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The road to returns

Written by Ijeoma Ndukwe
September 2011

Given the long-term nature of this asset class, pension funds seem like the most natural investors for infrastructure. Ijeoma Ndukwe examines the pros and cons of infrastructure in a pension fund portfolio

A new dawn is breaking in Europe, transforming the horizon for the region's investment in infrastructure. Infrastructure is a relatively new investment for European pension funds when compared to Canada and Australia - the latter nation having pioneered the privatisation of this asset class. However, there has been an evolution in the market shaped by an altered global financial world, which has created a landscape rich with opportunity. The European market for developed infrastructure is the largest with a current value over €4.6 trillion and estimated to grow by 10% each year to meet construction, upgrade and maintenance requirements. In the UK alone, the 2010 National Infrastructure Plan has indicated that some £200 billion of funding is required over the next five years. This need, compounded by macroeconomic uncertainty across Europe, has created a vacuum that needs to be filled.

Mark Crosbie, Managing Partner at Antin Infrastructure Partners says that there is currently a fertile set of opportunities in which to invest. "The source of such opportunities has increased throughout Europe as governments can no longer afford to build new high quality infrastructure or, alternatively, need to divest certain existing state owned infrastructure assets in order to strengthen national balance sheets following the economic crisis.

In addition, large infrastructure corporations such as utilities and transportation companies have been steadily divesting of high quality infrastructure assets as they seek to restore their own balance sheets, having typically entered the financial crisis with too much debt which is unsustainable today."

With a shortage of affordable private finance, traditionally provided by the banks, now is an opportune time for pension funds to look at infrastructure critically according to experts. Boe Pahari, head of European infrastructure at AMP Capital Investors, says that in the current climate there is a change in the supply and demand dynamics: "Private capital will be needed and will be attracted into various markets. For example the UK needs to take renewable energy production from where it is at three to five per cent to 15 per cent over the next five years. This requires massive amounts of capital so the UK is already looking at ways to attract private capital into this space. There are various EU directives around private equity and a lot of projects require refinancing. As refinancing approaches there will likely be a more conservative pre-crisis scenario so there will be a need for more capital."

Furthermore, there are certain opportunities that will not remain indefinitely, according to Antony Barker, managing director of JLT Pension Capital Strategies. "If you're looking into entering through social responsibility such as social housing or power such as solar power, there are a number of subsidies for investors at the moment which are not going to last forever. There are lots of investors who are going to want to tick the social responsibility box while making sure they get a good return on their investment."

One compelling factor for the increase in interest by European pension funds is inflation. Research conducted by First State Investments Research and Russell Investments revealed that in a survey of 64 European pension schemes 92 per cent of respondents claimed that inflation is "a slight concern or a serious worry." Inflation projection has been revised up markedly as a result of a surge in energy and commodity prices this year according to the European Commission. Hence it is no surprise that infrastructure is increasingly an attractive investment when it offers inflation linked cash flows.

The suitability of investment in this asset class by European pension funds does not stop at "stable predictable cash flows linked to inflation" according to Barker. "Infrastructure investments offer low correlation with other assets, long operational duration, low demand elasticity - we always need them - but supposedly high barriers to entry through either size or availability of expertise. Hence the asset characteristics are ideally suited to pension fund and long-term insurance liabilities." He continues: "Although pension funds typically invest through commingled funds on an equity-like basis, in practice exposure through debt is more tax efficient for cash extraction."

Gravis Capital Partners was the first to list on the London Stock Exchange's main market when it launched the GCP Infrastructure Investments fund last year. It focuses on investment in the subordinated debt of established UK Public Finance Initiative or PFI, which according to Rollo Wright, a partner at GCP, offers returns that are very predictable. "Because we're investing in debt you can be sure of what returns you're going to get. The returns are uncorrelated to other markets like equities." Wright continues: "We target an annual dividend yield of seven and eight per cent and that's not an IRR number. That's a return we aim to deliver every year."

There are funds such as Redington and Evolution Securities that say they have "gone back to basics" in their approach to investment in infrastructure. Whereas in the past infrastructure investments were structured in a similar way to private equity with low equity and high debt due to high leveraging, this model has been modified to give the investor more control over operations of business and a less volatile return. Henrietta Podd, director of fixed income at Evolution Securities, says: "A number of infrastructure funds have grown up around using more and more sophisticated ways of gearing those cash flows to deliver the required equity return. However if a pension fund really wants to invest in very stable long-term index-linked cash flows, why doesn't it just buy the entire cash flow rather than buy the geared equity?"

Larger pension funds are beginning to recognise that investing in 100 per cent of the full capital structure is an attractive proposition. A recent example was the acquisition of the 30-year concession to run the UK High Speed One project by two of Canada's largest pension funds. Robert Gardner, co-founder and co-CEO of Redington supports this strategy.

"If a pension fund invests in an asset or a fund of assets that has an un-leveraged financing model, i.e. 100% funded with equity, then the pension fund receives all the infrastructure cash flows net of any operating and maintenance costs. This can result in a risk return profile that looks much more fixed-income like in nature and offers a real return of between 3.5 per cent and five per cent depending on the risks of the specific project."

When it comes to returns there is a broad spectrum one can expect to receive, but Laurence Monnier, a fund manager at Aviva Investors, advises investors to look at the bigger picture: "You can look at single digit returns of seven to eight per cent or double digit of 15 per cent or more, but the important point is not the return but the risk you're taking for the return you want to get. If you focus on core infrastructure – one we think is most suitable for pensions - it can deliver low risk, long-term essential assets, stable cash flow and stable yield which are attractive for pension investors."

Illiquidity is an unavoidable aspect of this asset class. However, there are a number of ways of mitigating the associated risks. Jeffrey Altmann, director of European Infrastructure Investment Management at First State Investments, says investors should be looking at how funds buy these assets as he feels it is important to take a proactive role in the shareholding perspective. "Funds such as ourselves acquire 25 per cent so we have veto and influence on the board to affect outcome." Crosbie talks of the growing market in the sale of secondary positions in existing closed funds should investors need to exit earlier for any reason. Also, some funds like AMP are open ended, which means investors can enter and gain yield straight away and redeem at any time.

Undoubtedly, the suitability of infrastructure as an investment for European pensions is due to its long-term nature. Few funds are listed and they are most typically closed-end funds with a 10 year life. Crosbie says "Investors should be prepared to make such a longer-term commitment with their capital although they will, of course, receive a regular dividend yield throughout the fund's life and will start to receive returns of capital as the manager commences the exit of their investments, typically throughout years seven, eight and nine."

Illiquidity is not the only issue. Ongoing management is necessary to ensure that costs are being driven out and attractive IRR is delivered according to expectations says Barker. The monopolistic nature of core infrastructure can also be an issue according to some experts. They say that although it is protected from market shocks it is very much driven by the government's framework and can therefore be susceptible to a high amount of regulatory risk.

In addition, many experts advise pension funds to do their due diligence before they make an investment. "Regulation is changing across Europe so it's moving towards incentive based investment. ” Altmann expands.

Crosbie also emphasises the importance of asset liability management. "Risk mitigation has to start with their choice of manager with a credible focused strategy, experienced professionals and an established track record being 'gating issues' in such selection. Such managers will anticipate and manage risks on an ongoing basis as they steer the portfolio to its targeted returns." He suggests that key tools are portfolio construction and diversification alongside active management of portfolio companies. Crosbie elaborates: "It is for these reasons that pension funds - other than the very largest who have developed an infrastructure track record of their own and who can afford a large and dedicated team of experienced professionals - are probably better to allocate their infrastructure capital to experienced and dedicated funds rather than 'going direct' in the search for fee arbitrage. They may underestimate the extremely time-consuming nature of infrastructure investment and ongoing portfolio management and may not be able to source the proprietary deals which are often the source of superior returns rather than those acquired in an auction."

Despite the challenges, infrastructure appears to provide an obvious fit for potential investment according to the industry's experts. Pahari thinks that vital lessons of the financial crisis have been learned and infrastructure going forward will be far more stable. "The community has learned a lesson that, notwithstanding the quality of the asset, you need to have a moderate level of debt as it's susceptible to market changes. You choose the right government, the right countries, monopolistic aspects which underpin some countries activities and provide long-term inflation protected cash flow for the investor. That's why it makes sense."

Written by Ijeoma Ndukwe, a freelance journalist



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