The infrastructure repair bill is huge and more and more pension funds are willing to step in and plug the funding gap, but where are the assets? Mark Dunne takes a look.
Economic growth is expensive. Fixing and replacing Europe’s ageing roads, bridges, trains and airports as well as improving its communications network could cost €2trn by 2020, the European Commission said back in 2016. Also acknowledging the size of this task is the European Investment Bank, which believes governments should allocate 3.6% of GDP to upgrade the region’s infrastructure. Without such an investment it is difficult to see how sustainable growth in Europe could be supported.
Yet such a huge cost cannot be funded by the public purse alone. This has opened a door for pension schemes to step in and help plug the funding gap. It appears that they like what they have found.
Up to 70% of public sector pension schemes globally intend to increase their exposure to infrastructure in the next two years, a survey has discovered. This could see an additional $130bn (£98.4bn) pumped into the sector, estimates the survey’s co-author, the Official Monetary and Financial Institutions Forum.
Research carried out by Aviva Investors reported a similar conclusion. It says that UK pension schemes are planning a 51% rise in their average allocation of alternative income assets to 6.5%, up from 4.3%.
Dorset County Pension Fund is one institution that has increased its interest in infrastructure. At the end of March 2017 it had a £98m, or 3.6%, allocation to the asset class, up from £29m in 12 months. Meanwhile, the Devon County Council Pension fund had £194m at work in infrastructure at the end of March 2017, a 6% increase year-on-year.
Southwark Council’s final salary scheme, which is valued at around £1.6bn, has added wind and solar energy assets to its portfolio as part of a strategy to reduce its carbon footprint.
The decision to look at infrastructure resulted from a performance review of its portfolio. “Absolute return bonds were not giving the punch that we would be looking for,” says Duncan Whitfield, strategic director of finance and corporate services at Southwark Council.
So he has invested £30m into sustainable infrastructure in the UK and Europe. If these products meet expectations, Whitfield does not rule out making similar investments.
Mike Weston, chief executive of investment manager Pensions Infrastructure Platform (PiP), is seeing defined benefit (DB) pension schemes increasing their allocations to alternative assets, such as infrastructure. “There is a trend that has been going on for a long time and it is continuing to gain momentum,” he says.
It is easy to understand why institutional investors are fighting to get wind farms, roads and broadband networks into their portfolios. The long-term nature of these assets and their stable, inflation-linked income streams match the longevity and income requirements of institutional portfolios.
An era of prolonged low interest rates has also helped make them more attractive, as they generate superior yields than those offered by the more traditional income producing assets.
“It is an asset class that fits the objectives of the pension fund quite well. We can get a good overall return and it pays cash out relatively quickly,” says Chris Rule, chief investment officer of Local Pensions Partnership (LPP), a £15bn asset manager formed by Lancashire County Council and the London Pensions Fund Authority, which has a 10% allocation to the asset class.
The good overall return Rule is talking about is CPI-plus 4% to 6%, of which at least half should be income. PiP targets assets that offer PRI-plus 2% to 5%. “Our assets are performing as we expect them to perform,” Weston says.
“That is the point of this as an asset class. It is not like equities where the market can be all over the place. The volatility is much lower because the returns are contractual.”
Cornwall Pension Fund targets a 5% return above gilts from the £66.5m it has invested in infrastructure. Its trustees only expect the private equity and frontier market equity portfolios to generate a higher return at 6.3% and 5.5%, respectively.
But a steady cash income is not the only benefit of owning a bridge or a solar power farm. Real assets also provide diversification due to their low correlation to equities, therefore protecting a portfolio against a sell-off in the listed company markets.
They also protect against inflation – which can add to a scheme’s liabilities – thanks to their CPI-linked revenues.
Directly investing in infrastructure has perks aside from financial gains and protection. It could give an institution more control over an investment than if they bought a FTSE company. Buying infrastructure is a private market transaction, giving investors the potential to negotiate more influence over the asset.
Infrastructure is one of the reasons behind the pooling of local government pension schemes. In 2015, George Osborne, the then Chancellor of the Exchequer, stated his intention to encourage the 89 local government pension schemes to pool their assets to cut costs and achieve greater investment firepower to help fund much needed, but expensive, infrastructure projects.
These are, however, early days in this strategy. Some pools only became operational in April and are largely focusing on equities and fixed income.
“The alternatives are further down the development pipeline, so we have not seen a great change from the pools as yet, but we think that will come as they get their different assets managed on a pool basis,” Weston says.
Some pension schemes beat the government to the idea. In 2015, local government schemes of Greater Manchester, Merseyside and West Yorkshire – now collectively known as the Northern Pool – and LLP invested more than £1.2bn in establishing the GLIL Infrastructure fund, which now holds Anglian Water and Clyde Wind Farm among its assets.
A similar organisation is PiP. Its investors include Railpen, British Airways and the Pension Protection Fund as well as the local government pension schemes of Strathclyde and the West Midlands. PiP was established to help DB schemes invest in infrastructure at “a more appropriate cost”, Weston says.
One issue to consider before investing in this market is its illiquidity. However, investors should be paid a premium for this. High costs are another concern, but a bigger barrier for cash hungry long-term investors to enter the market is the lack of available projects.
“The chancellor has been telling us to invest in infrastructure. Well, where’s the opportunity? I don’t see a great deal out there,” Whitfield says.
Public auctions to invest in private assets are one way in, but, as Rule points out, it is a competitive landscape. “People are bidding high. You have got to find an edge,” he says. That could mean executing a deal quickly.
So pension schemes may have to find alternative ways of finding assets. This could be to develop relationships with other asset owners to work on finding assets together. Weston says that PPP/PFI has had bad press and as such is politically less attractive leading to fewer new hospitals, schools and roads, “the things that the country needs”.
“What we have seen is a lack of investable assets coming from government in terms of new builds,” he adds, “which is a shame because the funding from pension schemes would be there for them.”
This might not concern some investors in this space. Construction exposure in new build assets carries higher risk. “We are not getting into this asset class to take on risk,” Weston says. “These are lower risk assets, so we seek to minimise construction exposure.” One investor happy to take such a risk is LPP, which passes the responsibility to the construction company.
For example, LPP is funding new rolling stock for the East Anglia train line. The construction risks are offset by the manufacturer accepting responsibility for delivering the product on a certain date and for an agreed price. If they fail, there will be penalties. Rule is looking to form a similar deal for a wind turbine project.
He does, however, avoid speculative risks. His modus operandi is to get involved post-planning permission and invest in established and proven technologies.
New markets; old problems
Competition for infrastructure assets could get even tougher. Auto enrolment is set to swell the size of defined contribution (DC) funds and some of those retirement savings could find their way into this asset class.
One such investor could be the government’s workplace pension scheme NEST. But in June chief investment officer Mark Fawcett warned infrastructure fund managers to “up their game” if they want to manage cash for DC schemes.
His concerns centre on costs, which are capped at 75bps, and a lack of daily liquidity. For Weston this should not deter schemes from considering making an investment here.
“The value of a hospital today is going to be the same as it is tomorrow and the day after that,” he says, pointing out that there is nothing that says that there has to be daily pricing. “It is just what the industry has grown up with,” he adds.
So it is clear that changes are needed to allow DC cash to flow into the asset class, but the issue of supply is of greater concern. Whatever the future brings, more retirement cash put to work in infrastructure will benefit savers and the economy alike.