Written by European Pensions team
Chair: Duncan Hale, Head of Infrastructure Research, Towers Watson
Gary Allen, Senior Consultant, Aon Hewitt
Peter Hofbauer, Head of Infrastructure, Hermes GPE
Martin Lennon, co-founder and head of infracapital, M&G Investments
Niall Mills, Head of Infrastructure Asset Management, First State Investments
Jamie Perrett, Direcor, Index Research, FTSE Group
Paul Ryan, Managing Director and CEO, OECD Infrastructure Equity and Debt Strategies, J.P. Morgan Asset Management
Chair: There has probably never been more interest in terms of people wanting to talk about infrastructure and the role it might play in a portfolio. But in terms of people putting dollars in the ground we’re seeing quite a significant reduction to what we saw four or five years ago. There are a number of contradictions in the marketplace but we think this could potentially be a tipping point for the asset class; we think the way that institutional investors and asset managers work together has been changing and will continue to change over time, while the way that assets are priced could potentially also change over the next few years. What’s making infrastructure an attractive investment for pension funds? Have you seen that change over time in terms of the way people are using the asset class?
Allen: The main driver for our clients, mainly DB pension schemes, is diversifying away from equities. Infrastructure is seen as a diversifier in that context. It’s often looked at alongside other alternatives such as hedge funds, currency, commodities and the like.
Most pension schemes have put it into a diversified growth type allocation. If anything over time I think people are more willing to consider social infrastructure – PFI, PPP – sitting within a matching portfolio.
Hofbauer: The two things that our clients find most challenging to manage are inflation risk and life expectancy of their beneficiaries. Infrastructure is one of the areas on the liability matching side they have identified as where they can get better inflation linkage. There’s certainly some of our clients – the DB schemes, the mature schemes - where we can help match investments with their journey plan. Equally there are others that are newer schemes that are looking for slightly more alpha and more growth and see this as a lower-risk way of accessing that.
Chair: Has the product suite available been able to deliver those sometimes competing requirements?
Hofbauer: We encourage people to try and differentiate, and be clear what you’re after, because it’s not all things to all men. If you’re looking for a matching strategy then put in place a matching strategy and look for assets that achieve that.
Chair: Niall, Martin, do you want to comment on the discussions you’ve been having over the last 18 to 24 months compared to the discussions you were having before that? How much more sophisticated are investors getting in terms of trying to understand the risk profile and the underlying exposures they’re getting?
Lennon: The quality and the level of conversation you’re having today is almost unrecognisable from five years ago. One of the recent big trends is a real desire for investors to try and find alternative ways of sourcing recurring yield and a lot of people are going into the infrastructure space because certain infrastructure assets can provide that. If an investment also provides some inflation-linked characteristics then so much the better. Some investors have come to infrastructure from a fixed income point of view, whereas others have come from more of an private equity point of view and want to de-risk their portfolios and gain exposure to something more counter-cyclical in nature. The manager universe has started to reflect this. You’re seeing strategies that perhaps do differentiate themselves a bit more than they used to. Investors seem to know much better what they’re looking for and will be much more selective as a consequence. You used the phrase ‘tipping point’, I’m not sure it’s so much a tipping point but a very interesting development point, and maybe a bit of a fork in the road where we’ll see the industry develop a much broader product range than before.
Mills: ESG is right at the top of the list these days, and not just ‘do you have an ESG policy’, they actually want to know what’s going on in the assets. Different products and finding customised ways to work with clients is increasingly on the agenda. The diligence conversations have made managers sit up and really think of what’s in the portfolio. I think they’re very fruitful conversations.
Chair: Paul, your strategy is global, what type of conversations are you having with investors?
Ryan: Particularly from the US investors we’re seeing the benefit of many years of education come through. The homework and research that’s been done on the sector and individual assets, as well as a greater appreciation of the benefits of diversification, are paying off in the quality of investment diligence. Educated investors are engaged in very open, transparent discussions around regulatory risk, different regulatory models, the use of leverage, and increasingly the intersection of public policy, politics, and financial outcomes. This sophistication helps investors grapple with the assets that are coming to market today – a switch from more brownfield-type assets to what is in reality more greenfield - and how these opportunities can be structured with a view to keeping public policy in line with instead of at odds with private capital.
Chair: What about the case for listed? What role does listed play in the portfolio?
Perrett: Over the last 12 months we have seen a marked increase in interest to listed infrastructure, particularly from the US funds as they aim to diversify their exposure to alternative asset classes. Com-petition to access unlisted infrastructure has increased dramatically, with small to medium sized funds looking to access the more liquid assets of listed infrastructure as an alternative to pooled funds. The return streams of developed listed infrastructure have been relatively stable over the last five years with a 140 basis points per annum premium to listed equity. With higher yields, and lower volatility than listed equities, the listed infrastructure positive return streams have helped shift interest to this relatively new asset class. Unlisted infrastructure remains the key access point for the majority of the larger funds, but interestingly we’re actually starting to see some of them allocate into listed infrastructure as well.
Lennon: How broadly defined is listed infrastructure compared to how we in the private markets might define it?
Perrett: The definitions are similar with an emphasis on the core infrastructure sectors of energy, communications, and transportation. But you’re going to get particular sector biases, with utilities especially. There is a large exposure to the US in global equity benchmarks and for listed infra-structure there is a similar large allocation. One of the key differences between index providers surrounds the selection criteria of listed infrastructure. Some will just select by their proprietary classification system. This is a start but doesn’t really give you the type of companies that would fit into a core listed infrastructure definition. Indices that use this simple approach have tended to show more equity-like performance as you are including a lot more companies. This compares to indices using additional screening approaches that have tended to diverge with traditional equity performance. Listed infrastructure is still equity at the end of the day so you will have high correlations, but volatility tends to be lower with higher yields.
Chair: It brings us to the point about performance, and what people have actually seen through investing in infrastructure. Our experience is that it’s been mixed. For most funds most of the assets have done reasonably well, but in many funds there have been one or two investments which potentially stretched the definition of infrastructure and led to disappointment. Does anyone have any comments on that, and what they’d expect to see going forward?
Hofbauer: If you look at the history of the sector, early entrants performed very well when the returns relative to the risks were high. What the industry along with the broader financial market found is that just being in infrastructure itself didn’t mean that you were immune to a range of risks, including financial leverage, including macro-economic conditions. One of the things that’s come from the maturation of the industry is greater clarity around strategy, and greater clarity around not only what the asset class is designed to deliver, but what infrastructure can deliver in the sense of the underlying investment characteristics. The other major thing if you look at the industry’s track record is also about acquisition vintage. Vintage is a significant influence on performance over time.
Allen: 2007/08 vintages generally are going to struggle to meet their targets. A lot of that is market, with those vintages buying at pretty much the top of the market. There’s been some pretty high profile managers that haven’t executed at all well, and that hasn’t done anyone any favours. We’ve lived through that, it’s been a bit of a rollercoaster, so naturally there’s still a bit of scepticism among consultants and clients. One area where it’s pretty much delivered what it said it would is PPP/PFI, which is one of the very few asset classes which didn’t underperform during the crisis. If we can get more of that PPP/PFI type stuff, our clients really want that – matching their liabilities with indexed linked gilts is very expensive at the moment, so a very popular theme is alternatives to index-linked gilts.
Chair: On one hand we’ve got institutional investors saying they want these types of assets, on the other we’ve got a government that’s crying out for people to invest in these greenfield assets. Why the disconnect?
Allen: Our clients have been investing in greenfield throughout. For the right risk/return profile I don’t think we’re averse to greenfield. It’ll play a different role in the portfolio. It’s definitely diversified growth, it’s not matching at that stage. But we’ve got a number of clients that are willing to and have taken on greenfield risk, but I don’t see the projects there.
Mills: You can generally manage engineering procurement and construction risk through quality contractors. They’re good at wrapping it up and delivering it well, we’ve seen that. But the thing that we still can’t cope with is the planning risk and the time it takes to get these things off the ground.
Lennon: I suppose Gary your positive experience around greenfield has been predominantly in the PPP/ PFI space?
Lennon: That significant social infrastructure investment programme in the UK is somewhat historic when you compare that to where the government is trying to encourage investment now. Just one example would be the energy market. Part of the challenge here is that there has been so much uncertainty around policy and for investors that creates barriers to investment.
Chair: Our experience in greenfield has been that there’s largely three risks. The first is development risk, and most of our clients just don’t want to be involved with that risk profile. The second is construction risk. This is probably the one that’s least understood by the market, and to Niall’s point the structures put in place mean the risk to equity holders is actually much less than what it’s been in the past. The third one is the ramp-up risk associated with the revenues. This is why the PFI situation has been so much more positive than what we’ve seen elsewhere in greenfield, because PFI is all contracted with the government. The horror stories have been in some of the patronage risks where the situation at day one has been different to what people assumed it was going to be.
Lennon: It’s an interesting point about construction risk. I think there’s a lot of very satisfied infrastructure investors that have got exposure to utilities, many of those have been building out billion pound construction programs throughout that period of time. To say investors haven’t been exposed to construction risk isn’t strictly accurate.
Ryan: A lot of this is education. When you hear investors talk about brownfield versus greenfield, the brownfield assets they’re referring to are often inherently project-driven, a lot of capital being recycled, which can be very attractive. A sector that has a monopolistic profile or a tight oligopoly with a tonne of capital required is a very attractive place to be when properly managed. But pure brownfield doesn’t exist in the US, as we’ve seen it’s probably not going to. The solution is to be very public policy-driven, which is the public sector recognising that in order to get private capital you have to de-risk certain aspects of projects.
Chair: Globally, is there anyone that does it well from a public policy perspective?
Ryan: The capital that’s attracted to the UK regulatory framework is attracted for some very credible and powerful reasons. You’ve got a lot of transparency and experience in a regulatory framework, the people running regulatory bodies know the industry and I think that’s absolutely critical, and you’ve got an enormous need. Having a great regulatory framework is important to keep the capital coming in. There are plenty of other markets that are looking at the UK market saying ‘why are they successful, why have they been successful for a long time and what do I need to do to replicate that?’.
Mills: Through having stable regulation with a much smaller population than the US the UK has attracted hundreds of billions of investment, over £100 billion in the water sector alone since privatisation. The electricity market is probably double that, which is why comments like Miliband’s are not helpful. It’s not necessary against a background of many utilities proposing reduced or flat prices in their business plans. All the distribution networks in the electricity sector have proposed price reductions for the next five years, then the politicians come out with ‘we’re going to cap this and change that’ - it doesn’t need it, the utilities and their regulators are already being responsible.
Chair: Has that dynamic changed? Is there more regulatory risk today than there has been in the past?
Hofbauer: I think risk has increased, because of the fact we’re in a period of austerity. There’s a public interest element to everything we do and touch in infrastructure. It’s a long term partnership with key stakeholders – government and customers. As stakeholders if we don’t try to accommodate the challenges that have been faced by our partners the risk will go up.
Chair: Does that mean as infrastructure investors we should be accepting lower returns in periods like this?
Hofbauer: There’s some merit in being modest in aspirations over this period, yes.
Mills: There are ways to manage that as well. There are ways to invest over a longer period of time to reduce the short term impact, so it has become much more about resilience in these assets. It isn’t just about building great big shiny new plants and switching stations, it’s about trying to get your assets to last longer and that’s a way to manage through an austerity period.
Lennon: We all know, the number one risk in infrastructure is political risk. The positive thing about what we’re investing in is that it’s so utterly essential, what comes with that is that it’s so important to customers, government and other stakeholders. You ignore these relationships at your peril. This gets brought into much sharper focus when times are tough. What makes things harder – taking the energy point specifically – is that there’s a lot of demand being put on that industry by government, for example moving to a greener type of energy mix, that will cost a lot of money and government has not been perhaps overly forthcoming with telling the electorate that.
Chair: Are the guarantees a step in the right direction in terms of helping the industry deliver that in a cost effective way?
Mills: The strategy is to provide some certainty around the mega projects. The point Martin made about there being a cost to the green agenda, when you’ve got tariffs, yes it creates a degree of certainty but that means, generally, the consumer is paying more for that the commodity. Is that sustainable?
Chair: We’ve seen this across Europe. How has that played out across the continent?
Mills: The changes in tariffs we’ve seen have cost existing investors, they’ve had to write assets down, and it’s absolutely put other investors off. We’ve seen some very good projects, but because of the risk that there will be further cuts or lack of clarity in the regulation you can’t invest. It’s been totally counterproductive, but perhaps unavoidable?
Chair: Do consumers pay a realistic amount for infrastructure? Is it a new normal that people need to pay more for these services?
Ryan: It’s a mixed bag. We’re seeing pressure in power and water in the UK. There are consistent increases in things like tolls in the US where state departments of transportation are now linking tolls explicitly to CPI, which is very new. Or step changes in tolls to fund expansion or maintenance that’s overdue. You’re seeing that element of sustainable partnership coming together in different ways, it reflects the ultimate need, people’s ability and willingness to pay, and constraints around financing and required capital returns and public policy. It takes time.
Chair: Gary, looking at it across the institutional investment marke-tplace, are you seeing the way that people access infrastructure change?
Allen: Most of our clients invest in unlisted funds. Going into a sub-sector of listed equities doesn’t quite seem to work from a diversification perspective. The focus has been on unlisted and more active management. Traditionally it’s been down the closed-ended route, and there’s a lot more closed-ended funds but recently the open-ended funds are getting more attractive and we’ve recently started buy-rating open-ended options as well. They’re very attractive as it’s not a blind pool. You know what you’re getting into, they’ve got much longer track records now. There’s some liquidity there, some of the fees are actually more competitive as well. Open-ended funds can help a bit in terms of the two main things holding investors back from infrastructure: liquidity and manager fees.
Chair: Globally the industry is seeing a lot more of the largest investors move away from the fund route and think about other things like co-investment or direct investment. Peter, your shareholder is one of those that has gone down a different route. Why does that work for them?
Hofbauer: They had been investing in infrastructure for a long period of time. They were looking to increase their exposure to the asset class but were disenfranchised with the agency issue, with the lack of tailoring of strategy to the investment characteristics that they were looking for. But, equally they were sufficiently mature to recognise that there needs to be an appropriate governance framework put in place. Dealing with a £40 billion pension scheme wasn’t necessarily well suited to making direct investment. So they focused on putting in place a more tailored solution, part of a shared platform that was tailored in such a way that got the alignment right for them, that addressed the agency issue. That worked for them and has for a number of our other clients as well.
Allen: We’re seeing much more interest in co-investment and direct. Clearly it’s only the large clients that are going to be able to do that, it requires a lot more resource and commitment and governance than investing in a traditional fund structure. People have seen what some of the large Canadian and Dutch pension schemes have been doing and there’s some will to replicate that.
Perrett: There are many benefits of co-investment, but as more funds are looking to enter into new contracts in unlisted infrastructure it has increased competition in this space. Sydney airport is a recent example where we had Australia Super working with a consortium of Middle Eastern and Canadian funds. Recent reports are that they had to walk away because the bidding process for the airport was very competitive and overpriced.
Allen: The vast majority of UK DB schemes still have no exposure to infrastructure, and there’s still a lot of education to do. Probably 10 to 15 per cent have any allocation at all, so there’s potential to penetrate that 85 per cent that haven’t got it more. Going straight into a co-investment programme isn’t going to make sense for them.
Chair: I’d like to pull in the asset managers at that stage, what have your impressions been about this newer appetite for co-investment.
Lennon: We welcome it actually. We see a variety of different things. We see some investors that want to literally just come in as a direct partner and get involved, roll their sleeves up and bear the execution risk and everything else. There are relatively few organisations that can do that. For us as a GP, working with those people, we need to be very confident that we’re not increasing our execution risk. There’s also the potential to do a passive syndication form of co-investment. So, where GPs can take a slightly greater stake than the final hold position they want in the fund, and manage the process, complete the transaction, and offer to sell some down to those LPs that want to have a slightly increased exposure in a specific asset. It gives them some flexibility to shape the portfolio exposure they have, it reduces their overall fee drag, and actually if size and resource constraints mean they’re not able to manage it themselves they’re still relying on the people that are doing it for them anyway through the fund.
For me as a GP as well, what co-investment provides me with the ability to increase my diversification a bit more. Most infrastructure funds are lucky to get between eight and 12 assets max, these tend not to be highly diversified portfolios. What diversification you can obtain is still very important so if you can go from eight to 10 assets in a fund, I value that.
Hofbauer: Does that give you a conflict though? In terms of taking more in the fund and maybe some of your LPs wanting to take exposure and some not and then they’re left with a higher concentrated position?
Lennon: I don’t believe it does. We would never breach our fund diversification rights, so this would be within our exposure limits. We have been completely upfront with the fact that we are offering co-investment to partners and all the LPs are able to participate in that if they are able to. And I think even those LPs that are not able to participate in it actually say ‘if we can get a bit more diversification I can see the value in that’.
Mills: There’s an appetite for it, it’s part of the industry, you’ve got to embrace it and work with it. For us, the tricky bit - and I really endorse the point about execution risk - is making absolutely certain right at the beginning that any co-investor does understand the risk, does understand the costs, and importantly understands the resource that is required.
Chair: Paul, what makes a good co-investor? What do you want when someone comes to you and says ‘we want to be a co-investor’?
Ryan: Niall alluded to it, it’s understanding what they’re getting into and having a strategy that extends beyond, for example, the simple fee break in the short term. The benefits of the asset class are delivered over the long term, and you have to be in it for the long term. Alignment of vehicles is critical obviously, so you have to make sure that’s working. The pick-up in diligence that we’re seeing around making investments directly or as a partner or into a vehicle helps all this. People need to form an appreciation for the obligations over the long term around governance and manage-ment teams and operational risk and stakeholder relationships.
Chair: Would a product like the UK’s Pension Infrastructure Platform be appropriate for European investors or US investors?
Ryan: In the US there is the west coast infrastructure exchange. It is creating a dialogue around amassing pools of capital and creating projects and raising the level of dialogue that’s needed to create the opportunities and pull both sides together. That’s what’s missing in a young asset class, there’s not one answer but the more dialogue you have the better. There are certain needs on the investor side and on the public policy side that can be met through different vehicles.
Chair: We’ve seen similar things happen in Canada where a number of the small and medium size pension funds have got together. I want to switch gears quickly and talk about where people are seeing the opportunities. What are people seeing that is particularly exciting at the moment?
Hofbauer: We’re predominantly focused on the UK although our mandates go beyond that. We’re seeing several key areas of investment opportunity. Clearly there’s some sectors such as energy where there’s a significant need. And that’s coming in the form of either some of the incumbent operators looking to recycle capital and divest assets which are non-core, or alternatively looking at ways of partnering with institutional capital. There’s also probably some, certainly in the UK, early vintage funds that are nearing the end of their term that will be compelled to sell. I think that will migrate from more intermediated capital to maybe more direct investors given the scale of some of those opportunities. Then there are some specific sub-sectors, for example within energy the renewables market support regimes are there to encourage new investments.
Mills: That’s mirrored throughout a number of European countries. There are quite a few opportunities. They’re taking a bit of effort to realise and get onto the table, they’re not just landing in front of you in the form of a perfectly formed IM. And they’re different sizes and shapes. It is actually exercising the mind to really think ‘is it a good deal, is it executable, what’s the competition like, where does it fit?’ I really do think we’re looking at a very broad range of opportunities, probably broader than it was a year ago.
Lennon: We have observed for the last two or three years that the very large cap core utility deals have become incredibly well bid, and that’s partly because you have seen sovereign wealth funds and large directs going for those. You’ve seen some really fierce battles for these big deals. So as a manager we try to avoid situations like that, and we tend towards more small to mid-cap deals. As a consequence you may have to deal with a more complicated set of arrangements. For example you may not have a perfectly presented set of vendor due diligence provided to you, or you may be dealing with a business that actually needs to be separated out of another corporate and it’s not clean in that respect. Issues such as these take resource and experience to deal with, but ultimately we think that we’ll get a better return because of it. In terms of geographic focus for us in a way we’re restricted by our mandates – we’re a European focused entity - and really because of the ongoing austerity related issues in southern Europe we’re not very active there. The priority pipeline is the UK, the Nordics is quite interesting, and other parts of Western Europe too. We still see good levels of deal flow but it’s hard work at the moment.
Chair: Hard work in the sense the deals are more competitive?
Lennon: Certain parts of the market are competitive, we’re trying to avoid those, but you can’t really avoid competition completely. One of the things we’ve done differently for the last two or three years is highlighting opportunities much earlier and engaging on them much earlier. Getting involved early, getting your team ready, leveraging your experience, developing relationships with the vendor, policymakers, the regulator if it’s that type of asset, other stakeholders, so you’re moving the needle of the probability of success in your favour.
Hofbauer: What has made you change to do this now?
Lennon: We were doing it before, but the market is more competitive generally so we have to work even harder.
Mills: I’d say this is actually us doing our job properly. That’s the point. The deals are absolutely harder to make happen, you have to work harder. We’d say that if you haven’t been working on something for six to nine months before the IM comes out your chances are just too small.
Hofbauer: We’ve done an asset register of all the UK assets, we think it’s part of our job.
Ryan: I think a similar thing is happening in the US in terms of getting back through the fundamental work around sourcing, creating, and structuring opportunities. The mid-market is enormous in the US. There’s been a lot going on behind the scenes around the interaction between the public sector and particularly long term private capital to create transactions that work for both over a long term, so a more sustainable model as opposed to a more transactional opportunistic model.
Chair: What themes are we seeing in listed infrastructure at the moment?
Perrett: The core infrastructure sectors continue to be where the majority of interest lies. The alternative energy sector is starting to come into play, but the issue has been the lack of a track record. Social infrastructure is one of those interesting areas where we’re starting to see more interest but it’s very varied indeed with a lack of listings.
Chair: Here in the UK we’re seeing the replication of the listed PFI company strategy by companies investing in solar or renewable listed asset pools. Is that something you think we’ll see continue?
Hofbauer: Part of the push is driven by yield. It is interesting to see a lot of externally managed listed vehicles coming to the market, which generally attract retail type investors, where in other parts of the world including Australia they’re all being unwound. There’s virtually none left.
Allen: We’ve seen quite a lot of interest actually. There’s two types of listed. There’s the listed funds which are investing in unlisted assets, so in fact they’re very similar to the unlisted funds. Then you’ve got listed equity, so they’re very different obviously. We’ve seen quite a bit of interest in these PFI funds, a lot of them have got quite a large institutional base. They’re trading at significant premiums though.
Lennon: It would be fascinating though if we do see significant increases in the base interest rate, what happens to those vehicles.
Allen: I’m sure we’ll see them come right off, I’m sure they won’t be trading at 15 per cent premiums.
Lennon: It could be a double whammy because the underlying assets and the NAV might fall and then the appeal of the actual dividend distribution on a relative basis could also fall.
Chair: We’ve been talking about the appeal of yield, Gary do you have any impression of how attractive infrastructure debt is to institutional investors in the market?
Allen: There are lots of managers trying to raise funds. I haven’t seen an awful lot of real investing, and we haven’t actually got any clients that have invested yet. It’s a very different investment case to infrastructure equity. It’s a mixed bag, there’s floating rate, there’s fixed rate, some has got long duration, some has got no duration linkage. If there was an infrastructure debt product out there that offered long term inflation linked cashflows with a nice premium to index linked gilts you would see pension schemes very interested, but I don’t see any of that.
Chair: Would anyone like to make some wrap up comments?
Perrett: From an index provider’s perspective it’s about supporting our clients as they continue to seek diversification in the asset allocation process, providing the relevant tools, and being able to measure the performance of that particular opportunity set.
Ryan: I think we’re excited by the move from phase one to phase two with the punctuation being the GFC. The need is significant, pools of capital are there. We’re excited about infrastructure around the OECD broadly, and then specifically in a few of the markets we talked about.
Chair: I started by talking about contradictions. I don’t think we’ve solved all of them, but what has been promising and what’s really come out today is there’s much more discussion between the institutional investors and the asset owners and the asset managers. That can only help to get a more efficient and streamlined industry. It’s a very exciting time.