Shayla Walmsley explains why VER sees manager selection as one of the key elements when deciding to invest in infrastructure

Integrating infrastructure in an overall portfolio is a tricky business - not least because of problems with definition. Sceptics claim that many assets subsumed in the asset class in an attempt to access increased leverage or appeal to investor demand are effectively quasi-infrastructure assets - the difference, say, between motorways and the petrol stations dotted along them.

But it is also tricky because of difficulties with asset categorisation. Inclusion with real estate obscures infrastructure's arguably lower-return characteristics. Inclusion with private equity belies infrastructure as a long-term investment - despite a mini-industry of 10-year funds dedicated to it.

VER is in line with a trend (see George Inderst's contribution at the beginning of this section) within a private equity allocation via private equity-style funds invested in unlisted infrastructure companies. As yet, it makes up a relatively small allocation within a private equity portfolio that constitutes 20% of its ‘other assets' allocation; buy-out and mezzanine funds make up the difference. Other assets also includes 32% real estate and 48% absolute return.

Overall, alternatives made up €568m in June 2007 - around 5% - with a target allocation of 10%.

Although at VER infrastructure sits within private equity rather than real estate, investments even within the asset class are not homogenous. The portfolio includes assets in multiple stages of development via four different private funds - one primary infrastructure fund, which invests in new developments; two secondary funds, which acquire existing structures; and one ‘broad-based' fund, which invests in assets in various phases of development.

So what forms do the investments take? "We're only interested in indirect investment in infrastructure," says managing director Timo Löyttyniemi. "I won't say that it won't change in future but indirect investment is part of our investment culture. It's less time-consuming and more efficient."

What it is not, necessarily, he says, is less risky. Like other asset classes, including real estate, infrastructure spans the risk spectrum - hence VER's investment in both new developments and existing infrastructure.

However, VER has opted to minimise geographical risk, investing exclusively in European infrastructure. For Finland, the European angle makes sense not only for risk mitigation but because it represents a comfort zone for the only Nordic economy in the euro-zone.

"We like the euro-zone area," says Löyttyniemi. "We also feel that the legislative and cultural aspects carry less risk."

Investing in European infrastructure funds minimises those risks associated with political instability in potentially higher-risk regions such as Asia. Yet infrastructure and politics are inseparable, even within mature European markets. The UK, for instance - which in some senses is comparatively sanguine about foreign ownership - has seen parliamentary questioning of overseas acquisitions of infrastructure assets, notably ports.The difference between politics and investment-deterring politics, Löyttyniemi suggests, lies in a stable, predictable regulatory and legal environment - and smart acquisition.

"Investment agreements are so thorough that regime shifts won't affect the investment," he says.

With risks of geographic diversification hedged, the primary risks associated with infrastructure lie in the amount of leverage involved in these transactions. A recent report by Standard & Poor's attacked "loosely structured and highly leveraged loans" during the infrastructure finance boom of the past 18 months, claiming banks had been left with up to $34bn (€24bn) of paralysed infrastructure loans.

Although it stopped short of breaching an apparent consensus on infrastructure's attractiveness as an asset class, the S&P report argued that allowing sponsors to acquire assets at "eye-watering acquisition multiples" had dragged down credit quality across the infrastructure sector. This contrasts with Dutch infrastructure investors, for example PGGM which is relaxed about the high gearing of investments, such as the acquisition of Thames Water, the UK utility.

The recent sub-prime debacle will doubtless provoke more realistic pricing of infrastructure assets, and with it more realistic return expectations.

Yet at least for the present, Löyttyniemi remains sanguine about the scale of gearing involved in infrastructure acquisitions, placing his trust in expert fund managers to assess how much debt is too much debt.

"The risks at the moment are the use of leverage and how funds are structured," he says. "But it's difficult to say what will happen. The current liquidity difficulties aren't affecting infrastructure investment now but it will depend on liquidity shortages. Funds need to be clever to structure in a way that doesn't create difficulties."

VER is not alone in seeing infrastructure as a growth market. Even if the current proliferation of new infrastructure funds continues, they will be insufficient to mop up the number of investment opportunities in the medium and long term.

"We're seeing more and more funds created. Competition is intensifying and return estimates are more challenging than they have been. But there are also more assets available. In the years ahead, infrastructure will be a bigger market," he says.

VER sees its initial investment as a beachhead for a more significant commitment down the line. "We're looking to expand in this segment," says Löyttyniemi. "Especially in the long term, it's an interesting and attractive market segment. We're assuming that various governments in Europe will be looking to finance infrastructure projects with new types of solutions over the next 10-20 years. It isn't an asset class where you expect results this year or next."

Certainly, observers other than Löyttyniemi see burgeoning opportunities coming from strapped European governments. A recent report by Ernst & Young claimed that in the next decade global - not just European - governments would look to provide about 15% of the overall finance for infrastructure projects.

Nor does Löyttyniemi rule out direct investment in infrastructure at some point - a trajectory already established by pension fund infrastructure pioneers in Australia and North America. In the meantime, VER is monitoring fund opportunities with a view to expanding its indirect investment via other infrastructure funds - "not aggressively, though", he says.

Faced with a proliferation of infrastructure funds (and doubtless some attrition as the expertise-deprived fail to gain sufficient assets), Löyttyniemi predicts an increased focus among pension funds on choosing the managers best able to judge gearing, pricing and risk. "The diversity and knowledge of
managers will become better in future," he says. Selecting the best managers is the key."

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