The government wants pension funds to invest in national infrastructure projects. Luke Clancy explains how infrastructure can be used within a scheme’s portfolio
The UK needs to spend several billion pounds a year just to stand still in terms of its infrastructure requirements. On top of that, the government is keen to encourage investment in a range of infrastructure projects it deems necessary for the UK to dig itself out of its current economic hole.
The government has published, for the first time, infrastructure investment pipeline data covering 500 projects and programmes across both the public and private sectors.
The range of projects vary from low risk-return social infrastructure – often private finance initiative/ public private partnerships (PFI/PPP) – such as schools and hospitals, through to much riskier new build investments like wind farms or new road or rail developments.
The government is locked in negotiations with a number of potential investors. It has signed a memorandum of understanding with the National Association of Pension Funds and Pension Protection Fund, inviting them to consider the attractive risk-return profile of investing in infrastructure.
For most pension funds this would involve putting money into running existing infrastructure assets, which offer RPI inflation linked returns with minimal risk attached.
“The government is basically saying ‘we need to spend a whole load of money on new infrastructure assets and we don’t have it’”
A separate conversation, meanwhile, is taking place between the government and a more sophisticated group of large pension funds. These investors potentially have an interest in taking on construction risk and the higher returns associated with early stage, or ‘greenfield’, projects.
Tom Merchant, chief executive of the Universities Superannuation Scheme says the USS would be interested in brownfield investments, which offer “a fairly stable cash flow going forward, rather than investing in greenfield projects which carry a lot of development risk”.
A third discussion is taking place with insurance companies with large fixed income books. These investors are interested in investing in infrastructure debt. The important issue for these insurers is how liquid it will be.
Ian Berry, infrastructure and renewable energy fund manager, Aviva Investors, says: “The government is basically saying ‘we need to spend a whole load of money on new infrastructure assets and we don’t have it’.”
WHY IS INFRASTRUCTURE ATTRACTIVE?
The physical characteristics of the underlying assets and the long-dated inflation-linked cash flows they generate mean infrastructure is an attractive match for pension fund liabilities.
Pension funds could view investment in infrastructure as an alternative to liability matching assets, a bonds-plus type investment or a slice of equity that is lower risk and less correlated to economic activity. On the downside infrastructure can suffer from low liquidity and sometimes a lack of transparency.
However, infrastructure provides diversification from traditional equity and fixed income investments and benefits from stable demand since – unlike office buildings, for example – infrastructure is generally essential for the functioning of society.
Natural monopolies in the infrastructure market often exist, meaning investors avoid competition risk from other projects, and the sector is invariably well regulated.
Surinder Toor, head of investment management global infrastructure at JP Morgan Asset Management, says: “We exclude social infrastructure because the returns are lower. At the other end we exclude technological risk, such as broadcast towers, as the risk of substitution is too great. The sweet spot is regulated utilities as they are natural monopolies. We don’t own the commodity, we own the infrastructure that supplies the commodity, so there is no substitution risk.”
Rollo Wright, partner at specialist investment advisor Gravis Capital Partners, says pension funds are likely to be most interested in the more secure end of the infrastructure spectrum: “Accommodation or availability-based assets where the cash flows are based on the availability of the asset as opposed to the demand of the asset. I’m thinking of hospitals, schools, housing perhaps, backed by a public sector cash flow. Toll roads would more risky though.”
WHAT’S STOPPING FUNDS INVESTING?
Clearly it is not economic for most pension funds to employ in-house experts, given their relatively small infrastructure allocations, meaning only the largest funds can afford to invest directly in projects, but for smaller investments co-mingled fund offerings have been available for over five years.
The GCP Infrastructure Fund, for example, targets a running yield of 7-8% and has three pension fund investors representing a third of its assets under management, with West Yorkshire Pension Fund a cornerstone investor.
But typical infrastructure allocations by UK funds are only in the region of 1-2%. Canadian and Australian pension funds, on the other hand, have been investors in infrastructure for much longer than their UK counterparts.
Both countries dealt with their public sector pension positions much earlier than the UK. Also, in Australia superannuation reforms introduced retail flows of cash available for investment in infrastructure while in Canada, from the mid- to late 1990s, public pension bodies were separated out from the state with independent boards and funded with capital pools, again creating inflows into infrastructure.
Auto-enrolment could serve as a similar catalyst here. JP Morgan’s Toor points out that Australian and Canadian funds have focused on ‘brownfield’ mature assets, whereas greenfield projects require shovel-ready projects. “Some funds will invest in greenfield projects but they tend to be closer to the private equity space in terms of the types of returns they are seeking in order to compensate for planning, construction and potentially usage risk.”
“Everyone involved would like to see more clarity on the pipeline of proposed projects”
Wright says the UK institutional market is doing careful due diligence on infrastructure but taking time to get comfortable with it as an asset class.
He says: “This could be as a result of the strong culture of pension fund advisers that sit and advise pension funds where to invest. This could add a level of delay, to convince all the advisers that it’s a good idea before you even get to the trustees.” But the government may need to provide some kind of guarantee if it is to bring in pension fund investment.
Wright predicts: “In the same way that a PFI has a central or local government credit on the line for 30 years, I’m sure that future projects will require some kind of government backing.”
Berry says: “Everyone involved would like to see more clarity on the pipeline of proposed projects and many parties hope that the government will simplify and increase the amount of support. Personally, however, I wouldn’t expect a government guarantee to be provided in many cases.”
Rob Gardner, Redington founder and co-CEO, says he is already “matching people who need funding with clients who are interested in projects, without having to wait for a broader industry debate on a framework to make it happen.”
He says that with the banks reluctant to lend and the PFI model under political pressure, pension funds have a big opportunity: “Insurance companies and pension funds are now potentially the long term providers of either debt or equity funding to these projects as the government cannot fund them direct.”
CASE STUDY: LONDON PENSIONS FUND AUTHORITY (LPFA)
The £4.1bn LPFA began investing in infrastructure as asset class in 2004.
LPFA chief executive Mike Taylor says key drivers behind the decision to invest were that infrastructure is uncorrelated with other asset classes and provides stable, inflation linked, long term returns – a good match for pension fund liabilities.
The LPFA’s initial investment was through private financial initiatives and ‘clean energy’ limited partnership funds using experience gained in private equity investing.
These investments were initially supplemented with listed funds, then sold down to meet limited partner calls.
The LPFA’s portfolio encompasses three main sectors:
• Economic infrastructure (road, rail, ports, airports)
• Environmental and renewable energy infrastructure (solar, wind, biomass, waste recycling)
• Social infrastructure (health, education, street lighting)
The LPFA has a target allocation of 5%, or £120m, of the fund’s return-seeking assets. Its total commitment to infrastructure (including drawdowns to date) has been £180m. Its return expectations are benchmark RPI+3% and target RPI+5%.
The funds it invested in of the 2004-07 vintage have strong similarities to private equity funds, with a 10-year life, high levels of leverage and expectation of early distributions.
The 2008-11 vintage funds are longer term of up to 25 years, with a buy-and-hold approach.
Taylor says the LPFA is reviewing its asset allocation weighting in a fund strategy review and while it is too small to co-invest directly on its own it has an interest in investing though consortia alongside bigger funds.
One concern Taylor has at the moment with infrastructure funds is the rising level of illiquidity in rapidly maturing vehicles.
Taylor says politicians would clearly like to see more investment in infrastructure in London in particular, which the LPFA would like to support.
However, he insists that the fund must invest for the best returns it can achieve, commensurate with the risk taken. If those opportunities are to be found within London then that makes sense, but the returns and risk profiles need to be right.