Walk before you can run

European pension funds are catching up with the more experienced Canadians in infrastructure investing - but their approach is more cautious, says Shayla Walmsley

There was a time when infrastructure made sense only in a Canadian context. Now, not only US giants but also smaller European pension funds have caught on to the trend, though they are not - at least on a wider scale - investing in the Canadian style.

Canadians have been at it longer, for one thing. In the past decade Canadian pension funds took their cue from Australian investors that began to look beyond bonds when the Victoria state government went bankrupt. Following initial investments in infrastructure funds set up by banks such as Macquarie and with restrictions lifted on investing overseas, Canadian pension funds had begun to build up their in-house infrastructure teams to do it themselves. In other words, they followed the same trajectory they had with real estate investment.

Borealis, the real estate and infrastructure subsidiary of Canada's CA$47.9bn (€31bn) OMERS pension fund, initially provided proof of concept for direct investment - effectively for want of an existing business model. The separate investment entity both protects the pension fund from material risks and helps it compete with the private sector for talent by offering performance-based incentives not available at the pension fund proper.

Yet Morag Torrance, who completed her doctoral thesis on institutional investing in infrastructure and now works for Capital Partners, an Australian investment management firm specialising in infrastructure investing, points out that it will be all but impossible to replicate the Canadian approach now. "It would be difficult for newcomers to build up in-house teams. The market is complex and to be able to invest in assets requires an experienced and relatively big team," she says.

That is partly the reason why European pension funds have barely begun to explore the do-it-yourself option. For example, Dutch funds ABP and PGGM have begun to beef up their infrastructure due diligence teams as a prelude to direct investment, but the moves have been tentative.

Even Dutch pension funds "are - for the moment, at least - mostly investing via funds," says Henk Huizing, an adviser to Dutch pension funds on infrastructure investments. "They're looking at the possibility of investing directly, though so far direct investment has involved only a small number of assets."

By far the most common way to invest is indirectly. Of the three options for pension funds investing in infrastructure - listed funds (easy but potentially laden with considerable fees), private funds (ditto) and direct investment - the latter has proved rarer.

The DKK116bn (€15.6bn) Pensionskassernes Administration (PKA), the Danish occupational pension funds administrator, is looking at a fourth option, co-investment with funds it has already invested in. One advantage would be to reduce management fees. "Given the lower risk and return characteristics, we don't see why we should be paying the same fees as for any other asset class," says PKA portfolio manager Kasper Knudsen.

Torrance points out that around US$35bn of the $100bn raised over the past 18 months has been invested. Many funds "will probably find it difficult to put the money to work because they don't have the experience", she says.
It is a concern echoed by Huizing. "Competition will increase," he says, pointing to the proliferation of funds coming to market and forecasting a drop from current 20% returns to 10-15%.

Another likely trend he identifies - and one that will have an impact on European pension funds' infrastructure investment opportunities - is an increase in more niche funds. They might include geographical niches (for instance, funds for Europe, India or China) or sector niches, such as energy and airport funds.

Geographical diversification will be a significant shift. Even bold Canadian pension funds have invested ‘globally' in markets with western-style legal and regulatory structures. "The CA$106bn Ontario Teachers Pension Plan (OTPP), which in May acquired shareholdings in two Chilean water companies, cited that market's stable political environment and mature regulatory framework. Yet even this peculiarly aggressive scheme, which had CA$6.8bn invested in infrastructure at the end of 2006, ploughed investment largely into mature markets" - the UK and Australia (airports) and the US (oil pipelines power plants).

The $245bn (€173bn) California Public Employees' Retirement System (CalPERS) in September announced that it would establish an inflation-linked asset class characterised by "low to moderate risk". The class will include a $2.5bn pilot infrastructure programme, with existing infrastructure assets diverted out of real estate.
The shift made sense in that the infrastructure assets were out of risk-and-return kilter with their old homes. More broadly, though, there is an issue with clarification not only of where infrastructure belongs but of what it is. The CalPERS decision points to a more general dilemma. Is infrastructure real estate?

"Real estate is different. Even apart from the regulatory environment and infrastructure's monopolistic characteristics, there are significant differences," says Chris Lawton, an analyst at Ernst & Young. "Most investment in infrastructure is investment in operating businesses, compared with passive real estate investment."
OMERs would likely argue that it is, in fact, private equity - at least in terms of its inflation-hedging characteristics. Similarly, the £30bn (€42.7bn) Universities Superannuation Scheme (USS), in the UK, has since 2006 had a combined infrastructure/private equity portfolio, with more than £1.5bn invested to date. The fund has a target allocation of 5% to alternatives by March 2008, with a medium-term target of 20%.

The ambiguity around definitions is as much about assets as asset class. Even aside from political risk, the low-risk label that has long attached itself to infrastructure can no longer be taken for granted, according to Mike Wilson, managing director of infrastructure finance at Standard & Poor's. In a recent report, he accused institutional investors of having "traded favourable debt terms against the management of credit risk during the infrastructure finance boom". These "record-breaking debt multiples" have "dragged down credit quality across the infrastructure sector" and failed to return as expected.

Does that mean newly-investing European pension funds will shy away from infrastructure? Probably not. But it might well encourage them to rethink some of the more esoteric assets subsumed in it.

"Some [assets] are masquerading as infrastructure but are really retail tacked onto infrastructure," says Wilson. He cites as examples port and ferry companies, car parks and motorway service stations.

Even ‘traditional' infrastructure assets come in for Wilson's criticism. Despite the asset's strong monopolistic position and stable cash flow, he says, the ABP acquisition is unlikely to mitigate risk from the scale of debt, nor from market risks such as regulatory hurdles that will limit the firm's ability to expand capacity.

Yet Wilson's prognosis for infrastructure is optimistic. "I think the market will settle down. Infrastructure as an asset class is still very strong - it's just the relativities had got out of hand," he says.

US public pension funds, like their European counterparts, vary in their infrastructure investment readiness. They range from CalPERS, which recently reclassified much of the proto-infrastructure previously in its real estate portfolio, to California State Teachers' Retirement Scheme (CalSTRS), which is "delving down" into infrastructure, according to spokeswoman Sherry Reser - albeit less aggressively.

"We're in education mode, looking for opportunities," she says. "It isn't that there are obstacles to investing in infrastructure, just that it's a new investment vehicle for us. It's prudent to look at all sides and fully understand the ramifications. We're exploring the area. We're in the delving-down phase."

In between the committed CalPERS and the exploratory CalSTRS are schemes such as the Alaska Permanent Fund, managed semi-autonomously, which in June agreed an in-principle indirect infrastructure investment in the US, though it decided against an immediate formal allocation. The eventual investment is expected initially to be around $750m, or 2% of the $37.1bn pension fund.

You can see the attraction for pension funds of all provenances, although few European pension funds are as bullish about infrastructure investment as OMERs, which expects its investment to generate CA$1bn annually by 2010.

In September 2006, president of OMERS (then president of real estate subsidiary Borealis) Michael Nobrega, claimed infrastructure would help pension plans pay pensions "for the next 30 years". Before 2003 OMERS' alternatives portfolio, largely comprising real estate and private equity, made up 15% of the pension fund. That year, in an equities bear market, it increased alternatives to 40%, 15% of them in infrastructure.

Few would know better than Canadian pension funds how political opposition can scupper - or at least complicate - infrastructure investment.
That public sector pension funds would pitch their infrastructure investment in terms of the public good is hardly surprising. In contrast to most Canadian pension funds, which have bypassed their domestic market for the politically less loaded overseas markets, OMERS has pitched its home-grown status as a competitive advantage.

"Canadian funds are quite sensitive about investing in Canada after some political issues," says Torrance. "Borealis is an exception, investing mainly in Canada and seeing that as their role as a public pension fund."

In Canada, a CA$33bn federal initiative announced in the February budget has sharpened the focus on infrastructure. "There's no doubt we need investment in infrastructure. But there is a wide variety of opinions and they go in both directions," says Mary Johnson, a spokeswoman for state agency Infrastructure Canada.

In the hostile direction, a report published in August and commissioned by the Federation of Canadian Municipalities claimed: "Public Private Partnerships do not offer municipalities a magic solution to the real problem of financing infrastructure, the primary and often only real challenge facing local governments."
The report continued: "To leave the responsibility of financing to the private partner is a poor solution to a non-existent problem. Nevertheless, the truth is that some people have an interest in making us think that there is a problem … because they have solutions to sell."

It is not just a Canadian thing. A UK parliamentary report in January this year expressed scepticism over the acquisition of UK ports by overseas investors, although it stopped short of recommending stronger state subsidies to keep foreign investors over the other side of the Channel. Its call for caution would have affected Borealis, which was part of a consortium led by Goldman Sachs that acquired Associated British Ports Holdings last year.

So what can European pension funds investing in infrastructure learn from Canada?
First, keep expectations low and long term. "Canadian funds see infrastructure as a diversifier and if they can get returns above the pension promise of say 4% or 5%, those are the long-term types of expected infrastructure returns," says Torrance.

Despite encouraging noises aimed at institutional investors from, for example, the government of India, European and North American pension funds have focused largely on mature, western (rather than global, developing) markets. An investment manager at UK retailer John Lewis Partnership's pension fund, which has invested £25m in infrastructure, says: "There's maturity in the marketplace. We're looking at the UK and Europe. We aren't ready to go global yet - and that applies across the fund.

You don't go from nothing to global overnight."
Paul Reddaway at the London Borough of Enfield pension fund, which has invested £15m in infrastructure agrees. "We were looking at absolute returns," he says. "It's a well-developed market and we have expertise in Europe. It was seen as closely attuned to our objectives."

Second, play politics - or at least plan for it. Political risk, such as a government pulling the plug on a project, could be as much of an issue as financing or operational risk.
Third, exercise caution. Recent revelations over the scale of leverage in infrastructure deals should encourage increased scrutiny from European pension funds about the financing of the funds they invest in. But caution is as called for in the selection of markets and funds.

Pension funds scout infrastructure fund managers they think will provide expertise, manage risk and assets, win deals and leverage global networks. But they also need to decide on the duration of their commitment, negotiate acceptable fees, and ensure alignment between manager and fund.

"Direct investment requires more analysis than investing in funds, though there isn't necessarily more risk with investing directly. If you invest in a fund, the manager does all the work but you're still exposed because it's your money," says Huizing.
There's no hurry - at least not for due diligence-focused US pension funds, nor for trustee-dominated UK ones. For all their (theoretical) appetite for infrastructure, and despite the fact that indirect is often perceived as the lower-risk option, pension funds do not seem to share the urgency of fund managers to invest in infrastructure.

"Why invest in infrastructure now? Because we got around to it," says the John Lewis Partnership source.