Pension funds investing in infrastructure are looking again at risks - but not the ones you might expect. Shayla Walmsley reports

The economic crisis and problems with underperforming infrastructure funds haven't driven pension schemes away from infrastructure. It's just made them choosy about what they invest in.

"We're talking about investors increasing their allocation to infrastructure from 2.5% to 5%, or from 0% to 5%," says John McCarthy, European infrastructure investment head of Deutsche Bank subsidiary RREEF. "More capital is being allocated to the market, albeit that there is more caution around where it's invested and with whom."

What is perhaps surprising is that pension funds are looking to mature markets, rather than emerging markets such as China and India, where demand for infrastructure investment is overwhelming but the politico-economic structures surrounding it are often difficult to gauge.

In mature economies, state-sponsored demand for infrastructure investment is stronger than ever. In a burst of neo-Keynsian job creation in September, US president Barack Obama announced a six-year $50bn (€37.5bn) plan to rebuild roads, railways and runways. Among the measures announced were the building of 150,000 miles of road, the construction and maintenance of 4,000 miles of rail, and the reconstruction of 150 miles of runway.

In mainland Europe, cash-strapped governments are looking to non-state players to fund the maintenance of infrastructure assets. An adviser to a European government on public-private partnership (PPP) projects, interviewed on condition of anonymity, points to government backing for institutional investment in Dutch infrastructure. Despite risks becoming more aggressively priced, "revenues are effectively guaranteed, and there is little political uncertainty. Once projects are started, 99% of them will be completed," he says.

The question is whether the market and the pipeline are large enough. On certainty, it scores high; on market size, it scores low.

Even the UK, which appeared to have very few infrastructure assets left to divest, has residual opportunities. A report published in the summer by a UK thinktank estimated the sell-off of assets, including utilities and transport infrastructure, could raise £16bn (€19.2bn). Fund manager M&G is looking at the potential for government sales of infrastructure assets such as the high-speed rail link between London and the Channel Tunnel.

New risk regime
If there are opportunities relatively close to home, investors are re-evaluating what they had earlier taken to be an inherently low risk associated with infrastructure. They'll need to. Pension funds investing in infrastructure now need to factor in risks that perhaps were less obvious a few years ago.

Political risk, ever high on the agenda, has climbed higher. McCarthy points to governments in Spain and Italy reviewing the tariff regimes that support renewable energy - a sector that only exists because governments are providing subsidies that breed the cost differential between old world energy and renewables.

Leo de Bever, CEO of Alberta Investment Management Corporation (AIMCo), which manages assets worth CA$71bn (€51bn) for 26 Canadian pension and government funds, points out that regulatory risk in the UK market has not deterred investment in that market: it has simply repriced it.

"Regulatory risk is the biggest risk in certain transactions, especially if you're dealing with quasi-monopoly assets. The UK environment for water and power used to be seen as the most reliable, for example, but you've seen regulatory decisions less friendly to investors than before. That creates doubt. You want extra return in that situation."

He also cites the Ontario 407 toll highway, where a contract signed with one government was renegotiated by its successor. In that case, a court found against the government. But a less obvious case happened in Texas, where a foreign company won the auction for a toll road. The state then decided that the auction had been null and void and held another. A Texan company won second time around.

"Real estate and infrastructure assets are inherently tied to local conditions and political geography," says de Bever. "In environments where fiscal conditions are deteriorating, the tendency is to take a pound of flesh out of everyone."

Counterparty risk is likewise still on the agenda. It's simpler to own 100% of an asset, but it's also relatively rare. RREEF found its footing in Europe by acquiring minority shares with the intention of increasing its interest over time.

"You need some kind of assurance that you'll get the cash flow under a long-term contract," says Michael Underhill, chief investment officer at Capital Innovations, a US infrastructure investment firm. "It only makes sense if you have a good counterparty, such as the government or a government entity, or where it's an essential part of the counterparty's activity. If you don't stay strict on those criteria, you could end up with just another private-equity-type investment."

Assets under attack
Against long-acknowledged risks, physical security has climbed to the very top of the list. It isn't that investment in an oil installation in the Niger Delta was a risk-free option five years ago, but investors can now be pretty sure that any infrastructure asset in any developed or developing market is at risk of attack. It doesn't have to be techy; it could just as well be disgruntled employees or agenda-inspired activists.

Earlier this year, at the annual RSA international security conference in London, former counterterrorism head of the US National Security Council Richard A Clarke pointed to vulnerabilities in existing networks. "I'm not talking about some imaginary space; I'm talking about things happening in physical space," he told a session on cyber-conflict.

"If they can do it to you, if they've cut the power off and your citizens are cold and hungry, no-one will be impressed when you say, ‘Hey, but we turned the lights out in Isfahan'."

Professor Mustaque Ahamad, director of the Georgia Institute of Technology Information Security group, told IP Real Estate: "If we're talking about the bad guys reaching out and causing harm, there's clear evidence of risk. The internet allows people in places where they couldn't otherwise get at infrastructure assets. There's no gap between infrastructure and the internet."

Both the target and the source have evolved somewhat: the scope and level of expertise is increasing. "It started out with hackers defacing websites, then cybercriminals, then nation states," says Ahamad.

"There is no debate that there are vulnerabilities in infrastructure. Infrastructure wasn't built with this kind of threat in mind. It isn't part of the design of systems," says Ahamad.
What this means, of course, is that pension funds could find themselves sitting on assets that are targets of military or subversive attack. The lesson is not to stay clear of investment in Iran's nuclear programme - due diligence wouldn't have to be particularly sophisticated to flag that one up as a major punt - but to factor in the cost of vulnerability of run-of-the-mill infrastructure assets such as utilities.

Stephen Chesko, principal security engineer at Landis & Gyr and a specialist in utility security, claims that, in comparison with other industries, utilities have a "mature approach to risk". Although he claims the greatest risk to utilities remains frustrated consumers with baseball bats, he refuses to rule out states looking remotely to monitor and control power systems, or creating a mass disconnect.

"There has been a marked change from a year ago, with public pressure to take into account the risk," he says. "Utilities understand the risk model. Systemic risk is easier to explain, as is the need to mitigate it. Even small utilities understand the risk models. In the US, the pressures are largely political."

Roeland van der Zee, a senior consultant at AON Risk Consultants, points to activist groups disrupting construction. "Protest groups are likely to disrupt construction of road projects, tunnels, bridges and airports, citing environmental concerns," he says. "The main risk is delay - and it's a risk primarily to governments."

Still nothing to match it

Are there more risks associated with investing in infrastructure? Yes. Will these deter pension funds from investing in infrastructure? Probably not.

Given recent high-profile cases of fund underperformance, the continued appetite wouldn't necessarily be guaranteed. Most notable has been the announcement that 30 pension funds are suing for losses incurred by the Henderson PFI Secondary Fund II, promoted as a low-risk investment, which lost 60% of its value. The charge rests on the £1bn acquisition of PFI construction firm John Laing, which exposed the investors to the firm's pension fund liabilities. Among the litigants are the £15bn Railways Pension Scheme, and the British Steel and Fenner pension plans.

Yet Martin Lennon, head of the project and infrastructure finance team at M&G, points out that appetite for the asset class "hasn't changed materially" over time. Although investors might understand it a little better, they're still looking for the inflation hedge and lower volatility than they see in other asset classes.

The question is not whether but how pension funds will invest in infrastructure.
Asked whether Hendersongate had affected pension schemes' willingness to invest in infrastructure funds, Lennon says he hasn't picked up a change in the mentality: "Fund vehicles are still pretty much the only option smaller pension funds to get exposure to infrastructure.

"When you contrast European pension funds with their larger Canadian counterparts, the Canadian ones are big and they have uniquely large allocations to infrastructure. Their size means they have the kind of in-house expertise you need to invest in this asset class. That's not viable for smaller pension funds.

"For them, a fund structure is a good way to invest. Even with what's going on [with the Henderson fund], that won't change because it provides a useful route to market."

Investors themselves have changed, though. Not just in infrastructure, they're scrutinising fund terms more closely - and, according to Lennon, "they have a stronger idea of what they like and what they don't like".

What they increasingly like, it seems, is listed infrastructure. Capital Innovations, whose clients include CalPERS, Pennsylvania State Employees Retirement System, and the Bricklayers and Allied Craft Workers' pension scheme as a separate account holder, last year launched a second infrastructure vehicle aimed at pension schemes.

After recoiling from what they saw as over-leveraged funds ("Leverage is like a hammer: it can build a house or break your thumb," says Underhill), pension funds see listed as complementing a private infrastructure portfolio because it has similar return characteristics.

It isn't risk that's the problem, Underhill says. The problem is failing to price it adequately. Capital Innovations is looking at toll roads in China and France, for example, where it will take on traffic risk and exposure to the economic cycle. It's also looking at storage for bulk liquids at port terminals with only medium-term contracts.

"Risk is not per se bad as long as investors are adequately compensated for it," he says. "In the end, investors need to ask themselves how much they want to insulate themselves from risk when it means at the same time insulating themselves from returns.

"Unfortunately, it's still a necessity to make some risk calculations for those kinds of returns."