June, 2015 Print
Matthew Craig, LAPF Investments.
Matthew Craig looks at how local authorities are assessing the opportunities in infrastructure investing
Infrastructure is now arguably the asset class of the day, but like any highly fashionable item, prices can be high and it is not necessarily for everyone.
Leaving aside the gripes, there are clear reasons why infrastructure is the talk of the town among long-term investors, be they sovereign wealth funds, pension funds or insurance companies. A key reason is the very low yields on many fixed income assets. Demand has been very strong for secure government bonds among pension funds looking to match their liabilities for some time and lately the use of quantitative easing in the US, Japan, the UK and in the Eurozone has artificially depressed the income that investors earn on bonds. Thus, infrastructure is seen as providing a stable alternative to fixed income by many, as many infrastructure assets pay out a regular income.
Infrastructure can provide diversification to portfolios weighted towards equities and bonds. Some of the world’s largest investors were taught a salutary lesson about the equity risk premium in 2008-09 and want a wider spread of assets. Infrastructure assets can be unlisted or listed and in either debt or equity forms. Infrastructure itself encompasses a wide range of possible assets, from ports, roads, railways and airports, to hospitals, schools or utilities or telecoms, wind farms or power lines in the modern world. Infrastructure can be based in either the developed world, which either needs to build new infrastructure assets, such as high speed train links, or replace ageing bridges or water pipes, or it can be new developments in emerging markets such as China or India.
Eric Lambert, an independent investment adviser, commented: “Infrastructure is an excellent asset for LGPS pension funds: very long-term, with stable, predictable cash flows, with often explicit or implicit inflation-linkage at a yield vastly better than index-linked Gilts.”
However, Lambert added that there appears to be an enormous gulf between an acceptance of the case for infrastructure, and funds investing in it. “The right products at the right prices are hard to find; demand has created a supply scarcity and pushed prices and, in some cases, management fees too high.” As a result, he said that some local authority pension funds are looking more locally, based on easier access and lower costs. Some local authority funds are also co-investing, such as the recent link-up between the London Pensions Fund Authority and the Greater Manchester Pension Fund to invest in infrastructure projects, with a preference for those in either the London or Manchester areas.
Infrastructure based around water use is a sub-sector within infrastructure but one which could become important in the future. There is increasing demand for water as the world population increases, living standards rise and extreme weather events such as droughts become more common. As a result, investors are now looking at ways to invest in water-related assets. Kleinwort Benson Investors director, head of business development and client services, Geoff Blake, commented: “It is estimated that $11.7 trillion of infrastructure investment is needed for water, partly through large-scale projects, such as new dams and reservoirs, particularly in emerging countries like China and other countries in Asia and Latin America. There is also a need to replace and repair existing infrastructure; most of the US water network is at the end of its natural life.”
Infrastructure assets can provide a known income, based on regulatory agreements such as a set price for energy created by a wind farm, or an income that varies according to usage, as with a toll road. In either case, there may be inflation linkage, making it attractive for investors with inflation-linked liabilities, such as UK pension funds.
The need for countries to build or upgrade their national infrastructure in order to be competitive creates a strong economic case for it. At the same time, many governments do not want to incur all of the costs themselves, particularly if they want to reduce their level of debt, as is the case in a number of developed countries. This has created a virtuous circle in the eyes of many, where long-term investors can provide the finance needed in return for a stable asset that will pay them an inflation-linked income over many years.
Despite the obvious rationale for infrastructure, local authority pension fund allocations are generally still in single digits. Nick Vickers, head of financial services, at Kent County Council, said: “We have a 2.5% allocation to infrastructure fund of funds. We will not be adding to this.” At Strathclyde Pension Fund, head of pensions, Richard McIndoe, commented: “We have made commitments to infrastructure of around £200 million. Percentage of assets under management is still less than 1% as these commitments are fairly recent and largely undrawn.” And at the West Midlands Pension Fund (WMPF), assistant director, Mark Chaloner, commented: “WMPF has an allocation to infrastructure with target exposure of 6%. We currently have capacity to invest more, with less than 4% actually invested.”
On the attractions of infrastructure to local authority funds, McIndoe cited its long-term nature, the running yield to investors and inflation protection, adding: “We are currently most interested in UK and renewables.” Investors in renewable infrastructure, for example off-shore wind farms, solar technology or other types of clean energy, has the benefit of ticking the box of socially responsible investment, while government support can mean there is a guaranteed price for the output for relatively long periods. At the same time, there can be political risk; investors in Spanish solar energy plants got their fingers burnt, as it were, when austerity measures led the Spanish government to renege on its guaranteed pricing model.
At WMPF, Chaloner commented on the case for infrastructure: “The main attractions to us are index-linked cash flows and steady growth – ideal for a fund with long-term pension liabilities. We have a preference for equity over debt and for lower risk projects. Other funds may have different requirements and therefore investment preferences.” A preference for lower-risk infrastructure projects is likely to be a hallmark of pension fund investments, something Vickers concurs with: “We only see developed infrastructure as being a legitimate asset class for mature local authority pension funds.”
The growing interest in infrastructure has led to bidding wars pushing up prices to a point where prices are too rich for some. Vickers commented: “We think developed infrastructure is over-priced and that there is better value in mainstream UK property.” On the pricing issue, McIndoe said: “Pricing has become more of a challenge but this mostly means that more selectivity is required.” Chaloner agreed that pricing has risen, making selectivity more important, but added that pricing is now an issue in most asset classes, given the boost to asset prices from QE.
For many pension funds, finding the right vehicle is an issue with infrastructure. In the past, private equity funds were used, but pension funds generally want lower costs, no leverage and long-term investment. One solution has been the development of the Pension Infrastructure Platform (PIP) by a number of UK investors, under the aegis of the National Association of Pension Funds and the Pension Protection Fund. The PIP is now up and running and a number of local authority funds are among its founding supporters. McIndoe said: “We are a founder investor in the PIP and have committed to both their funds raised to date. We have also invested in a number of other funds. We have not made co-investments to date, but may do so.”
The PIP could help ease the flow of pension fund assets into infrastructure, but the duty of pension funds is to fulfil their investment mandate. As Kent’s Vickers put it: “Our concern is to generate returns that meet the funds long-term investment target for a given level of risk, our fiduciary responsibility is to our scheme members and employers, not broader national economic priorities.”
In many ways this is the crucial issue for pension funds. They need to ensure that any infrastructure assets meet their own investment needs. If this is the case, then infrastructure may find a new source of finance, and pension funds an invaluable addition to their investment wardrobe. Sometimes even fashionable items can be practical, long-lasting and, dare one say it, good value for money. If infrastructure can do this for investors, then it could be a case of “darling, absolutely fabulous” as they compare infrastructure investments.