The impact of index funds and industry super on public M&A in Australia

In brief

• Index funds and industry super funds are dominant players in Australia’s public markets and their presence on a target company share register will impact how a takeover or scheme plays out.
• Index funds may stall the progress of a takeover bid until it becomes unconditional (usually after control passes).
• Large super funds may have a long-term view on value that puts less weight on the immediate upside of selling into an M&A transaction.

The impact of index funds and industry super funds on public M&A in Australia

Index funds are thought to represent around 15% of the market in Australia, a percentage that is growing steadily. The figure is higher in the US – perhaps as much as 25%. It is estimated that index funds own between 20% and 30% of many major ASX listed entities. 

Index funds aim to track the performance of a relevant index (such the S&P/ASX300). The reasons for their growth are well-known. This includes:

• Studies have shown that few active managers can beat the index over a long period of time;
• That means a low fee alternative which produces the same or a better outcome with potentially lower risk is very attractive; and
• In Australia, the APRA annual benchmarking encourages funds to hug the index to avoid underperformance (which can lead to them being unable to take on new customers if they do not match up 2 years in a row).

Meanwhile, industry super funds have grown to become the largest investors in the history of the ASX. The reason for their growth is also well-known, namely the massive capital flows generated by Australia’s compulsory superannuation system. In recent years, we have seen the consolidation of funds into a smaller number of mega-funds. This increases their collective power (as witnessed in the recent debate about whether a bidder should seek shareholder approval if it is issuing shares under a takeover or scheme which represent more than 25% of issued shares).

Given their significance, anyone contemplating M&A activity in the public markets in Australia will need to consider the extent of index funds and super funds on the target company’s register and whether that may impact tactics for the transaction. Each raise discrete issues

How do index funds behave in M&A transactions?

Because they track the index, so long as a company is part of the index, the fund must hold the stock. The impact is different in a takeover scenario and a scheme scenario, due to the different nature of those transactions.

Takeovers bids

In a takeover situation, generally speaking, to avoid the risk of not tracking the index:

• index funds will not pre-commit to a takeover or scheme transaction;
• they will not accept a conditional offer as that will tie up their shares for the period from acceptance until the takeover bid is unconditional; and
• they will only accept a takeover bid to the extent that the target will be removed from the index or its weighting reduced. Typically, these things only happen after the bid is unconditional, which usually requires control to have passed, and the bidder’s control of the entity is almost complete.

This tends to slow down the progress of a takeover bid. In short, index funds can act as roadblocks to efficient capital reallocation — the very thing takeovers are meant to achieve.

However, there can be a countervailing effect. Once a takeover bid goes unconditional and the bidder begins to accumulate a significant shareholding, the index weighting of the company will reduce and the index fund will sell the shares (often into the bid). For this reason, it can accelerate the flow of acceptances once control passes or the bid becomes unconditional. It can have a snowballing effect.

One particular problem arises where the bidder is unwilling or unable to free the bid from conditions at less than 90% and index funds hold more than 10% of issued shares (a common scenario). In that situation, a bidder seeking to reach 90% will be frustrated unless it declares the bid unconditional at a lower level of acceptances and takes on the risk that goes with that. This can be the case even where the bid is at an attractive premium and the Board recommends the proposal. 

For this reason, the rise of index funds is expected to have had a negative impact on market efficiency and acts counter to the economic arguments in favour of takeover bids. This was summarised in the CLERP paper on takeover bids in 1997 as follows:

Takeovers promote efficiency in the capital market in a number of ways. The threat of takeover provides a strong incentive for company directors and management to use capital efficiently. A failure to use the company’s assets efficiently would ultimately be reflected in the company not providing an adequate return on its capital, leading to an underperforming share price. These circumstances could lead to the company becoming a potential takeover target. In the event of a takeover, directors and management face the prospect of replacement by nominees of the new shareholders. The prospect of a takeover acts to overcome the principal-agent problems inherent in the separation of company ownership and control, for example, where it is impracticable or too costly for shareholders to ensure that directors act in their interests. It provides market-based incentives to encourage adequate corporate performance and provides a penalty where this is not achieved.

A takeover can promote efficient resource allocation where the control of the company’s assets is transferred and the assets are put to a more productive use. Similarly, the new management may be able to improve productive efficiency of the company by making goods or services at a lower cost, for example, due to economies of scale or scope by integration with its existing operations. The new corporate ownership and control may also facilitate dynamic efficiency by making the company more responsive to changes in technology, creating opportunities for innovation or improved production processes. Prospective bidders monitor potential targets and bid for a company if they consider that they can profit from improving its management.

These objectives are undermined if it becomes too hard or impossible to confidently launch a takeover bid. This problem would be worse in a company with a higher index weighting as chances are that more index funds will need to hold the stock. It is no answer to say that a scheme still remains possible as that requires the board of the target to support the proposal.

In response to these concerns, Justin Mannolini presented a paper at a Law Council conference earlier this year arguing that the compulsory acquisition threshold in takeovers should be lowered to, say, 80%. That would reduce the impact of index funds holding a substantial stake and have the effect of restoring a takeover bid to a meaningful possibility.

We support that idea as it would enhance the ability for the market for corporate control to allocate Australia’s resources to those who are best placed to use them to their fullest potential.

Schemes of arrangement

In a scheme of arrangement, the position is slightly different. While an index fund would be very unlikely to pre-commit to a scheme proposal or provide a voting intention statement, index funds do vote on schemes. They would typically have regard to the board recommendation and the advice of proxy advisers. Another reason to favour a scheme over a bid. 

That said, the process requirements and time to fulfil them vary by fund and are opaque. It is generally not enough to rely on having sent out the company’s carefully prepared materials to shareholders. If there is a significant passive presence on the company’s register, seeking attention and engagement from passive funds can require its own set of resources and becomes a workstream in itself.

How do super funds behave in M&A transactions?

Large super has been an active participant in M&A transactions. The best-known examples are super funds joining in a consortium with private capital. Some examples are:

• AusSuper joined with BGH to propose a scheme for Healthscope in 2018 (unsuccessful);
• AusSuper also formed a consortium with BGH to propose a scheme for Navitas in 2019 (successful);
• Various super funds combined for the Sydney Airports scheme (including AusSuper, IFM and QSuper with GIP, UniSuper rolling their stake too) in 2021 (successful).

This has been less frequent in takeover bids, but there are examples:

• In 2024, Australian Meat Industry Super Fund made an unconditional on-market bid for Dynamic Group Holdings Ltd (a mining services company), valuing the target at $38m. It first built a stake of 19.87%. No due diligence was undertaken. The bid was recommended in the target’s statement and declared best and final. Control passed quickly. The bidder reached 98%, but did not invoke compulsory acquisition. The company recently sought delisting.
• In 2024, Hostplus was co-bidder with Charter Hall for Hotel Property Investments. No due diligence was undertaken first (other than a review of publicly available information). The initial bid was rejected by the target. Improved terms were again rejected, but eventually shareholders started to accept and the bid was successful reaching 90% and compulsory acquisition. Changes to the index weighting as the bid progressed assisted the flow of acceptances.

The rise of very large super fund investors with a focus on long term value has improved the sophistication of investors and is an important counterweight to the passive dynamic. 

That is demonstrated by AusSuper’s rejection of the Origin board’s recommendation of the Brookfield/EIG scheme in 2023 at $9.53 (which was a 64% premium to the pre-offer price of $5.81 and was viewed as being in the ‘best interests’ of shareholders by the independent expert). AusSuper made its views known and bought more shares to defeat the scheme. The shares are now trading at $12.78 per share, which seems to vindicate AusSuper’s views. 

Another example is the privatisation of Sydney Airports in 2021 where UniSuper rolled-over into the consortium rather than sold out for cash under the main deal. They must have considered the long-term value was superior to the offer price of $8.75 per share. Had the transaction been conditional on their support, the transaction may have failed.

Conclusion

The presence of index funds and large super on the register of a target company will require careful consideration by the bidder and by the target company in order to assess how likely it will be that the transaction will receive the support necessary. Understanding their drivers is essential.

In today’s market, knowing who’s on the register is as important as knowing what you’re offering. Passive funds may stall a deal; super funds might make it — or break it.