Infrastructure as an income source and diversifier for pension plans

Panellists

CHAIRMAN: Jonathan Stapleton, editor at Professional Pensions

Ash Kelso, head of asset management for infrastructure investments at Columbia Threadneedle Investments

Kevin Humpherson, senior investment advisory team manager at Deloitte

Linda McAleer, senior research consultant at Hymans Robertson

Neil McPherson, managing director at Capital Cranfield Pension Trustees

 

To what extent are schemes looking at infrastructure as an asset class? Is there increased appetite for infrastructure?

Kevin Humpherson

Infrastructure has always been a diversifier and is a key source of income, which is a trend that is getting stronger among pension schemes as maturing income becomes a key issue. Considering the traditional markets or illiquid markets are at in terms of pricing, the sort of yields you can get, the availability of gilts and corporate bonds, the fact that infrastructure can be an area of low correlation to the wider economy is an alternative investment.

Infrastructure has always been popular with pension schemes and is becoming more popular. The issue facing trustees is illiquidity because historically the structure of funds tends to be 10 plus years. There's always been a view from pension schemes that they cannot necessarily take too much illiquidity, however for many schemes they can. Nevertheless, that is one of the hurdles with the asset class.

Linda McAleer

If we go back around 10 years, early investors in the asset class were investing for diversification. In the last few years, the prospect of higher income returns while allocating to a diversifying growth asset has been attractive. While the high income is nice to have for clients that are diversifying, it has been a key driver for some of our clients investing in the asset class for the first time.

Neil McPherson

Income is by far the major driver for [pension plans] to invest in the asset class.

The other issue is that infrastructure is a very broad church - from putting concrete in the ground to collecting the rents from everything that has already been built. For most of our schemes, the interest is where there is a good, steady, dependable cash flow that matches the liabilities that has a better return characteristic than gilts, for example. That is where the interest is, rather than private equity investment - put some money in here and see where it goes. Income is the driver.

The caveat is that I am talking only about private sector, closed defined benefit (DB) schemes in the UK. It is different if you are a Local Government Pension Scheme, CalPERS (California Public Employees' Retirement System), or PGGM (a Dutch multi-employer scheme) - they have a different dynamic.

Ash Kelso

We have seen a lot more of the local authorities starting to look at infrastructure as an investment. They are seeking exactly the same things as the corporate pension plans and the cash-generative, long duration infrastructure asset class provides a good fit. Whilst they remain open to accrual, local authority schemes are maturing, and their maturity profile, coupled with the new pooling arrangements, give them a critical mass for investment purposes.

Neil McPherson

Looking at the critical mass point, how does a small to mid-size scheme access infrastructure? How do you get the right deal because the big ones never touch the sides? They always go to the big buyers. If you are talking about the local authority schemes reaching critical mass, where does that leave 95% of the UK schemes that do not have that scale and cannot write the £50m tickets?

Ash Kelso

Small to mid-size pension funds will have much smaller allocations to infrastructure with scale, expertise, ongoing governance and costs being the main barriers. There is a significant cost associated with a pension fund going direct and typically, smaller pension funds concentrate on indirectly accessing infrastructure through specialised funds.

The point on the structure of the infrastructure investment is a really good one. A lot of small pension funds will need some flexibility as to when they exit particular infrastructure investments, so they need to make sure that they have the ability to come out. These funds should look at open-ended fund structures and the level of choice investors have is now beginning to broaden.

Are you looking at a global opportunity set for infrastructure?

Ash Kelso

We are currently focused on Europe, with the unique mix of economies, demographics, supportive legislative and regulatory regimes and significant disruption trends providing infrastructure investors with great opportunities. Understanding each of those in detail and how the individual assets operate is fundamental to finding and realising value.

Also, there is currently significant demand for large or "trophy" infrastructure assets which is creating upward pressure on prices, however our view is that small and medium sized assets have not experienced the same intensity of demand and offer better value.

Kevin Humpherson

One of the main risks is sourcing and deploying capital when there is such a huge stock of dry powder. There is currency risk, too. It depends to what extent you need the income balanced against sterling income. I would always favour a European or global approach given the wider opportunity set.

Neil McPherson

It is not just the currency; there is the potential the credit risk changes. In the EU if the project has got state or canton backing, or the equivalent, that is a great help towards mitigating risk or giving comfort on the credit side. Then there are environment, social and governance (ESG) factors to consider. You need to ask if the ESG standards you want applied to an infrastructure project are the same in parts of Asia as they are in Luxembourg.

How can ESG risks be addressed and incorporated into infrastructure investment, especially given the long-term timeframe of investments? What are the challenges?

Linda McAleer

ESG considerations are definitely important for infrastructure investment. The infrastructure managers we see take ESG risks seriously and considerations are becoming embedded in processes. There are many aspects of ESG to consider and potential ESG issues may be part of an asset management play where the intention is to improve certain impacts through further investment in the company.

Neil McPherson

For some ESG is a filter to get over and for others it is an alpha generator because your investment is going to give better returns.

Linda McAleer

ESG can be a risk mitigator if you want assets to be sustainable for the long term.

Ash Kelso

We see incorporating ESG considerations into our investment analysis and asset management plans as an enhanced risk management tool - an infrastructure asset that has a strong ESG performance will generate better long-term returns for the investor.

Many investors focus principally on the environmental part of ESG, automatically allocating capital to renewables and green energy. Although this is fundamental in helping reduce the impact of climate change we still need to invest much more broadly to support the decarbonisation of existing infrastructure. Improving the ESG footprint of investments is also about looking at assets that have the ability to transition toward a greener or more socially responsible world.

Focusing only on renewables cuts off a large area where managers can make positive changes to other assets such as improving the social impact, community relationships, diversity and governance arrangements. Renewables and green energy are only one part of the story.

What actions to do you take to manage assets and improve them?

Ash Kelso

There are a number of elements. One is making sure ESG considerations are formally embedded within the investment process and within the team.

The manager needs to include people who are responsible investment specialists, not just notional responsible investors, as they bring additional insight and value creation compared to, for example, a deal team with only traditional M&A experience.

You need formal policies and procedures, and set requirements for analysing the environmental and social impact of potential investments. The manager then needs to formally adopt these policies and procedures at every stage of the investment process, from initial screening through detailed due diligence and in the asset management ESG improvement planning and ultimately the reporting of outcomes to investors.

Linda McAleer

It is an interesting point having dedicated responsible investment people. Ideally we would get to a stage where a dedicated team/person is not needed because everyone is involved. You do not want one or two people considering these issues while the rest of the team think they do not need to worry about them because they have a specialist doing it. You want it to be embedded in the culture where everyone is thinking about RI considerations and driving forward positive change.

Kevin Humpherson

ESG should be a key part of infrastructure investing and not just in the renewable sector. Are these assets having a positive impact on the ecosystem they are based in? Asking such questions helps the productivity and sustainability of the asset and can contribute to the value of the asset in 10 years' time. That can be difficult to understand. Look at how far ESG issues have developed in the past 24 months and then think of where we are going to be in eight or 10 years.

Linda McAleer

From a governance perspective, you can be more involved and influential if you have a company board seat. You can push agendas. At a different level, investors might also have seats on advisory boards of closed-ended funds, which may allow them to be heard more.

Ash Kelso

A big part of ESG improvement is working closely with the company management team and reporting on progress, tracking how that asset is performing across a range of asset specific ESG criteria. Once you acquire the asset, you can set up a plan for how it should develop over the 10 years and continually track and report against those plans.

Neil McPherson

What about reporting wider than ESG? Fiduciary management is a very broad church. There are many styles under one label. Infrastructure is an even broader and fiduciary managers now have to address this through the CMA requirements and their clients' demands. We need more transparency and clarity on pricing and benchmarking. Within infrastructure how transparent is the investment, what benchmark can be used and how do you monitor the investment?

Ash Kelso

Investors are looking for more information not only on the financial performance but also on operational and ESG performance. There are a number of organisations that are benchmarking ESG performance and are becoming more recognised by investors, like GRESB [ESG benchmark for real assets]. The market is definitely evolving, and something that we as asset managers can help drive and shape.

Neil McPherson

This is not the best way. GRESB is self-selecting to some extent and is not as transparent as I would like. I am not giving any answers on how we can do it, but it is a sub-optimal way of assessing.

How do you compare different structures and ways of accessing different types of infrastructure?

Linda McAleer

A lot of the time it is less about infrastructure fund A versus infrastructure fund B. It is more about why you are considering the asset class, what you need from it and which vehicles best satisfy that need. There are pros and cons for every route.

If you think of the traditional closed-ended funds, they are concentrated in terms of the number of investments in each fund. A lot of our investors are tight on governance so may only be allocating to one or two infrastructure funds. Therefore they need to have diversification within the funds.

For a lot of the traditional private equity style funds they expect to provide exposure to around eight assets, but many that we see have just six individual companies.

You are not going to have a diversified portfolio from six investments. Some of our early investors in the asset class went down the fund of funds route for exactly this reason. Infrastructure funds of funds tend not to be like traditional private equity funds of primary funds. They are much more focused on secondaries and co-investing and at least provide diversification for investors who do not have the governance budget to become as diversified as they would like through single manager appointments.

Kevin Humpherson

It comes down to what investors are looking for in infrastructure. We help clients by having views, talking through the pros and cons of each investment. We do have views on certain styles or sectors we think are attractive.

You mentioned listed and unlisted. In my view one is equity and one is infrastructure. Almost all of the reasons why you find infrastructure attractive you do not get with listed infrastructure. But when it comes to closed-ended and open-ended, it is down to the client's objectives and constraints.

There is a lot of benefit in open-ended structures and not just the liquidity aspect. You can see what you are investing in, something you may not get with a closed-ended fund. One of the concerns with investing in these structures is when capital can be drawn down. There can be a bit of blind investing involved in a closed-ended structure.

New funds and managers are coming to the market recently where 10/15 years ago there were fewer big players has been beneficial. We have seen much better alignment of interests between GPs (general partners) and LPs (limited partners) in terms of fees and structure.

Neil McPherson

We talked about fees and could accept PE type fees at an early stage. That is when you do not know where it is going to go for 10 years. At the other end when it is built, it is essentially facilities management. Investors are not going to pay PE fees for facilities management.

Ash Kelso

An open-ended fund structure is much more "fit-for-purpose" when investing in long-term infrastructure assets. The managers can be much more forward looking, in particular to meet disruption challenges. It gives them the ability to build and hold a diversified portfolio, make meaningful improvements to both the operational performance and sustainability of the companies they control and react to changes in the economy. You can sell assets, you can buy assets and can better manage or diversify exposure to certain macro drivers.

Linda McAleer

One of the difficulties in closed-ended funds is the ability to keep investing in the company and assets. Even with funds that are officially closed-ended, they may have a bit more flexibility on extensions every five years or post year 10. This is positive as it gives a bit of flexibility on how long you own the company/ asset. However, it does not bring the flexibility to keep investing in a company already owned. The fund structure does not allow investors to put more money into assets they already own.

Ash Kelso

Closed-ended fund structures may limit the opportunity to make meaningful improvements to assets and there is serious disruption arising from global challenges such as climate change, new technology, ageing infrastructure and growing populations. Considerable investments in infrastructure will be required but the problem for many funds is clarity on when this will occur.

An example is the electrification of transportation. Disruption in energy infrastructure is being partly driven by the electrification and automation of vehicles, which means that major changes will be needed.

There is no consensus on precisely when it is going to happen and what the model is going to look like. There are different schools of thoughts on this. Will people be driving down the motorway and need to stop and charge or will battery technology improve range? Will most private vehicles be charged at home or will dedicated commercial rapid charging premises be the solution? Owning assets in the transport sector in a closed-ended fund means managers may not to have the ability to react to changes, to further invest, to transform their asset before having to exit and losing value.

What returns can schemes investing in infrastructure expect?

Neil McPherson

That is the six million dollar question. Much of the argument for infrastructure in its broadest sense is that it diversifies the portfolio. But why would I go into an infrastructure fund? In return terms what is the comparison between an infrastructure fund and a diversified growth fund (DGF) in that respect? What money are you are going to get back from it?

Kevin Humpherson

From infrastructure, you can get as high as mid-double digits returns if it is a pure greenfield type strategy.

If you find an infrastructure strategy that can deliver somewhere in the region of a 5% cash yield and an IRR (internal rate of return) slightly above that, it is probably conservative for infrastructure.

Neil McPherson

Recently I read a report that said globally, for large funds, 5% was by far the most common level.

Kevin Humpherson

A 5% cash yield from infrastructure has assets underlying that deliver cash. Generally speaking, DGFs do not deliver cash.

Neil McPherson

Your point about the contractual underpinning that might be on cash that is going to come through and protect the creditworthiness of the investment is key and an attractive position.

Kevin Humpherson

If you are in the right sectors it can give a low correlation from traditional asset classes such as equities and bonds whereas DGFs tend to invest in these traditional asset classes.

Neil McPherson

Many schemes, particularly smaller ones that come to us often have 70% liability-driven investment and all the growth is in DGFs, 30% or 40% of the assets. What sort of proportion of asset allocation to infrastructure do you see with your clients?

Kevin Humpherson

Illiquidity plays a part however infrastructure is now becoming more accessible to smaller clients. Historically smaller pension schemes tended to avoid infrastructure because of their size and scale. That is changing. Where we have clients invested in infrastructure, I do not think a 10% allocation is unreasonable.

Neil McPherson

That is exactly what we hear. Cash flow to meet liabilities is becoming much more important and that could grow.

Linda McAleer

When UK pension funds first allocated to the asset class 10 years ago, they were making 2% or 3% allocations. This has grown to 5% or higher as investors have become more comfortable with the asset class. In those early days managers were coming along with a track record that was not pure infrastructure but, for example, had been developed as part of their private equity portfolio. There was hesitation to allocate.

Two things need to be considered.

1. This may be the first-time clients coming into infrastructure have invested in a LP/GP structure (they may not have had private equity in their portfolio).

2. Overall allocations to illiquid assets.

Investors now have illiquidity from property, private equity, private debt and infrastructure.

The overall allocation to illiquid assets needs to be considered. This will depend on how mature the pension scheme is and what liquidity they need. For those that do not need liquidity, up to 30%, or even higher in some cases, might be okay.

Kevin Humpherson

Another argument for an open-ended structure is that the manager has more scope for active management because you mentioned equity PPP and PFI [private finance initiative]. I am not sure that is an area we would want to be invested in, given some of the comments from the [present] UK Chancellor and the potential of a Labour government. If you had invested in a closed-ended fund four years ago in that area of the market, you are quite exposed to unforeseen changes in the economy.

As an investment for pension schemes, how do you expect infrastructure to develop over the next three to five years?

Kevin Humpherson

There will be more appetite in infrastructure. A combination of headwinds in the market and the introduction of different funds available - structures and exposure to different areas of the market - will mean that selecting the strategy becomes more important. There are very different areas of the market you can get exposure to, so depending on what your objectives are, being sure to pick the right strategy to suit the client is what I see as being particularly key in the next few years.

Linda McAleer

Allocations have been growing and will continue to grow. A lot of investors have made their first steps in the asset class, initially seeking diversification across geographies, sectors and assets. As allocations grow, and once they have the broad sector and geography exposure, they can start to implement satellite allocations for specialist sectors or parts of the market that may create better value opportunities.

Neil McPherson

On the positive side, infrastructure has some attractive characteristics that would meet the requirements of UK private sector DB schemes.

We are at an early stage for many investors as they go into this asset class with a relative lack of transparency compared to other asset classes. This has to be overcome. That can be done with their managers and consultants as the industry develops. Fiduciary management was in exactly this position three years ago.

The worry at the back of my mind is that something goes wrong, whether a political shock or something that discredits the sector. The breadth and diversity of the sector makes that risk more likely, and if it goes wrong the whole sector gets tarnished, particularly with relatively inexperienced investors.

There is an education element required from advisers and managers.

Ash Kelso

From what we have seen, there is definitely growing interest in the asset class. For some schemes this is the first time they may have looked at infrastructure. They have an appetite for diversification and are aware there is opportunity.

There are several ways for schemes to get into infrastructure, but to get the best from the asset class, a fund needs to be structured so it actually delivers the return characteristics the scheme is looking for. A scheme may have buyout as an end game, for example, and an open-ended fund may be more buyout friendly.

A key driver for schemes is the search for predictable cash flow with long maturity which fits well with infrastructure investments.

Neil McPherson

I cannot see any direct defined contribution angle. There is money going to DC. That is the future. Is there a role for infrastructure in DC? There is a lot of talk about bringing illiquid assets into DC, but it is hobbled by the need for daily liquidity.

Linda McAleer

It is a great point because a lot of DC investors, particularly those in the early stage in their career, are allocating every month to their DC scheme and do not need liquidity for many years. Infrastructure could be an ideal class for them. We have not seen DC funds in the UK invest in unlisted infrastructure yet, but that may be what is to come. That will certainly be interesting.

Neil McPherson

At the other end, where you want cash flow because you do not want to go to annuity, an individual needs cash flow the same as a pension fund needs cash flow. But you need scale to do that.

What are your key takeaways from this discussion?

Neil McPherson

I am leaving a lot more informed on infrastructure than I started and many of my concerns and preconceptions have been at least partially addressed.

Kevin Humpherson

ESG could be a growing issue for the market. Infrastructure should play a key role in a scheme's ESG values. As the market develops it will become key. It is not necessarily just about investing in renewables. These are key assets to the economy and areas where, asset managers and therefore investors can drive change. As focus on ESG continues to grow I believe that will become a key focus within infrastructure investing.

Linda McAleer

Infrastructure is a very diverse asset class. It can play various roles within a portfolio. I am certainly interested in how propositions might develop to accommodate long-term DC investors. That will be a challenge.

Ash Kelso

For me what has been interesting is that we are all looking at this asset class from slightly different perspectives but are all in agreement that it is an investment class that pension funds should be looking at, which is very positive for the market.