Infrastructure’s allure shines post-pandemic

October, 2020 Print

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Emma Powell, LAPF Investments.

Emma Powell looks at the benefits of solid returns and diversification offered to pension schemes by investment in infrastructure


It is too early to tell whether Prime Minister Boris Johnson’s pledge to unleash a wave of measures that will enable the UK to “build, build, build” its way out of a coronavirus-induced economic slump will prove little more than empty rhetoric.

But even putting the government’s “New Deal” aside, there are a multitude of reasons investors have been drawn to infrastructure against a backdrop of historically low interest rates and equity market volatility. With global infrastructure projects needing around $3 trillion in financing each year, using scheme investment capital to finance the building of roads, hospitals and renewable energy assets could provide a single solution to two problems.

Infrastructure was the second best performing asset class for local government pension schemes last year after private equity, according to research by Pensions and Investment Research Consultants (PIRC), returning 11.7%. That compared with the 7% returned by equities and 4% by bonds during that period.

In recent years, the opportunity to gain superior returns has been one of infrastructure’s prime attractions for yield-hungry investors. That has gained added urgency following the pandemic after central banks globally cut rates and unleashed fresh waves of quantitative easing, which left the yield on government bonds languishing at historic lows.

Core infrastructure investments can typically generate returns of between 7-9% and cash yields of between 5-6%, says Hamish Mackenzie, head of infrastructure at Deutsche Bank-owned DWS, while higher risk investments return between 10-12% and cash yields of 6-7%.

Mackenzie says that he looks for an asset that can deliver long-term, largely yield-based, returns that have a relative degree of certainty through the cycle. “And that enjoy a strong market position through its size, through regulation, through barriers to entry that will then allow it to deliver that long-term return to investors with a relative degree of stability through the economic cycle,” says Mackenzie.

Low interest rates could also give infrastructure projects a boost from a financing perspective. Infrastructure assets are inherently capital intensive and lend themselves to the use of leverage, says Mackenzie, which makes cheap debt attractive. “But equally that brings with it risk because what goes down will always come up,” he says. Managers need to be careful about how they use that debt, he says.

Uncorrelated returns
The benefits of potentially more stable returns have been highlighted by recent equity market volatility, with the FTSE 350 and S&P 500 posting their strongest second quarters in more than 10 and 20 years, respectively, after March’s market crash. “That lack of correlation has always been one of the key defining features of infrastructure as an asset class,” says Mackenzie.

For those investing in publicly-listed infrastructure trusts, the income available has also proven more resilient in the face of coronavirus, relative to equities. Admittedly, there has been some disruption to asset owners’ ability to service infrastructure due to lockdown measures, says Newton Asset Management portfolio manager, Paul Flood. “But these haven’t been significant, which has led to sustainable dividends,” says Flood. That is in stark contrast to many listed companies, which have cut their shareholder payouts in order to preserve cash in the face of trading disruption caused by lockdown.

Infrastructure can also offer an element of inflation linkage. That is partly because some projects have clauses mandating that returns will also rise in line with RPI to compensate for rising costs.

But the regulatory frameworks many essential infrastructure projects operate in also play a part. For instance, the prices set by utilities typically rise in line with the retail price index, under controls set by regulators. What’s more, lots of assets have exposure to gross domestic product, so inflation linkage is inherent, says Mackenzie. “But equally if you look at the long-term performance of regulated utilities, that performance has been more determined by the periodic regulatory settlements rather than inflation,” he adds.

 

 

For investments made via pooled third-party funds, it is important to gain a good understanding of the performance of individual assets rather than the top-line returns. “It has to be relatively granular in terms of what you’re looking at because of the underlying nature of the assets that are generating the returns,” says Pete Smith, senior investment consultant at Barnett Waddingham. Investment committees should be able to get that information from fund managers, he adds.

Achieving scale
Yet despite around half of local government schemes having made some investment into infrastructure and the asset class making up just over a quarter of the total alternative exposure of the average fund, allocations remain small within local government schemes at just 3%. The UK’s pension funds have lagged those of the Netherlands, Canada and Australia, with those from the Netherlands investing in infrastructure since the early 1990s.

However, that longer track record has been facilitated by the scale offered by the superfund structure, something which the more fragmented UK pension system has not traditionally offered. Indeed, direct infrastructure investment has traditionally only been achievable for the largest schemes, with other schemes making an allocation via pooled, third-party funds.

Yet the establishment of LGPS pools has enabled more schemes to access the asset class. One of the government’s key aspirations in creating the eight investment pools was to make it easier and cheaper for individual local government schemes to access infrastructure, reducing investment management fees and minimising the risk of over-exposing schemes to any one asset, sector or asset manager by enhancing scale. With that scale, investment pools, such as Brunel Pension Partnership, have also stated their desire to increase the proportion of direct investment in infrastructure, including supporting projects in the UK.

Around 35% of Brunel’s first cycle infrastructure portfolio is invested in renewable assets, which receive a considerable chunk of funds allocated to infrastructure. The London Collective Investment Vehicle first closed its infrastructure fund last year, after receiving initial commitments of £399 million, making an initial infrastructure investment of €75 million into the Macquarie GIG Renewable Energy Fund 2. The Macquarie fund is completely focused on renewable energy, with the majority of investments being in wind and solar assets.

A recent report from the Social Market Foundation think tank has also argued that the government should encourage more UK pension funds to merge into fewer, larger funds able to invest large sums in big long-term projects, as “building new roads, power sources and communications networks could create much-needed jobs and make Britain’s economy more productive and resilient.”

It is easy to see how allocations to infrastructure can also fit with schemes’ goals of integrating environmental, social and governance approaches into investment strategies. There is also a rise in the understanding of the need to take a more ESG-enabled approach towards the supply/demand characteristics within the infrastructure market, says Smith. “In order to meet energy transition the capital expenditure required for that is huge,” he explains.

However, while ESG considerations have had a positive impact on making allocations to the asset class, it should not be overstated. The potential for infrastructure returns to match the liabilities of the scheme is a greater attraction, says Smith.

“I think just the cashflow durability that you typically get from an infrastructure investment and the relatively solid yields that come through are helping schemes, where their focus is turning more towards how they’re actually [going to] meet their future cashflows,” he says.

In terms of government support, details of the strategy for boosting infrastructure projects are due to be revealed in the autumn. But it should not necessarily be assumed that talk of stimulus will translate into a notable rise in new infrastructure projects. “There’s always been a gap between the rhetoric of the government trying to get capital in and the availability of shovel-ready projects,” says Mackenzie. Long-term stability and a conducive regulatory environment are more important to encouraging new projects rather than subsidies and support, he adds.

There can be practical problems in growing an allocation to infrastructure, such as finding enough assets with the right risk/return profile. What’s more, the increased cost associated with finding those assets also contributes to investment management fees being higher than other asset classes. However, interest rates are seemingly not moving upwards any time soon and there is every chance that global equity markets may oscillate further as the threat of a second Covid-19 wave, which could spark fresh lockdowns worldwide, looms. Infrastructure is one asset among the few that could provide schemes with solid returns and diversification benefits, as they seek to plug deficits and meet member payment obligations.

 

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