Local pension funds are investing in the UK’s new Pensions Infrastructure Platform. Pam Atherton looks at the challenges and the alternatives
Pension funds are increasingly looking at infrastructure investment in their search for long-term, inflation-linked yields and attractive returns, in a period of low interest rates and volatile stock markets.
A number of UK pension funds have already taken the plunge, and with mixed results. Some funds have experienced disappointing returns because of write-offs, disproportionately high management costs and mediocre risk-adjusted returns.
So can a form of infrastructure investment be found that meets the needs of pension funds? The UK’s Chancellor of the Exchequer, George Osborne, proposed the idea of harnessing the financial clout of pension funds to fund infrastructure projects in his 2011 autumn statement.
Since then, a joint venture between the National Association of Pension Funds (NAPF) and the Pension Protection Fund (PPF) has established the Pensions Infrastructure Platform (PIP). The objective is to help pension funds invest in core infrastructure projects, free of construction risk and on an availability basis, so as to avoid excessive GDP risk.
It will feature low leverage – no more than 50% per project and 50% across the PIP as a whole. Fees will be low at around 50bps, investments inflation-linked and the fund seeking long-term cash returns 2-5% above RPI inflation.
PIP is fully independent of the government and will be run as a non-profit-making organisation, although it will maintain a constructive relationship with the Treasury. PIP has so far garnered the support of 10 funds as founding partners, promising £100m (€116m) each in seed capital, subject to the PIP being satisfactorily completed.
The latest funds to support the PIP are London Pension Fund Authority (LPFA) and Lloyds TSB, joining British Airways, BAE Systems Pension Funds, BT Pension Scheme, the PPF, the Railways Pension Scheme (Railpen), the Strathclyde and the West Midlands Pension funds. A tenth investor is yet to be named. Although these are all major schemes, the PIP is open to pension funds of all sizes.
Work is now under way to complete the development of the PIP and it remains on track to launch in the first half of this year. Although it has secured £1bn of commitments to date, PIP’s target is £2bn.
A corporate administration structure is now in place and PwC has been engaged to provide support to PIP in the selection of a manager. Investment criteria, asset preferences and fee structures will also need to be agreed, and regulatory authorisation, if needed, will be sought.
Joanne Segars, NAPF chief executive, has described PIP as “unique”, saying “it has been designed by the pension industry with the pension industry’s needs firmly in mind, and will be aligned with funds’ long-term interests.”
Appetite for infrastructure is strong, according to a Preqin report published in July 2012, which shows that the world’s largest 100 institutional investors have committed over €200bn to infrastructure investments.
Over the last decade in the UK, many Local Government Pension Schemes (LGPS), including Greater Manchester, Strathclyde, Kent County Council, South Tyneside, Islington and Croydon, have invested in various forms of infrastructure and social housing.
The group of 24 investors which unsuccessfully sued Henderson over the management of an infrastructure fund, included some of the UK’s biggest names, such as BBC, Tesco, Smurfit Kappa, Bupa, B&CE, British Steel, NM Rothschild, Fenner and Southern Electric, demonstrating the strong interest in the asset class.
London Pensions Fund Authority chairman, Edmund Truell, who has confirmed that London’s public sector schemes will be consolidated into a single fund, has said it will invest heavily in local infrastructure and has urged the LPFA to reduce its allocation to gilts, in favour of infrastructure.
At the end of 2012, the UK’s £36bn Universities Superannuation Scheme (USS) announced that it had acquired the rail line connecting Australia’s Brisbane airport to the state capital. This followed a similar deal to invest in the Sydney airport rail link, alongside several other pension investors.
Alternatives to PIP
The bulk of small to medium-sized pension funds, however, remain wary of infrastructure because of the level of fees, due diligence and monitoring involved. The wide range of investment vehicles and charging structures available can also be daunting for even the most well resourced schemes to unpick.
Exposure can be gained via listed funds (ETFs, listed holding companies of private assets, mutual funds of listed securities) and private funds (open-ended, closed-ended or separate accounts). Whichever vehicle is chosen, the fee structure can make a significant difference to net returns. An infrastructure asset, such as an electric grid, could be owned by both open-ended and closed-ended funds, but generate substantially different returns, depending on how the fund and its fees are structured.
In addition, listed assets can sometimes trade at substantial discounts to their fair valuations, allowing for significant value creation through opportunistic arbitrage.
Investors also need to avoid overpaying for assets, since value creation in infrastructure is limited to cash yield and use of leverage, due to infrastructure assets frequently being regulated and subject to caps on tariffs or capital growth. This means there is little scope for fund managers to influence growth of profitability.
High entry prices have led to some spectacular losses of capital because fund managers have fallen into the trap of paying on the basis of previous deals and discounted cash flows, when these may have been inflated temporarily because of a flood of capital into the asset class, as happened in 2006.
Potential infrastructure investments need to be assessed case by case, with investors and their advisers liaising with and monitoring their fund manager, both during the due diligence process and, crucially, post-investment to avoid strategy drift, overpaying or making risky acquisitions.
In the case of the 24 (mainly) pension funds which litigated unsuccessfully against Henderson, one of their principal gripes was that it used the entire fund, plus leverage, to purchase John Laing, at a cost of £1bn. (Henderson denied all the claims and settled in January 2013 by paying the investors’ legal costs, without any admission of wrongdoing or liability).
Debt investments and relative value
Investors should also consider the relative merits of whether to invest via equity or debt, or a mix of both. Sometimes a higher return can be achieved opportunistically by acquiring junior debt in an infrastructure company, rather than its equity.
Infrastructure debt investments have a good record of providing predictable yield and very limited risk of capital loss. Historical data from S&P and Moody’s demonstrate how senior secured infrastructure debt has loss rates below the already low corporate loan loss rate levels of 1% (net of recovery of capital).
Pension Denmark, the €16bn Danish pension fund, purchased a portfolio of €270m infrastructure debt assets at 83% of their face value from Bank of Ireland.
The USS, which has a long-term commitment to infrastructure, announced in February that it is to provide £95m in 20-year, class-B debt, to Affinity Water, which is active in south east England.
Gavin Merchant, senior investment manager for infrastructure at USS Investment Management, said the manager’s investment philosophy was based around strong relationships with a “select number of core infrastructure companies. In doing so, we hope to be able to work with the management teams of these companies to offer a unique and flexible source of long-term financing. We see these relationships as long-term partnerships, where we can potentially provide capital for future financing requirements of the business.”
Investors can also access debt investment through secondary transactions, distressed investments and via junior debt. All these strategies are opportunistic, but offer substantial downside protection and stable returns in the 9-12% range. Crucially, the cost of accessing debt strategies can be as low as 30bps on invested capital, compared to the traditional 1-1.5% fees on capital committed for equity investments.
Some pension funds, including RBS, have chosen to avoid fund structures and focus on relative-value investing, with the support of specialist advisers.
The Canada Pension Plan Investment Board (CPPIB) and Queensland Investment Corporation have both established balanced portfolios of private direct infrastructure equity and debt, including special situations securities, approaching each investment individually, in order to identify if value is better accessed through debt or equity.
A relative-value approach tends to result in lower asset volatility, better risk capital allocation and, ultimately, higher returns, with far lower costs than committing to fixed geographic or sector-focused funds.
Through direct equity investments, investors are more in control of when and how capital is deployed and what type of capital structure is put in place. This is the principal reason, together with lower costs and better transparency, why investors have moved from fund investing to more active ‘hands on’ direct investing, adopting a relative value approach case by case.
Some specialist advisory firms and consultancies are also willing to form syndicates of pension funds and other investors to reach critical mass, so that smaller investors can access the asset class. By pooling resources across investors with similar needs, capital can be allocated to existing portfolios of assets, and across debt and equity, whenever relative-value is seen as appropriate.
Some investment consultants say that such dedicated solutions can be put in place at a fraction of the cost of a traditional fund, while leakage of value for customised solutions can be less than 10%, compared to 30-50% for traditional funds.
Others disagree, such as Duncan Hale of Towers Watsons who says the issue for smaller pension schemes “is more around access and governance”.
He explains: “Many smaller schemes find investing in unlisted asset classes difficult. Our experience has been that many smaller funds find investing in smart, beta listed infrastructure funds, where mechanistic screens are used to ensure that the assets selected reflect core infrastructure characteristics, appropriate for their circumstances.”
In an period of low investment returns, infrastructure could play an increasingly important role in pension funds’ portfolios, and how they access it will have a direct impact on risks and returns.
Those investors without the firepower to engage in direct investment may find value through public markets (bonds and equities), and, if willing to accept an illiquidity risk, may find that debt investments provide similar, if not better, returns than equity investments, in exactly the same assets. Investors who are willing to commit the resources to a relative-value approach may benefit from lower costs and greater flexibility.
In the March 2013 budget, George Osborne announced that the government is earmarking a further £3bn for infrastructure spending. Consultants have given this a cautious welcome, largely because the interests of the government and pension funds are not always aligned.
“There is a gap – perhaps bridgeable through education – between the type of projects the government is seeking investment for (new builds) and the types of investments pension funds are looking to make (refinancing),” says Deborah Zurkow, infrastructure debt CIO at Allianz Global Investors.
“By deepening investor understanding of this specialised sector, we can improve the chances of new projects getting off the ground, while investors tap into an asset class with attractive, risk-adjusted, returns in a low-yield environment.”