UK pensions: Major investors in the making
The consolidation of 89 local authority funds into eight pools has yet to transform the way Local Government Pension Schemes invest in real assets, says Brendan Maton
There are plenty of infrastructure opportunities to be had in the UK. The latest government analysis suggests that £600bn (€678bn) in investment is required over the next 10 years, with almost 700 projects in the pipeline. However, less than £10bn of infrastructure spending in the current election cycle – all in the transportation sector – has been earmarked for funding directly by Britain’s local authorities.
But within one department of every cash-strapped local authority, there is plenty of patient capital being put to work. This is from the pensions office, which oversees obligations to fund past and present employees’ retirement. Five years ago, the Chancellor, George Osborne, noticed that these savings were worth almost £200bn. Inspired by the infrastructure commitments of similar-sized Canadian and Australian pension funds and Middle Eastern sovereign wealth funds, Osborne set in train new regulation to channel more local authority workers’ savings into building and maintaining roads, hospitals, digital networks and solar farms.
The 2015-16 subsequent government report crowed about how a small number of British wealth funds were being created and how “the government will work with authorities to establish a new local government pension scheme platform to boost infrastructure investment”.
Osborne’s theory made sense. Why not put more local money to use locally? The UK’s controversial private finance initiatives were drawing ever more criticism as an accounting ruse that made central government appear less indebted than was the case. Osborne – and any subsequent Chancellor – could do with another source of cheap, long-term financing.
The problem with how that theory was implemented is evident in the very phrase British wealth funds. It mislabelled pension savings, of a defined-benefit nature – and therefore measurable obligations – as the kind of sovereign wealth money that might set a return target but has no real obligations. The administering authorities of the Local Government Pension Scheme (LGPS) are responsible if pension benefits do not get paid. They can demand more income from the thousands of other organisations that also have workers in the scheme. In the last resort, central government can step in, or Parliament could introduce emergency legislation. But the £200bn administered from Cornwall to Cumbria is definitely not national wealth – it is exclusively for the benefit of five million current and former local authority workers.
This does not mean that infrastructure does not appeal to the 89 separate funds of the LGPS in England and Wales. Nor does it mean their assets could not be more efficiently directed via pooling. For ‘lumpy’ long-term projects, such as the Thames Tideway tunnel or HS2, it makes good sense for capital investment to be pooled.
But two years after it was envisaged, a new local government pension scheme platform to boost infrastructure investment is nowhere near being established. What we have thus far are eight pools (the phrase British wealth funds has been dropped) that will select and monitor third-party investment managers on behalf of the 89 administering authorities, with each retaining responsibility for their fund’s asset allocation and investment strategy.
The most advanced of these pools, which are due to be fully operational in April, have already created sub-funds in equities. But infrastructure is much further behind. The one operation that stands out is GLIL, a £1.3bn limited liability partnership whose stakeholders are London Pension Fund Authority and the pension funds of Greater Manchester, West Yorkshire, Lancashire and Merseyside (see Q&A with Chris Rule). These authorities have made no secret of their desire to see GLIL become the national infrastructure platform. A second GLIL vehicle is obtaining FCA authorisation to attract capital from a wider set of local authority funds.
But how successful GLIL will be is hard to gauge because of the curious interplay between public policy and regulations on the one hand and free-market dynamics on the other. The eight new pools have been created in haste – by order from Whitehall – but with no guidelines on how to operate better and no sensitivity to their existing modus operandi.
They are expected to have economies of scale of at least £25bn. Two pools mustered far less but were still approved. Among the authorities in these pools happen to be stakeholders in GLIL. Does this mean small is beautiful, or that the pools should all collaborate to move more capital into infrastructure faster? It is hard to be scientific with a tiny set of data, but we can say attitude matters more than size.
Take, for instance, the London CIV (Collective Investment Vehicle), in some ways the most advanced and in some ways the most complex of the pools. London has 32 councils involved. From these, the CIV convenes one group of local politicians, typically the chairs of each authority’s pension fund committee; and one group of finance officers from each authority, who are legally responsible for administering the pension fund.
The former are not typically investment savvy; it is not part of their day job and their involvement in pensions is at risk from any major change in local political power. Changes in personnel on the pension fund committee are frequent.
“The chairs think they have the power in the pension fund, but the finance officers know they do,” one observer explained.
The London CIV had a presentation on infrastructure more than a year ago from a commercial manager. One insider told IPE Real Assets it was evident from the presentation that the CIV was nowhere near ready to handle infrastructure, where complex decisions have to be made in a matter of weeks. “Local authority pension committees would need three meetings, which means nine months, to evaluate and approve a major investment,” he observed.
This does not mean the London CIV will not get round to infrastructure pooling. But it will not be any time soon, while the CIV already offers multi-asset and equity sub-funds.
Of course, the pools are agents of the authorities. So speeding up decision making is an issue for the 32 councils, not primarily the CIV itself. But in a structure with two separate groups, each with 32 members, it is not surprising that progress can be held up. It must then be recognised that some of the 66 individuals involved, and their colleagues back at base, do not want to be part of the CIV at all.
This complexity has been recognised as a problem in a recent internally commissioned report by Willis Towers Watson.
The report alleged that some briefings on the London CIV’s development had been based on political affiliations, despite the cross-party, non-political nature of the vehicle. Each LGPS fund is overseen by a board of local councillors.
Last year, the London CIV was forced to issue a statement denying it had advised against investing in UK infrastructure in case of a change of government in the country.
Some of the pension schemes involved in the London CIV had expressed “significant distrust” in other stakeholders and were looking at joining other pools, according to the Willis Towers Watson report.
Despite the London CIV launching 12 funds and attracting more than £6bn since it received regulatory approval in 2016, the vehicle has suffered major setbacks recently, with the departures of CEO Hugh Grover and CIO Julian Pendock.
Tim Mitchell, Adam Gillett and Oliver Faizallah, investment consultants at Willis Towers Watson and co-authors of the report, said the London CIV was “under-resourced and underfunded”, with “gaps across all aspects of operation”.
One cause of reluctance is a desire to keep power for pension fund decisions within the borough. The mooted cost-savings of pooling – estimated at £200m-300m per annum across the LGPS – are less important to these people than the sense of control and patronage.
A distinction must be made between local power and local expenditure.
There is very little bias, especially in real assets, by local authority pension funds to their own region. Greater Manchester is proud of its real assets – mostly property – in the North-West of England. Lancashire has recently made local commitments to student housing in Lancaster and a logistics hub nearby. Other council pension funds exhibit a bias towards the UK more generally – for example, the London Borough of Ealing. But by international standards, these local authorities are truly global investors. So local power over pensions is not to direct money locally, which is another awkward moment for Whitehall politicians. George Osborne was naïve – or must have thought local authorities would be naïve – in allocating to real assets patriotically.
Another important consideration in terms of local power and local investment is that some authorities do not want some projects to go ahead in their area – there can be opposition by local residents to whom councillors and executives feel more beholden than pension scheme members.
The London CIV insider added that UK opportunities were generally not the most attractive in terms of risk and return – which is what matters to pension funds.
Kevin Frisby, a partner at UK pension fund consultancy LCP, agreed that his clients tended to look at infrastructure opportunities globally. “We are very keen on the asset class, especially open-ended unlisted partnerships. Where else are you going to get a 5% real yield and prospects for capital appreciation in current markets? The other route would be a platform that gives diversification across developed-market infrastructure listed equities, but this is more volatile and does not provide the same cash yield.”
Even GLIL is not promising that it will restrict itself to British opportunities in its second fund. The irony is that some of that £600bn expected for UK infrastructure over the next 10 years will come from local authority pension fund capital – in that sense Osborne will have got his wish. But that money is likely to travel via a couple more links in the chain than the ‘local government infrastructure platform’ envisaged.
“There is a perception that fees in private markets are titanic”
This has been the case with Thames Tideway, which is backed by British pension funds but via investment specialists, Amber Infrastructure and Dalmore Capital.
“As a greenfield investment, Thames Tideway was attractive because of the risk-sharing mechanism and the yield it offered from day one,” says Richard Fanshawe, head of private markets at Brunel Pension Partnership, a pool for 40 funds, including several local authorities in south-west England.
It is also underwritten by the government, which is another irony for a country that has been trying to bring in long-term capital to replace public finance.
Another established, indirect route is via investors that own Britain’s utilities, including some well-known infrastructure specialists. Among gas distributors, Macquarie and Hermes have a majority stake in Cadent. First State is joint-owner of Electricity North West and Anglian Water Group. South Staffs Water, which includes Cambridge Water, is 75% owned by KKR’s global infrastructure fund.
There was a putative bid for Cambridge Water by a consortium of British pension funds co-ordinated by investment consultancy, Redington, several years ago. In line with the comments from within the London CIV, one of the challenges was getting the pension funds up to speed with the demands of pitching to control a real business. That bid did not succeed.
But if UK pensions funds go via global infrastructure funds, they will get exposure not just to water utilities in the UK but also a diversified group of real assets overseas.
Plus ça change
Local authority pension funds are planning to raise their commitments to real assets, but this will happen mostly via existing relationships with renowned commercial investors.
Hampshire County Council, for example, is planning to double its capital in infrastructure via existing provider Grosvenor Capital Management. Nottinghamshire is increasing its infrastructure commitments from 0.9% to 2.6% of total assets, according to its latest annual report, with JP Morgan Asset Management the most recently appointed manager.
Even funds such as the ‘challenger’ vehicle GLIL have used and will continue to use other commercial investors to access infrastructure opportunities.
Two issues present themselves. When the pools do get round to real assets, what happens to existing investments? It seems sensible to leave well alone, which means commitments made in 2018 might not be realised until 2026 from closed-end arrangements. There will be fresh money available each year in between from pension contributions, But it suggests a slow build for the pooling of real assets.
“Some funds are actually turning cash-flow negative,” says Mark Mansley, CIO at Brunel Pension Partnership. “But they have done well from rising equity markets, so the majority of funding for real assets comes from selling other securities.” He sees the major issue as getting commitments deployed – unlike Frisby, who reckons deployment at a push can be made within three months.
“There was an initial hesitation when pooling was announced,” says Sergio Jovele, partner and head of the London office of Partners Group. “But since then it has been mostly business as usual. Funds have their strategic allocations to reach and they have been investing.”
The second issue regards fees. A primary reason of pooling – of securities as well as real assets – was to save money by economies of scale. “There is a perception that fees in private markets are titanic,” says Mansley.
The push to reduce those fees has had a close relationship with the Financial Conduct Authority’s (FCA) drive to make costs in all types of asset management in the UK more transparent. Thus, the FCA’s Institutional Disclosure Working Group draws heavily on work done for the Scheme Advisory Board of the LGPS. A template for cost disclosure for real assets mandates is expected by August.
Jovele makes the usual point that people have to compare like for like: a diversified value-add global portfolio is not the same as UK core, even if they are both infrastructure. He also suggests that the UK government’s initial concerns about costs related to fund-of-funds fees. Certainly the function of the pools as captive manager selectors diminishes the need for third-party funds of funds.
This is certainly a function Mansley expects Brunel to fulfil.
Jovele says Partners Group has discussed with LGPS funds how joint ventures, as distinct from limited partnerships, work with very large, sophisticated asset owners. Partnerships might be the future, but this is not yet clear.
Peter Hobbs, managing director for private markets at bfinance, says that over time the pools will aim to join the ranks of the larger, more-direct global investors. “It will take a long time for them to become like an APG, but that is the direction they are going – they see themselves as asset managers for the underlying funds,” he says.
“I think what they will do is go from the fund-of-funds model to much more direct control where they can do separate accounts and have relationships with some of the big managers and operators. But this probably won’t happen in a meaningful way until three to five years.
He adds: “This is a significant move. Rather than having 10 investors in one pool, you are going to have one asset manager and the 10 sub-investors. That relationship between these eight asset managers and the asset management industry is going to be very interesting.”
Mansley and Fanshawe recognise that the likes of Brunel will be making commitments of possibly hundreds of millions of pounds, but they will not be in the top tier of asset owners globally.
Things might have turned out differently if the UK government had pressed ahead with the stronger initial option of bringing the asset management of local authority pensions under one rather than eight roofs.
Instead, little has changed in terms of their governance. The LGPS pools were born out of a desire for systemic change, but without the necessary status.
For a similar story, look at the Pension Infrastructure Platform (PIP), established six years ago for UK pension funds to invest in infrastructure (a rational outsider might well be confused as to why the LGPS could not use the PIP as a national infrastructure platform).
After growing pains, the PIP is now up and running. But as just another investment option for pension funds. The PIP was never gifted the status to systemically alter infrastructure investing in the UK, and as a result it will not. Much the same can be said of the LGPS pools.
This is accepted by those who have joined them – most of whom have transferred from LGPS funds rather than the private sector.
Mansley says the government’s ambitious expectations at the beginning have given way to a mood of pragmatic progress. Fanshawe says Brunel can access the PIP or GLIL, but is also looking to work in collaboration with the other pools, like-minded institutional investors and managers.
There is no pretence of a national platform but there is hope of some economies of scale.
Q&A: LPP takes direct infra route
Chris Rule is CIO at the Local Pensions Partnership
Where is LPP in the process of pooling infrastructure and property real assets?
LPP successfully completed the pooling of the infrastructure assets of its two shareholder pension schemes: Lancashire County Pension Fund and the London Pensions Fund Authority in 2017. LPP’s global infrastructure fund, GLIL Infrastructure, launched on 30 June 2017, offers investors a cost-effective, diversified exposure to global infrastructure assets through a portfolio of direct holdings, infrastructure funds and co-investments. The total committed capital of the Global Infrastructure Fund is £1.5bn.
LPP is in the detailed planning stage for pooling property assets. LPP has developed an investment strategy for property investment which seeks to generate sustainable and growing rental income from a broad range of property sectors, including land and residential property.
Both asset classes are likely to pose different challenges. What are chief among them and how do they differ?
Both infrastructure and property are by their nature illiquid assets, so illiquidity presents a very significant challenge when selecting an appropriate investment vehicle for pooling. The Authorised Contractual Scheme is considered as the preferred choice of investment pooling vehicle (IPV) for liquid assets such as publicly traded equities, as these assets can be sold relatively quickly and can meet investors’ liquidity needs. However, this is not the case for infrastructure and property. The time it would take to sell or liquidate these assets is lengthy, generally months, if not years.
For property there is the additional challenge of the Stamp Duty Land Tax .
In the UK, any transfer of direct property normally attracts Stamp Duty Land Tax (SDLT). Limited seeding relief has been granted to allow property to be transferred into an Authorised Contractual Scheme (ACS) for pooling, but as explained, we do not consider an ACS is an appropriate vehicle for holding illiquid property assets. In our view, an Exempt Unauthorised Unit Trust (EUUT) would be considered as an appropriate vehicle for holding direct property assets and can be designed to offer proportionate and appropriate liquidity provisions, but EUUT does not qualify for seeding relief.
A viable pooling solution would be to use an EUUT for all future direct property purchases, leaving existing direct property assets on the balance sheet of the investor. The sale proceeds of any direct property on the balance sheet would then be reinvested through the EUUT. This way of pooling property assets is time-consuming, as many property assets could remain unsold on the balance sheet for years before being sold and the proceeds reinvested into the EUUT. Furthermore, splitting and managing property assets across a pooled fund structure and investor’s balance sheet would present significant administrative challenges and costs. We believe an optimal pooling solution with full benefit to investors would be to grant EUUT seeding relief.
Does LPP expect to change the way it invests in these asset classes over the long term – for instance, more direct investing or international strategies?
LPP is taking a more direct approach in infrastructure. The Global Infrastructure Fund has a global mandate and we look to invest directly in the UK and Europe. GLIL was set up with the intention of accessing direct infrastructure, leveraging the capital and resources of the underlying partner funds. The pooling of resource and capital allows the underlying partner funds to access opportunities that would have been difficult to do by themselves.
GLIL has invested about 50% of its committed capital across the renewables, transport and regulated sectors. The investments include a minority shareholding in Clyde windfarm, two rolling-stock transactions (East Anglia and Southwest Franchises), and Anglian Water.
In property, scale is less important, but having greater investment expertise in-house will enable LPP to look at more specialised property investment opportunities, such as the various routes into the residential property sector.