Notes to and forming part of the financial statements

C. General Business Disclosures

Finance provides advice on investment mandates and governance arrangements for the investment funds. This includes advice on the credit of amounts to and debits of amounts from the investment funds. The Future Fund Board of Guardians (the Board), supported by the Future Fund Management Agency (FFMA), is responsible for the management and investment of the assets of the investment funds. The investment funds consist of the following:

• Building Australia Fund (BAF) - an investment fund established by the Nation-building Funds Act 2008 to make payments in relation to the creation or development of transport, communication, eligible national broadband network, energy and water infrastructure. The BAF is expected to be closed by 31 December 2018, subject to the passage of legislation.
• Education Investment Fund (EIF) - an investment fund established by the Nation-building Funds Act 2008 to make payments in relation to the creation or development of higher education, research, vocational education and training, and eligible education infrastructure and to make transitional Higher Education Endowment Fund payments. The EIF is expected to be closed by 31 December 2018, subject to the passage of legislation.
• DisabilityCare Australia Fund (DCAF) - an investment fund established by the DisabilityCare Australia Fund Act 2013 to reimburse the Commonwealth, States and Territories for costs incurred in relation to the National Disability Insurance Scheme Act 2013.
• Medical Research Future Fund (MRFF) – an investment fund established under the Medical Research Future Fund Act 2015 to support medical research and innovation into the future.

Key judgements and estimates

In applying Finance's accounting policies, management has made a number of judgements and applied estimates and assumptions to future events. Judgements and estimates which are material to the financial statements are located throughout the investment funds disclosure.

Policy and measurement

Investment Mandates were issued by the responsible Ministers on 14 July 2009 for the BAF and EIF and on 1 July 2014 for the DCAF. The Investment Mandates set a target benchmark return of the Australian three month bank bill swap rate + 0.3% per annum calculated on a rolling 12 month basis (net of fees). The Investment Mandates also require the Board to invest in such a way as to minimise the probability of capital losses over a 12 month horizon.

The Investment Mandate for the MRFF was issued by the responsible minister on 8 November 2015. This mandate states that the Board is to adopt an average return of at least the Reserve Bank of Australia Cash Rate target + 1.5 to 2.0% per annum, net of investment fees, over a rolling 10 year term as the benchmark return on the Fund. In targeting the benchmark return, the Board must determine an acceptable but not excessive level of risk measured in terms such as the probability of losses in a particular year.

All investments are designated as financial assets at fair value through profit or loss (FVPL) on acquisition. Subsequent to initial recognition, all investments held at FVPL are measured at fair value with changes in their fair value recognised in the Schedule of Comprehensive Income. Investments are recognised and derecognised on trade date where purchase or sale of an investment is under a contract whose terms require delivery of the investment within the timeframe established by the market concerned. Investments are initially measured at fair value, net of transaction costs that are directly attributable to acquisition or issue of the investment. Investments in collective investment vehicles are recorded at fair value on the date which consideration is provided to the contractual counterparty under the terms of the relevant subscription agreement. Any associated due diligence costs in relation to these investments are expensed when incurred.

The following methods are adopted by the investment funds in determining the fair value of investments:

• Listed securities, exchange traded futures and options and investments in listed managed investment schemes are recorded at the quoted market prices on relevant stock exchanges.
• Unlisted managed investment schemes and collective investment vehicles are re-measured by the investment funds based on the estimated fair value of the net assets of each scheme or vehicle at the reporting date. In determining the fair value of the net assets of unitised unlisted managed investment schemes and collective investment vehicles, reference is made to the underlying unit price provided by the manager (where available), capital account statements and the most recent audited financial statements of each scheme or vehicle.
  Manager valuation reports are reviewed to ensure the underlying valuation principles are materially compliant with AAS and applicable industry standards including International Private Equity and Venture Capital Valuation Guidelines as endorsed by the Australian Private Equity and Venture Capital Association Limited.
• Derivative instruments including forward foreign exchange contracts, interest rate swaps, credit default swaps and futures are recorded at their fair value on the date the contract is entered into and are subsequently re-measured to their fair values at each reporting date. Further disclosures regarding the use of derivatives by the investment funds is presented in Note C2.3.
• Asset backed securities, bank bills, negotiable certificates of deposit, mortgaged backed securities, government securities and corporate debt securities which are traded in active markets are valued at the quoted market prices. Securities for which no active market is observable are valued at current market rates using broker sourced market quotations and/or independent pricing services as at the reporting date.
  MRFF Investment Companies (MRFFICs)

Whilst all investments are held by the Board in respect of the relevant investment fund, some investments are indirectly held through wholly owned investment holding companies, MRFFICs. The MRFFICs are funded primarily via loan arrangements from the MRFF and each respective MRFFIC. These loans are designated as financial assets and measured at fair value with changes in their fair value recognised in the Schedule of Comprehensive Income. Loan assets are repayable on demand. Interest rates are set on the loans having regard to the 10-year government bond rate in the market in which the underlying investment is made. As the MRFFICs hold a material portion of the investments of the investment funds, these are recorded on a net assets basis in Finance’s primary schedules. For risk management purposes these are disclosed by the underlying investment held by the MRFFICs as this provides users with more relevant information in relation to the investment portfolio and Finance’s exposure.

Collective investment vehicles

The investment funds, directly and via the MRFFICs, have committed to provide capital to various collective investment vehicles. Collective investment vehicles are entities that enable investors to pool their money and invest the pooled funds, rather than buying securities directly. Collective investment vehicles are used to invest in private equity funds, hedge funds, debt funds, listed equity funds, infrastructure funds and property funds and are usually structured as interests in limited partnerships and limited liability companies. The total of these commitments at balance date is $386 million (2017: $95 million). The investment fund’s commitments, being capital calls, are set out in the various underlying subscription documents. While the actual timing of the capital calls to be made by the managers of these vehicles is uncertain, as it is dependent on the managers sourcing suitable investment opportunities, the investment funds have recorded the commitments as being current in accordance with the underlying legal documents. The investment funds have appropriate liquidity planning in place to ensure a suitable allocation of resources will be available to cover these future commitments of capital.

The table below provides more detailed information on the commitments and outstanding calls of collective investment vehicles held directly by the MRFF, DCAF and via MRFFICs at balance date:

C2.3 Managing financial risk

The investment funds have entered into derivative contracts to manage their exposure to foreign exchange risk, interest rate risk, equity market risk and credit risk. The investment funds also use derivatives to gain indirect exposure to market risks. The use of derivative financial instruments by the investment funds is governed by the Nation-building Funds Act 2008, the DisabilityCare Australia Fund Act 2013 and the Medical Research Future Fund Act 2015.

C2.3.1 Market risk

Market risk is the risk of loss arising from movements in the prices of various assets flowing from changes in interest rates and foreign currency.

Interest rate risk

Interest rate risk exposure

The investment funds are exposed to risk of loss arising from movement in the prices of various assets flowing through interest rate changes. The total exposure for each class of financial asset is set out below.

Interest rate derivative contracts

The investment funds had open positions in exchange traded interest rate futures contracts and interest rate swap agreements at the reporting date. Interest rate derivatives contracts are used by the investment fund's managers to manage the exposure to interest rate risk and to ensure it remains within approved limits. The notional value of the open contracts and their fair value are set out below.

Interest rate sensitivity analysis

The impact of a change in interest rates is disclosed in the table below, with all other variables held constant. The table demonstrates the impact on the operating result of a 20 basis point (2017: 30 basis point) change in bond yields with all other variables held constant. It is assumed that the 20 basis point change occurs as at the reporting date and there are concurrent movements in interest rates and parallel shifts in the yield curves. A 20 basis point movement would impact on the debt portfolios' (including derivatives) contribution to the investment funds’ operating result. The impact on the operating result includes the increase/(decrease) in interest income on floating rate securities from the basis point change.

Foreign currency risk

The investment funds undertake certain transactions denominated in foreign currencies and are therefore exposed to the effects of exchange rate fluctuations. Exchange rate exposures are managed utilising forward foreign exchange contracts. The exposure in AUD equivalents to foreign currency risk at reporting date is as follows.

Foreign currency sensitivity analysis

The sensitivity analysis table below demonstrates the impact on the operating result of a movement in the value of the AUD relative to the actual net exposures as at year end, with all other variables held constant.

Other price risk

The MRFF and MRFFICs are exposed to price risk arising from equity investments. The equity price risk is the risk that the value of the MRFF equity portfolio will decrease as a result of changes in the levels of equity indices and the price of individual stocks. The MRFF and MRFFICs are held at FVPL. The exposure to equity price risk at the reporting date was as follows:

Equity derivative contracts

Equity futures are used to manage the exposure to equity price risk. The notional value and fair value of the MRFF open positions at 30 June 2018 are set out in the following table.

Equity price sensitivity analysis

The analysis below demonstrates the impact of the following movements on the MRFF and MRFFIC’s operating result.

• +/- 20% on Australian equities
• +/- 15% on International equities The sensitivity analysis has been performed to assess the direct risk of holding equity instruments. The analysis is undertaken on the base currency values of the underlying exposures.

C.2.3.2 Liquidity risk

Liquidity risk is the risk that the investment funds will not be able to meet their obligations as they fall due. The Nation Building Funds (NBFs) and DCAF are currently invested in cash and cash like instruments under the current Investment Mandate. Accordingly, the risk of these funds not being able to meet their obligations is low. The MRFF must be in a position to meet the distribution payments required of it up to the amount periodically declared as distributable by the Board, which is managed under the Short-term Liquidity Risk Policy. This includes a short-term crash test which is applied to the portfolio to ensure it is able to meet its immediate cash flow obligations under a plausible but very severe market dislocation.

C.2.3.3 Credit risk management

Credit risk is the risk of loss that arises from a counterparty failing to meet their contractual commitments in full and on time, or from losses arising from the change in value of a traded financial instrument as a result of changes in credit risk on that instrument. The Board sets limits on the credit ratings of debt investments when appointing investment managers. These limits are reflected in the underlying investment mandates and are monitored by the FFMA with compliance reported to the Board. The investment fund's maximum exposure to credit risk at reporting date in relation to each class of recognised financial asset is the carrying amount of those assets as indicated in the investment fund’s financial position.

Credit exposure by credit rating

Credit risk derivatives

The investment funds managers utilise credit default swaps to gain exposure to, and to hedge, credit risk. The investment funds transact in credit default swaps in the form of centrally cleared over-the-counter contracts. Centrally cleared transactions are cash margined at least daily. Managers are required to fully cash back all sold credit protection positions. Outstanding positions are marked to market and collateralisation of out of the money positions is required by the central clearing exchange.