NEST CIO warns industry on missing out on DC pensions market, while CalSTRS discriminates in favour of transparent managers

Infrastructure fund managers have been told to “raise your game” if they want to win business from the UK’s growing defined-contribution (DC) pensions sector, according to the CIO of NEST.

Speaking at a conference in London, Mark Fawcett, who oversees the investment strategy of the UK’s biggest DC pension scheme by membership, said the infrastructure investment industry needed to “completely recalibrate” some of its thinking to “access DC investors in the UK”.

Fawcett revealed that the £3bn (€3.4bn) NEST, whose assets are expected to double annually in the coming years, will begin searching for infrastructure managers soon. In the summer, the pension fund will launch a search for alternatives and private credit managers, including “an infrastructure debt sleeve”, before searching for infrastructure equity managers at a later date.

But Fawcett, speaking at the EDHECinfra Days 2018 conference, highlighted some inadequacies with the current approach to infrastructure fund management, including those relating to costs, liquidity and time horizons.

“My challenge to you today, if you are in that business, is think about some of the comments I’ve made, and think about the right structures for this DC market,” he said. “We are not the only scheme that will be growing strongly. I think it is a massive opportunity.”

He argued in favour of “evergreen” funds for today’s DC schemes, rather than closed-ended vehicles with finite lives. “That structure itself – open-ended, evergreen – creates issues,” he admitted. “But given the cash-flow profile of DC schemes in this country, I think that’s a challenge worth taking on.”

He added: “We need funds which have a very long horizon, aren’t going to be closed at any specific period and have liquidity points where we can put money in on a regular basis. We don’t need daily dealing, we don’t need monthly dealing, but we do need some line of sight.”

Fawcett also took issue with the typical cost structures of infrastructure funds, which he said were incompatible with the low-cost model of DC pension schemes. The default funds of DC schemes, which hold the vast majority of their capital (99.8% of NEST’s members select the default fund), are required to charge no more than 75bps.

“A lot of funds that we see have a private equity-type charging structure and that is no use,” said Fawcett.

EDHECinfra Days 2018 conference held in London

EDHECinfra Days 2018 conference held in London

NEST also wants co-investment opportunities, which can help reduce costs, but also for “knowledge transfer”, he said. “We need to be an informed customer, we need to get up the learning curve of private-market investment and we look to our managers for a long-term partnership to help us do that.”

The lack of diversification was another complaint. “Too many funds are concentrated on large investments,” Fawcett said. “We want primarily to capture the infrastructure beta.”

Finally, he said he wanted “to see evidence” of environment, social and governance (ESG) risks “being properly integrated” into processes rather than “ticking the box” of responsible investment.

Fawcett said none of these obstacles would ultimately prevent NEST from investing in infrastructure, but they might influence how it invests.

“As a long-horizon investor, we absolutely believe we should be investing in infrastructure – both equity and debt – and we need an evolution of opportunities in order to do that,” he said.

But he said if appropriate structures were not forthcoming it might force NEST to look at other solutions, citing the example of IFM Investors, which was established by Australian superannuation funds to aggregate capital and invest in infrastructure directly.

“Either we set up a UK IFM, or you guys raise your game to meet the needs of the DC pensions sector in the UK,” he said.

Speaking later that day, David Cooper, head of debt investments for the EMEA region at IFM Investors, said: “Our 28 pension fund shareholders are all defined contribution schemes… They are bigger than NEST, but NEST will grow much quicker than we are currently growing.”

Another large – and growing – institutional investor is the California State Teachers’ Retirement System (CalSTRS), which had $1.75bn of $225bn in assets invested in infrastructure at the end of 2017.

At the EDHECinfra conference, Paul Shantic, director of inflation sensitive investments, said CalSTRS was working to structure an infrastructure portfolio with the help of a handful managers willing to be very open and transparent. “The managers… that have said, we will let you have access to all of our due diligence, we will let you have access to our internal memos… we will let you have access to our internal models – those are the ones that have been successful,” he said.

“We are concerned about the downside,” Shantic said. “It you’ve been through the process and we understand how you do that, and something goes wrong, that is easier for us to absorb – rather than you being a black box.”

mark fawcett

Over recent years CalSTRS has increased its infrastructure staff from three to eight, and has shifted away from funds in favour of separate accounts, partnerships and co-investments. Shantic said CalSTRS was looking to work with a “stable of managers” to “structure our portfolio, rather than having a lot of managers who might have 10 to 15 – or five to six – assets in their funds”.

Eugene Zhuchenko, executive director at the Long-term Infrastructure Investors Association (LTIIA), said there were a number of innovative approaches and structures being devised by a number of investors, such as CalSTRS, that now had several years’ of experience with the asset class.

These innovations sit “between the classic fund model and the direct investment model”, he said. “Those guys will look more and more at different solutions and models.”

But benchmarking continues to be a challenge for these investors. CalSTRS uses an inflation-related benchmark for its infrastructure investments, seeking to outperform the consumer price index (CPI) by 400bps. “There should be an inflation component to it, but we all know it’s not a good benchmark,” he admitted. “That’s why I’m here and we’re interested in pursuing a better benchmark for the asset class.”

At the same time, Shantic recognised that CalSTRS was able to come up with a benchmark relatively quickly off the back of years of work done in more established private markets, like private equity and real estate.

EDHECinfra is seeking to create a series of benchmarks for infrastructure, and the panel session was entitled: Do we now have an infrastructure asset class?

Shantic said CalSTRS did not start with “hard and fast definition” of infrastructure when it began investing in the asset class, but rather focused on characteristics and where it belonged in the wider portfolio.

“It’s not private equity, it’s not real estate; it’s got a cash flow aspect, which is very important, and it’s not fixed income,” he said. “This is a stable, cash-flowing asset for us with a modest upside in terms of total return.”

Shantic added: “As things develop in the asset class, we definitely want to move to some sort of definition. I’ve seen three or four that make some sense. Hopefully I’ll walk out of here with another definition that I can possibly use.”