithium

12 months ago, we summarised the lithium market in FY20 as follows: "lower prices, operational issues, curtailments/mothballing, value destruction and bankruptcies". With hydroxide prices now ~USD15,000/t CFR into North Asia and 6% spodumene (SC6) ~USD700/t, share prices up multiples in 12 months, lithium contracts being agreed and consolidation taking place, the tables have certainly turned.

Obviously, prices are now up but we ask ourselves has spodumene become more attractive? Since the days of Standard Oil markets have been debating the appropriate economic split between upstream and downstream operations. It is not an easy question, and like many in markets can be answered by supply and demand fundamentals. When lithium markets were oversupplied spodumene was bid down to marginal cost of production (lower in some cases as entities like Alita/Tawana and Altura went into administration) however 2021 has seen the market tightening and prices reflecting that. Furthermore, with upstream producers expressing an increased desire to vertically integrate the spodumene left over for the hydroxide refineries is limited, so the margin available to upstream producers potentially increases. Companies like Pilbara Minerals (PLS) are even going a step further: by creating an exchange to sell spodumene into and investigating a midstream product with Calix (CLX).

Source: Pilbara Minerals Corporate Presentation, May 2021

Hence we see a natural progression for downstream players, facing potential spodumene shortfalls to also seek increased integration via JV tie-ups/ acquisitions. Given the political climate it seems likely FIRB would stymie attempts to acquire Australian operators by certain players and see greater integration between African upstream (hardrock) entities and China downstream players to avoid these players ending up like the HBO show Ballers (1). As we commenced writing this note, supportive of our thesis, it was announced Gangfeng would pay Firefinch (FFX) USD130m for a 50% stake in the Goulamina mine in Mali.

This preamble is a long-winded way of saying anyone with uncommitted spodumene should receive a greater share of value for it. Before the market got tight MIN was already planning for this and recent announcements have reinforced a desire to convert all spodumene to hydroxide within their own supply chains.

Mt Marion

Mt Marion continues to perform strongly with a steady run rate of ~450ktpa, recoveries (>85%) and costs (~USD350/t CFR) best in class. Although we don't have updated reserves/ resources on the project MIN point to the project having a 20+ year mine life. We now value MIN 50% stake in Mt Marion at ~AUD560m assuming an ~20 year mine life, providing MIN steady state EBITDA of AUD90m p.a. (ex Mining Services) (2).

Wodgina

In relation to Wodgina planning is currently underway to restart the mine after it was placed on care and maintenance in November 2019 following construction. Given greater scale, lower strip ratio, higher grade and more favourable cost structure, potential exists for Wodgina to have a far superior cost structure to Mt Marion, albeit we await clarity on what this may look like.

MIN had previously suggested a cost of USD296/dmt at 65% recovery for 750ktpa of SC6 but given the learnings from Mt Marion (and other operators) we see potential for production at a higher rate and lower product spec (5.5-5.8%) at improved recovery and cost.

We now value MIN 40% stake in Wodgina at ~AUD1,060m assuming a ~30 year mine life, providing MIN steady state EBITDA of AUD150m p.a. (ex Mining Services) (2).

Lithium Hydroxide - International Opportunity

We reiterate our view that Kemerton will likely be fed by Greenbushes and MIN's owns 40% even if it's not fed by Wodgina. Furthermore, Kemerton being fed by Greenbushes does not alter MIN's ultimate ambition of converting all of their spodumene (both Wodgina and Mt Marion) to hydroxide. Given quoted costs in China for downstream(3) vs more than double that in WA it is likely we see JVs established in China as the likely location of hydroxide refineries. We have provided an updated summary of our lithium hydroxide valuations below.

Source: Chester Asset Management (with reference to various announcements around lithium hydroxide plants)

 

Iron Ore

At the time of our last note iron ore (62% dmt CFR fines) was trading at ~USD105/t and Fortescue (FMG) at AUD14.00/share. We admitted 12 months ago we weren't predicting >USD150/t and still expect at some stage prices will roll over but MIN has certainly benefited from that strength. Due to our complete inability to predict the iron ore price we continue to use our FMG model to interpret a long term (LT) iron ore price implied by the market with FMG at AUD22.00/share. We continue to acknowledge this as an imprecise science but for us remains a useful exercise. Notably we now acknowledge that previously we had only modelled reserves but appreciate that higher iron ore prices would see resources convert to reserves. Hence we've added an additional scenario showing the implied iron ore price from 100% resource conversion.

The outcome of this is we continue to use consensus USD66/t (real) LT as our assumed base case 62% Fe price (after 3 years using ~consensus) but flex this to USD80/t LT as an upside scenario.

MIN notably at their most recent AGM announced a strategy around the four hubs of: Utah Point, Yilgarn, Ashburton and Southwest Creek. We provide an update on each of these below.

Utah Point

Currently MIN are exporting Iron Valley tonnes from Utah Point but in addition will export Wonmunna, Lamb's Creek and Wedge Iron Ore through the port. MIN is currently developing a 10 year, 14Mtpa mine plan for the hub (within 12 months). Iron Valley and Wonmunna will form the base of production. Wonmunna was notably acquired (Q1 FY2021), developed and commenced production (March 2021) in the space of 6 months, showing all of the benefits of Next Gen Crushing plants referred to in this document. The all in cost of acquisition and development for 5Mtpa of capacity was quoted at AUD126m with output potential of 10Mtpa for "little additional capital cost".

Yilgarn

The Yilgarn hub consists of infrastructure at Carina and Koolyanobbing. MIN is currently in the process of finalising a 10 year mine plan that includes Koolyanobbing, Parker Range and Mt Richardson. Planned capacity for the hub is 13Mtpa.

Valuations of Existing Operations

Source: Chester Asset Management, Mineral Resources Announcements

Ashburton

The latest with regards to the Ashburton iron ore project is that it is anticipated to be construction ready in August 2021 with a 2 year development (so first production 2H CY23). The project hub has been earmarked as 25-30Mtpa. The key sources of supply for Ashburton are Bungaroo South and Kumina.

Notably, recently a subsidiary of MIN has also bought a 15% stake in Aquila resources that has a 50% stake in the Australian Premium Iron JV. I.e., MIN now has effectively 7.5% of the API project. Baowu owns 42.5% while US company AMCI and South Korea's POSCO each own 25% of API. The key project of the JV is the 40Mtpa West Pilbara Iron Ore project. It was reported MIN paid AUD10m for the stake which also gives them exposure to Eagle Downs Coking coal project in QLD and Manganese assets in South Africa. We watch with interest how this asset may play into the strategies around Ashburton and Southwest Creek.

Southwest Creek (SWC)

In our previous note we provided a model for a 20Mtpa Marillana operation. Since then, MIN announced the desire for the business to be a 40-50 Mtpa operations consolidating more than just Marillana but also Ophthalmia and other stranded deposits. MIN has also announced that farm in agreements under the JV with Brockman had been satisfied and the JV had been amended(4) to include the Ophthalmia Project. Hence at least half of the SWC is proposed to come from Marillana/Ophthalmia.

MIN are still competing for berth rights (3 and 4) at Southwest Creek which are reserved for emerging / junior iron ore miners. Although there is no guarantees around access there are certainly other options if they aren't successful in securing rights. Hence we are surprised to see little value reflected in analyst valuations for the project.

Valuations of Growth Projects

Our valuations for Ashburton and SWC are summarised below. Notably capex is a key area of uncertainty however we have provided analogues below to drive our assumed capex figures.

Source: Chester Asset Management with input from BHP, RIO and MIN announcements

 

---

---

• Central bank digital currencies (CBDCs) are already operating in the Bahamas and being trialled in China. They will be introduced by many countries over the next five years.
• CBDCs enjoy the crucial advantage of total security, because a central bank can't go broke. But, in order to achieve broad acceptance, CBDCs also need to be cheaper or faster or more efficient or more private or more convenient than the alternatives.
• CBDCs differ from other cashless payment instruments such as credit transfers, direct debit, stablecoins, or cryptocurrencies, because they are "government money", being direct liabilities of the central banks. Issuing this "extra currency" involves costs, but CBDCs also allow central banks to see real-time transactions, create audit trails, monitor criminal activities, and prevent money laundering.
• Although an Australian CBDC is unlikely in the near future, the technology is evolving rapidly, and may have important effects on the global financial system.

---

INTRODUCTION

We've all heard of digital currencies like Bitcoin, Dogecoin, and other cryptocurrencies. What most people haven't noticed is that the world's central banks are planning to issue their own digital currencies. In fact, China has already been trialling digital renminbi on its unsuspecting citizens. What will central bank digital currencies (CBDCs) mean for banks, payment systems, and national economies?

CBDCs differ from other cashless payment instruments such as credit transfers, direct debit, stablecoins, or cryptocurrencies, because they are "government money", being direct liabilities of the central banks. Issuing this "extra currency" involves costs, but CBDCs also allow central banks to see real-time transactions, create audit trails, monitor criminal activities, and prevent money laundering.

Central banks had been quietly pondering CBDCs for several years, but most of them kept their ideas under wraps for fear of confusing their political masters. The world's parliaments are largely composed of middle-aged white men who know less about online phenomena than their teenage kids do. Until two years ago, talking about CBDCs would simply confuse the politicians.

The turning point came in June 2019 when Facebook unveiled its plan for a global digital currency called "Libra" (as in the tampon). Libra was to be a blockchain-based currency operating under Swiss regulation, which could be used in any country and also for money transfers between countries. In order to avoid the wild fluctuations in value which we have seen in Bitcoin and other crypto-currencies, Libra was to be a "stablecoin", which meant that its value was to be based on a fund of actual currencies and US government bonds.

Unfortunately or not, Facebook completely screwed up the launch of Libra. Management was not prepared for the regulatory requirements, even for such basic issues as talking to the Swiss regulator (that speaks 4 languages, in addition to English), incorporating privacy protections, and complying with anti-money-laundering rules.

More importantly, the company was totally deluded about its reputation in the eyes of US politicians and the US public. Questioning by US congressmen was mostly very hostile, making it abundantly clear that Facebook was neither liked nor trusted. No, really. Politicians in other countries expressed similar criticisms of Libra and Facebook. In response, the company announced in September 2019 that it would not launch Libra anywhere in the world until it had gained approval from US regulators.

This public relations disaster saw the departure of some of Facebook's key partners, extensive re-design of Libra (including basing it on the US dollar alone), the renaming of Libra as "Diem", and the indefinite deferral of any launch.

For central banks, however, it now became possible - even desirable! - for them to talk about their plans for digital currencies. A new sense of urgency also came from the Chinese central bank's announcement in October 2019 that it had been developing a digital renminbi since 2014, and would start public trials in April 2020.

 

TRIALLING CHINA'S DIGITAL RENMINBI

China's central bank has not yet finalized the design of its digital renminbi, which is also known as the e-CNY (for electronic Chinese yuan) or DCEP (for Digital Currency and Electronic Payment).

DCEP is intended to simplify retail and wholesale digital transactions and inter-bank settlements, with the added aim of reducing money laundering, gambling, corruption, and terrorism financing. The DCEP technology will allow users to transfer money by touching each other's phones, regardless of whether they are connected to the internet. But the DCEP will operate entirely through the banking system - Chinese individuals and companies will not have accounts at the central bank.

DCEP will certainly not undermine the Chinese banking system. The four biggest banks, with about 40% market share, are not only State-owned but also play essential roles in the Chinese government's fiscal and monetary policy mechanisms. DCEP will employ encryption which will allow users to carry out transactions without identifying themselves to merchants. The Chinese authorities may also choose to pay some salaries or benefits in DCEP, and they may require some taxes to be paid in DCEP.

According to the central bank, DCEP is not intended to replace cash completely, or to supersede the two privately-owned digital payments systems, Alipay and WeChat Pay, which are used by more than 90% of China's population. The two systems are operated by the tech giants Alibaba and Tencent respectively. These systems are able to collect detailed data on all users and their transactions, then to analyse this data in order to market other products to them.

Although the central bank has said that DCEP will not replace Alipay and WeChatPay, the owners of these two payment systems know very well that they are being targeted. China's financial regulators have spent the last three years bringing both payments systems very firmly under government control in terms of settling, reporting, and reserving.

In 2021 the regulators forced the parent companies to become fully regulated financial holding companies, which meant that they had to clean up their activities, and also to divest a number of lucrative peripheral businesses which they had started in recent years. In addition, Alibaba and Tencent have "given" DCEP access to the details of their hundreds of millions of users. China's tech giants will do exactly what the Party tells them to do, and they WILL do so with visible enthusiasm (cue the enthusiasm, please).

The Chinese central bank will be able to see and record all account balances and all transactions for every DCEP unit, and the resulting economy-wide picture will give it a fine-grained, real-time view of macro and micro trends. It will, however, apply the principle of "controllable anonymity" to sharing this information. Participating banks and merchants will only be able to see transactions in which they are involved, and they will not be permitted to retain their part of the transaction data for any longer than needed.

The DCEP will eventually be used for cross-border payments, once all the kinks have been ironed out of its domestic operations. For example, it is not yet clear how overseas DCEP users could make purchases in China, or what DCEP access would be given to foreigners visiting China. (See Chorzempa 2021.) But China's central bankers have been at pains to stress that, although DCEP may eventually facilitate the internationalization of the renminbi, it is not intended to compete with the US dollar as a means of international transactions or a global reserve currency. These functions depend on long-term factors such as capital export controls, trade volumes, available swap lines, user preferences, and relative volatility, which are mostly outside government control. (See Zhou 2021.)

 

THE FIRST CBDC IS ALREADY UP AND RUNNING

The Bahamas launched its Sand Dollar on 20 October 2020 after ten months of trials. The new digital currency is not a stablecoin or a cryptocurrency. It is issued as a liability of the Central Bank of the Bahamas, equivalent to the existing paper currency and backed by the same reserves as the paper currency. It is open to wholesale and retail use by all banks, merchants, and payments providers operating in the Bahamas, although prohibited from acceptance by non-domestic payees.

The transactions trail is fully auditable and will be monitored for fraud prevention and criminal activities, but user confidentiality will be preserved by strict regulatory standards. Holdings of Sand Dollars by individuals, businesses, and non-supervised financial institutions are subject to size restrictions, so that the Sand Dollar does not operate as a close substitute for traditional bank deposits. Circuit breakers will be used to prevent systemic failures or bank runs. (See Central Bank of the Bahamas 2019.)

The Bahamas is over-endowed with banks, but most of them do not cater to the local population of 389,000, who are scattered across more than 700 islands. GDP per head is USD$27,000 (about half of Australia's), with a sharp division between rich and poor. The Sand Dollar is intended to:

• Encourage financial inclusion, with a minimum of basic deposit and checking facilities for individuals and point-of-sale terminals for businesses
• Reduce the fees which payments providers charge merchants
• Support offline functionality
• Improve delivery of government services, such as pensions
• Improve financial literacy
• Prevent money laundering and tax evasion
• Be usable on digital wallets and mobile phone apps
• Provide real-time monitoring of banks' transactions and liquidity.

The Sand Dollar could be described as cash without the anonymity. Its use is also subject to some restrictions which are intended to reduce systemic risk and protect financial stability. Its economic function is similar to the effect which the spread of mobile phones had in many under-developed countries, where they improved national connectivity quickly and cheaply by skipping the traditional step of building a landline network.

 

POLICY CONSIDERATIONS

For the next few years, CBDCs will be in the design and testing stage. Their parent central banks know that they enjoy the crucial advantage of total security, because a central bank can't go broke, whereas any privately-owned bank may default at any time. (Remember how the GFC took down Lehman, Bear Stearns, Wachovia, ABN Amro, Royal Bank of Scotland, Northern Rock, and many more banks?). But, in order to achieve broad acceptance, CBDCs also need to be cheaper or faster or more efficient or more private or more convenient than the alternatives. (See Brainard 2020.)

CBDCs also bring new risks for financial stability. For example, they may be so attractive that they begin to replace bank deposits, thereby depriving banks of a vital source of funds. They may crowd out cash in retail transactions, and thereby limit the choices of the poor, rural, and elderly, as has been happening in China. Because CBDCs can be moved from account to account almost instantaneously, they could trigger a run on a bank, or even a run on the currency. Thanks to Facebook's PR disaster, many governments are now legitimately worried that their money supply and payments system - as well as their citizens' personal data - may one day fall under the control of some foreign technology company. (See Panetta 2021.)

Two weeks ago, Fed Governor Lael Brainard set out some of the major policy considerations which need to be taken into account when designing a CBDC:

• Preserve general access to safe central bank money
• Improve efficiencies in payments, clearing, and settlements
• Lower transaction costs
• Promote competition and diversity
• Reduce cross-border frictions
• Complement (rather than replace) existing currency and bank deposits
• Preserve financial stability and monetary policy transmission
• Protect privacy and safeguard financial integrity
• Increase financial inclusion.

No matter how a CBDC is designed, it will have to be written into a country's legislation regarding the central bank, legal tender, and the banking system. This task will be neither quick nor easy.

What regulators will not do is to give legal tender status to unregulated stablecoins or crypto-currencies, because if these become legal tender, they may be hoarded or suddenly transferred, which would make it possible for financial stability risk to be concentrated in issuers or holders whose operations, cash flows, and balance sheets are not visible to the authorities. That means the regulators might have to deal with "a run on the bank" when it didn't even know there was a bank, let alone that it was in trouble. (See Brainard 2021.)

 

DESIGN FEATURES OF CBDCS

China's DCEP and the Bahamas' Sand Dollar are not the only ways to run a CBDC. For example, both are designed as an account-based, centralized ledger with total visibility for the purpose of preventing money-laundering and other crimes. A CBDC could also be designed as a token-based, anonymous transaction tool, offering the same level of privacy as cash. (See Bache 2021.) To Chinese policymakers, a CBDC is a means of resisting the dominance of the two tech giants Alibaba and Tencent in the payments system.

CBDCs may be retail (for everyone) or wholesale (big users only). A retail CBDC may operate through the banking system, like China's, or it may interface directly with consumers and companies, allowing them to own accounts at the central bank. A wholesale CBDC would be restricted to wholesale users (such as banks) who will use them for inter-bank transfers of large sums, or for their reserve accounts at the central bank. (See Estenssoro 2021.)

A CBDC may be subject to complete centralized control, like China's, or it may be run as a distributed ledger ("blockchain"), perhaps with partial oversight and selective permissioning in order to restrict its use for illegal activities. No central bank is likely to issue a CBDC which is purely based on a distributed ledger (blockchain), because this would lack the essential functions of transparency and control.

Would a CBDC pay interest to its holders? Of course, cash does not pay interest, but there may be reasons why a retail CBDC would do so. A CBDC which paid negative interest (i.e. its value decreased the longer it was owned) would contain a powerful incentive to be spent sooner rather than later. For a wholesale CBDC, however, the issuing central bank might pay variable rates of interest when it wished to incentivize banks to hold CBDC deposits or reserves rather in alternative forms.

It is unlikely that CBDCs will be used for cross-border transactions in the near future, because of the legal and administrative difficulties. Any cross-border CBDC would have to meet the regulatory obligations of every jurisdiction where it was used. Because these obligations can differ widely from country to country, the regulatory burden would be considerable. The same goes for the administrative requirements of each country's payment systems. Any cross-border CBDC would have to interface perfectly with payment systems on both sides.

There are two forms of cross-border CBDC which might be adopted relatively early. The first is a CBDC which was restricted to central banks only: it might be adopted by a small group of countries, with its acceptance widening over time. The second is what Facebook still hopes to do with Libra/Diem: a CBDC which handles small-value international transfers such as the remittances of migrant workers. Such a CBDC would need regulatory approval of the sending and receiving countries, but it could be hedged around with restrictions to prevent domestic use, money laundering, and criminal activities. This "remittance CBDC" would fill a market gap, because current global payments systems charge 5% to 7% commission on small remittances.

 

HOW FAR BEHIND ARE OTHER CENTRAL BANKS?

At present, more than fifty central banks are researching the costs and benefits associated with issuing their own CBDCs. (See Boar and Wehrli 2021.) Few of them have made their research public, but the European Central Bank (ECB) set out its ideas in detail last year. (See ECB 2020.) The ECB described seven scenarios under which a digital Euro (e-euro) would be worth creating:

• enhanced digital efficiency in the monetary and payments system
• a decline in the role of cash as a means of payment, which adversely affected vulnerable groups
• providing leading-edge functionality to compete with other currencies or other payments systems
• a tool to improve the transmission of monetary policy
• a backup system to cope with cyberattacks or natural disasters
• to improve access to the euro outside the euro zone
• reducing the cost of the payments system, or to be more environmentally friendly.

The ECB's retail euro would be legal tender, operating through banks and other authorised intermediaries. Protecting privacy would be important, subject to the trade-off against identifying money laundering, tax evasion, and other criminal activities. The amounts which individuals and businesses could hold in their accounts would be limited in size. Initially at least, the e-euro would be restricted to EU residents, with the possibility of short-term exemptions and later expansion.

The ECB does leave open the possibility of allowing "bearer e-euros" which would not require the usual identification by users. It also considers the possibility of issuing two types of e-euro: one would be used for basic transactions, offline as well as online, while the other would function as a policy instrument carrying a variable (and potentially negative) interest rate.

 

WHAT WILL HAPPEN WHEN THE RESERVE BANK OF AUSTRALIA CREATES ITS OWN CBDC?

Last year the Reserve Bank of Australia ("RBA") published a short paper outlining the issues associated with a CBDC. (See Richards 2020 and Richards et al. 2020.) The paper concluded that CBDCs were a solution for problems that did not exist in Australia. We already have financial inclusivity, in that almost all Australians have transaction accounts and the means to execute online transactions via mobile phones, credit cards, etc. The current payments system is efficient, relatively cheap, and open to new players. The other policy considerations listed by The US Federal Reserve's Governor Brainard are not material issues in Australia. So Australia's big four banks need not worry about CBDCs in the next few years.

The RBA indicated that it would continue to monitor developments in the global CBDC space, and that it would not hesitate to introduce a CBDC if there were compelling reasons. The RBA paper did discuss some of the design choices for an Australian CBDC. Preliminary indications are:

• A retail CBDC with a "very significant" role for the private sector
• Account-based, token-based, or a hybrid?
• Capable of handling payments in person, online, and offline
• Probably not using a blockchain platform
• Privacy, but not as anonymous as cash
• Restrictions on holdings, for reasons of financial stability
• Unlikely to pay interest.

 

CONCLUSION

The digitization of money has only just begun. It will take at least five years before we will have realistic assessments of what works and what doesn't. The design choices which central banks make in their digital currencies will eventually affect all the players in the financial system. Arminius Capital will provide regular updates on significant developments.

---

REFERENCES

Bache, Ida Wolden. 2021. Fintech, Big Tech, and Cryptos - will new technology render banks obsolete? Oslo: Norges Bank. Speech 11 May 2021.

Boar, Condruta and Wehrli, Andreas. 2021. Ready, steady, go? - Results of the third BIS survey on central bank digital currency. Basel: Bank for International Settlements. BIS Paper 114.

Brainard, Lael. 2021. Private Money and Central Bank Money as Payments Go Digital: an Update on CBDCs. Washington DC: US Federal Reserve. Speech 24 May 2021.

Brainard, Lael. 2020. The Digitalization of Payments and Currency: Some Issues for Consideration. Washington DC: US Federal Reserve. Speech 05 Feb 2020.

Brunnermeier, Markus K., James, Harold, and Landau, Jean-Pierre. 2021. The Digitalization of Money. Basel: Bank for International Settlements. BIS Working Paper 941.

Central Bank of the Bahamas. 2019. Project Sand Dollar: A Bahamas Payments System Modernization Initiative. Nassau: Central Bank of the Bahamas.

Chorzempa, Martin. 2021. Testimony to US-China Economic and Security Review Commission. Panel 4: China's Pursuit of Leadership in Digital Currency. Washington DC: Peter G. Peterson Institute of International Economics.

Estenssoro, Amalia. 2021. Central Bank Digital Currencies: Back to the Future. St Louis: Federal Reserve Bank of St Louis.

European Central Bank. 2020. Report on a Digital Euro. Frankfurt: European Central Bank.

Panetta, Fabio. 2021. Evolution or revolution: the impact of a digital Euro on the financial system. Frankfurt: European Central Bank. Speech 10 February 2021.

Richards, Tony. 2020. Retail Central Bank Digital Currency: Design Considerations, Rationales, and Implications. Sydney: Reserve Bank of Australia. Speech 14 October 2020.

Richards, Tony, et al. 2020. "Retail Central Bank Digital Currency: Design Considerations, Rationales, and Implications." Reserve Bank Bulletin, September 2020. Sydney: Reserve Bank of Australia.

Zhou, Xiaochuan. 2021. The Digital Currency and Electronic Payment System. Beijing: Tsinghua PBSCF Global Finance Forum. Speech 22 May 2021.

---

There is a long held ideal that when investing in equities, the level of volatility is correlated to the return; the more risk you put on the table the greater the return you expect to get back. Of course, the amount of time invested also needs to be considered, but for investments over 3 years (and beyond) this ideal is generally accepted, as evidenced by the number of scatter graphs used in fund marketing material.

Volatility is managed by fund managers in several different ways, but generally it comes down to portfolio construction. The number of stocks in the portfolio, the size of the position held in each stock (and sector), and the buy and sell triggers, all affect the volatility of the portfolio.

Typically, the funds management industry uses Standard Deviation as a measure of volatility. Standard Deviation measures the dispersion of monthly returns both above, and below the average monthly return. The smaller the funds standard deviation, the less volatile it is. The larger the standard deviation, the more dispersed the returns are and the more volatile it is.

But does this show through in data, and is past volatility any sort of indicator of how a manager should have performed?

We have looked at the returns and standard deviation over the past 3 and 5 years of all Long Only Australian Equity Funds (107 funds) on the www.fundmonitors.com database and broken these into quintile rankings. The funds with the best performance fall into the 5th quintile (best) and funds with the lowest standard deviation fall into the 5^th quintile (best).

Looking at the data over 3 years as at the end of May 2021:

• Of the 22 funds that made up the 5^th quintile for performance, only 9 of them were in the 1^st quintile for standard deviation, showing that strong performance does not require higher standard deviation.
• One of the funds in the 5^th quintile for performance was also in the 5^th quintile for standard deviation and 4 of the funds were in the 4^th quartile for standard deviation.
• At the other end of the spectrum, only 6 the funds in the 1^st quintile (22 funds) for performance (worst performers) were in the 5^th quintile for standard deviation showing that standard deviation and return are not correlated over this timeframe.

Running the data over 5 years shows that standard deviation and return become slightly more correlated:

• 12 of the 19 funds in the 5^th quintile for performance were also in the 1^st or 2^nd quintile for standard deviation.
• For funds in the 5^th quintile for performance the average 5-year performance was 16.14% p.a. and the average standard deviation was 19.03% p.a.
• For the funds in the 1^st performance quintile the average 5-year performance was 6.48% p.a. and but the average standard deviation was quite high at 15.27% p.a.

Clearly, while there is some minor correlation in this data, the ideal of using standard deviation as a measure of manager skill, especially in isolation, is not a prudent investment conclusion. Investors and advisors should be looking at multiple risk data points such as Sharpe Ratio, Sortino Ratio, Up and Down Capture and Downside Deviation, to help them make the most effective investment decisions.

---

The value creation that Private Equity can bring to businesses, by contributing expertise across strategy, M & A and process enhancement is well documented and particularly applicable to private family or founder owned companies. This value creation comes when growth is accelerated through customer expansion, operational efficiencies are improved,  cost are reduced,  IT systems are implemented and additional talent is employed.  In an analysis of the US Private Equity mid-market, Adams Street Partners found that over 70% of value creation either came from revenue growth or multiple expansion largely as a result of business process enhancement, as opposed to value growth through financial engineering or debt leverage, which is often the perception of how value is created.

What is possibly more important but less well-documented is the value that is created through the "art of the exit": being able to determine the right time to sell and identifying the best method of selling a company to maximise investor returns. 

There is a common misconception that the primary source of equity release or exit from a private equity fund's portfolio comes from an Initial Public Offerings (IPO) and listing on a public share market, which was predominately the case in the late 1990's and early to mid 2000's where there were a number of high profile Private Equity IPO exits that generated significant returns for private equity investors.

However, there are at least three main methods of equity release that Private Equity fund managers consider when planning to exit a business, often years in advance of the actual exit outcome:

 

1. IPO: by listing a company on a public exchange, a seller can often achieve an optimal pricing outcome by removing the discount that is typically applied to unlisted business valuations.  Further premiums can be achieved by listing when equity markets are more buoyant making timing an important decision.  As attractive as IPO's may seem, one drawback to an IPO as the primary source of an exit for Private Equity backed businesses is that IPO windows, that is those periods where public investor appetite exists to buy new listing opportunities, can rapidly close and we have seen this occur recently with a number of high profile IPO's being withdrawn due to a reduced level of support from brokers and their clients.  Another drawback can be that after listing, sellers need to retain equity in the listed company which introduces market risk that is not desirable for most private equity investors.
2. Trade sale: Selling to a larger or listed company often in the same industry sector who may be looking to expand their existing operations to other geographic regions or to add to their existing product or service offerings.  These exits can attract premiums in situations where the purchaser is listed and trading at a higher earnings multiple thus gets an automatic uplift through multiple arbitrage.  Alternatively, there are private buyers who may be prepared to pay a premium for a business that provides a strategic platform to launch a new growth initiatives.
3. Secondary Sale to a global private equity fund or institutional investor: These exits often occur where an acquirer is looking to either achieve a long term yield on the dividends from an acquired company or otherwise seek to expand the existing companies offerings to an expanded global market.

 

Private equity managers add significant value when it is time to sell / exit a portfolio company by allowing the company's executives to remain focussed on growing the business while the private equity managers utilise their expertise to pinpoint the right method and time to achieve the best price for the sale of the business.

In this article we will look at examples of some recent exits from the Vantage's Private Equity Growth Fund portfolios (VPEG2 & VPEG3) to illustrate how Vantage's private equity managers are able to generate significant returns for Vantage Fund investors:

1. IPO: Lynch Group

During April 2021, VPEG2 underlying fund Next Capital Fund III, completed the fully underwritten bookbuild for the IPO of portfolio company Lynch Group. Lynch Group successfully listed on the ASX on 6 April 2021, raising ~$206 million at $3.40 per share. The transaction followed a transformational investment period for the Company across the 5.4 years of ownership by Next Capital.

ynch Group has evolved from predominantly an Australian supermarket wholesale business with a fledgling growing asset in China, to the largest Asian vertically integrated grower and multi-channel wholesaler of cut flowers and potted plants across Australia and China. Next Capital sold ~50% of the fund's shareholding into the IPO. The remaining ~17.0% holding will be in escrow until release of Lynch's audited 1H FY22 financial results in March 2022. This IPO exit delivered Next Capital Fund III and its investors, including VPEG2's investors a strong multiple of invested capital.

2. Trade Sale: MessageMedia

During June 2021, Vantage's VPEG2 & VPEG3 underlying funds Mercury Capital Fund 2 (MCF2) and Fund 3 (MCF3) announced the sale of MessageMedia for USD$1.3 billion (AUD$1.7 billion) to Sinch, a leading global cloud communications business listed on the Nasdaq Sweden. This exit marks an excellent investment for Mercury Capital Fund 2 and Fund 3 and is representative of the strong partnership that Mercury formed with the founder Grant Rule and the management team.

Following MCF2's investment in MessageMedia in August 2018, the business transformed from a primarily Australia and NZ based SMS provider to the leading global Server Message Block (SMB) Customer Engagement platform. MCF3 subsequently made an additional investment in MessageMedia during November 2019, which further supported the business's transformation in rebuilding the management team, consolidating the platform and the successful add-on investment of US-based messaging platform SimpleTexting. Once completed, the sale will deliver MCF2 and 3 investors, including VPEG2 & VPEG3 investors with an exceptionally strong return on investment.

 

3. Secondary Sale to Institutional Investor: iseek

During June 2021, VPEG2 underlying fund Next Capital Fund III announced the sale of iseek, Australia's leading cloud, Data Centre and Connectivity provider to a UK based Information Technologies and Telecommunications Infrastructure Fund.

Following Next's acquisition of iseek in August 2018, management have heavily invested in the construction of two state of the art physical data centres in Brisbane and Townsville and captured material contract tenders from large state government agencies and tier one corporate clients. These initiatives, along with the industry tailwinds of organisations outsourcing data storage providers, positioned the business to have a strong long-term opportunity set, representing an attractive investment for the international acquirer. The sale of iseek will deliver another robust investment return to Next Capital Fund III investors, including VPEG2 investors.

All three of these transactions will result in excellent performance outcomes for our investors.  In fact, across the June 2021 quarter, five underlying company exits were either completed or announced from Vantage Fund portfolios. These exits will deliver Vantage's Funds an average gross 4.9 X return on invested capital, representing an average gross Internal Rate of Return of 73.9% per annum.

 

MORE EXITS PLANNED FOR THE SECOND HALF OF CY2021

The market environment and economy generally remains very supportive of exits at the moment and a number of other companies across Vantage's portfolios are also positioning for exit across the second half of 2021. As managers across each of Vantage's Funds position each underlying company for sale, the number of exits from each Vantage Private Equity Growth Fund portfolio is expected to increase. These exits will ultimately provide Vantage Fund investors with an increase in returns and further distributions, providing a robust platform for each Vantage Fund to deliver their targeted returns to investors over the term of each fund.

Vantage Private Equity Growth 4 (VPEG4) remains open for investment to new investor until 30 September 2021.

Please click below to access further information about VPEG4