Rachel Dalton reports on LGC research into LGPS infrastructure investment plans, sponsored by Aviva Investors
LGC research can reveal Local Government Pension Scheme funds are adopting more sophisticated techniques in infrastructure investing as they gain confidence in the asset class and collaborate through pooling.
A survey of LGPS fund officers and elected members serving on pension fund committees, sponsored by Aviva Investors, has shown an increased enthusiasm for infrastructure assets, plans to invest in infrastructure products more tailored to individual funds’ needs and an appetite for direct investment.
In April 2018, the eight LGPS pools must ‘go live’; the government expects a sizeable proportion of funds’ assets to be managed via the pools.
Critically, though, the government does not expect all of funds’ portfolios to be run within the pools at this stage; it expects funds to have plans in place to invest in infrastructure via the pools. A greater proportion should be invested in infrastructure than the funds individually have managed but the government has given funds a little grace in delivering this part of the project.
The Department for Communities & Local Government recognised that many funds’ existing infrastructure and other real assets are held in long-term contracts, which would be prohibitively expensive to exit early. However, officers are hard at work to create a national infrastructure solution via which all eight pools can invest.
In the meantime, many individual funds are gradually increasing their allocations to infrastructure on an ad-hoc basis in the search for greater long-term yields than are available from more ‘vanilla’ assets.
LGC’s research has found that most funds already have allocations to illiquid assets but there is considerable variation in the size of allocations, relative to funds’ total assets, from one fund to the next.
Which of these assets would you consider investing more in
The most popular illiquid asset for LGPS funds was property, in which 80% of the 40 fund representatives participating in the survey said their fund had invested. The lowest allocation to property, as a proportion of a fund’s total portfolio, was 3%, whereas the largest was 40%.
More than half (56%) of respondents said their fund invested in infrastructure, with the mean allocation at 7% of their total assets but the largest allocation at 24%.
Private equity and private debt also featured in funds’ illiquid allocations.
Unsurprisingly, given the government’s instruction to funds to allocate more to infrastructure, 75% of respondents said their fund planned to invest more in the asset class in future, while 53% said their fund planned to up their investment in property.
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The survey revealed that LGPS funds have clear plans to change the way in which they invest in the asset class in future.
Thirty-five per cent of respondents said their fund currently invested in infrastructure equity. This was followed in popularity by infrastructure debt (18%) and then unlevered infrastructure (1%), in which investors buy the whole infrastructure project’s capital structure and gain full control of the assets.
However, the survey revealed that as funds delve deeper into infrastructure, they plan to use more sophisticated means of investing: 43% of respondents said their fund planned to invest in infrastructure debt in future, while 35% had plans for unlevered infrastructure.
Equity remained a popular choice for the future; 35% of respondents said their fund planned to invest this way.
Interest in infrastructure can be traced to a number of benefits: respondents to the survey identified the diversification of their portfolio as the top advantage of infrastructure investing (75%), while income generation (73%) and return generation (68%) were also highly-prized attributes of the asset class. In fact, the mean return that respondents expected from infrastructure investments was 9%: significantly more than traditional, liquid assets.
However, LGPS investors still had a number of concerns about infrastructure. When asked about the drawbacks of infrastructure investing, a lack of suitable opportunities was by far the biggest problem for LGPS funds, with more than half (53%) citing this as a disadvantage.
Respondents were also concerned about the cost of infrastructure investment, which is often higher than that associated with more traditional assets, and the length of time their fund would have to be ‘locked in’ to infrastructure (both cited by 38% of participants). About a third of respondents also said the complexity of infrastructure deals was a barrier to investing.
Some LGPS funds have already made significant in-roads to infrastructure investing.
The Greater Manchester Pension Fund and the London Pension Fund Authority created GLIL, a dedicated investment vehicle for infrastructure, in 2015. The two founding funds invested a total of £500m, and GLIL has invested £45m in train fleets, £60m in green energy assets and £150m in a wind farm. The funds within the northern pool – West Yorkshire, Merseyside and Lancashire – joined GLIL in December 2016 in order to satisfy the government’s pooling requirement, taking the total assets committed to the vehicle to £1.27bn. The vehicle’s owners have expressed an interest in turning GLIL into an infrastructure vehicle for all LGPS funds, although it is not yet known whether more LGPS funds will join it or create another solution.
In March 2017, the Berkshire Pension Fund – which is set to join Lancashire and the LPFA as part of the Local Pensions Partnership pool – purchased a 20% stake in specialist asset manager Gresham House. Gresham House has launched an investment platform for alternatives, on which it will offer funds focusing on housing, infrastructure and ‘innovation’ targeted at the LGPS. Berkshire has provided the cornerstone investment for the first fund and, along with other investors including another LGPS, have invested £150m.
Shift in vehicles
Pooled funds have been the primary vehicle through which LGPS funds have been investing in infrastructure. A pooled fund, in this sense, is a vehicle containing a number of opportunities created by an investment manager. By investing this way, pension funds can access opportunities together that might be prohibitively expensive as individual investors, but this option would not allow an individual pension fund to tailor the opportunities in which it invests to its own needs very closely. Just over a third of respondents to the survey (35%) said they currently took this route.
Only 13% of respondents invested via segregated mandates, in which an asset manager separates the investments of an individual client to tailor them more closely to that pension fund’s requirements. An even smaller proportion of LGPS funds used a ‘fund of one’ product, in which a pension fund is the sole investor in an infrastructure fund run by an investment manager, or other vehicles such as a dedicated infrastructure vehicle owned by the pension fund itself.
However, the survey suggests a shift towards more advanced techniques. Respondents still planned to use traditional pooled funds in future to the same degree as now; one fund officer said this option presented less of an administrative burden than others, and another said that due to the small size of its planned infrastructure allocation, a pooled fund would be the best way to achieve diversification.
A third of respondents, however, said they would invest via segregated mandates in future, hinting at a desire for solutions more tailored to individual pension funds.
Some respondents said they would primarily invest in infrastructure in future via their pool, and so the pool-level strategy would dictate how they go about this.
When asked how infrastructure investing would work within pools, just over half of respondents said their pool group would continue to access infrastructure via traditional pooled funds, albeit with an improved position with asset managers due to the scale they could achieve as a pool rather than as individual clients. They cited convenience, access to a diverse range of infrastructure opportunities and lower fees as the main benefits here.
However, 30% said their pool would use a national infrastructure platform (which does not exclude investing in infrastructure as individual funds or at pool level). These respondents said they expected the national platform, which has not yet been set up, to have a “decent pipeline” of opportunities, “bring together the required expertise” for effective infrastructure investing, and provide the scale necessary to achieve “access to larger opportunities” (see box for national platform plans).
The role of asset managers
With just 8% of respondents saying they would manage infrastructure investments in-house, it was clear from the results that even after pooling is implemented, fund managers would still be part of many LGPS funds’ infrastructure investment operation. However, the survey hinted at a shift towards more management either by LGPS funds themselves, at pool level, or via a national infrastructure platform.
Twenty-eight per cent of respondents expected to outsource the origination and management of infrastructure opportunities to investment managers.
A slightly smaller proportion expected pools to originate and manage infrastructure assets directly themselves, while 8% said fund managers would source infrastructure opportunities for pension funds but pools would take over the ongoing management of these.
Some respondents said their fund could invest in infrastructure via all of these methods at once, while others said their plans were not yet confirmed.
LGC conducted its research during March 2017 with representatives from 40 LGPS funds
Expert comment: Myth or reality? Addressing the challenges of an infrastructure allocation
Do the benefits of investing in infrastructure justify the costs?
Investing in infrastructure may be more costly than liquid markets, because each asset is unique, requires niche research and might need to be actively managed to maximise value. But the costs need to be offset against the potential advantages. Infrastructure assets can carry a premium compared with comparable listed credits. They may also enhance portfolio diversification, offer downside protection, generate predictable cash flows and appeal from a social or environmental perspective.
The ability to assess these trade-offs is important, as investors have different needs and tolerances. These influence where to invest in the capital structure and whether the benefits outweigh the costs.
Should investors be concerned about illiquidity?
Many infrastructure assets are relatively illiquid, do not trade on an exchange, and it may be difficult to find buyers in volatile periods. Nevertheless, there is a subtle relationship between illiquidity and the returns associated with assets that trade infrequently. Illiquidity premia - higher returns than comparable liquid credits - can be a source of competitive advantage, but few investors monitor them.
Assets that generate long-term, predictable income may be particularly attractive to investors using cashflow-driven approaches or seeking assets for liability matching. More certain investment outcomes can outweigh any liquidity concerns. The investor can reap the rewards of illiquidity, with the intention of holding assets to maturity.
Are there enough investment opportunities available?
The UK has set out a national infrastructure pipeline that encompasses £500bn of investment by 2020-21, and McKinsey believes that about $3.3trn of infrastructure investment is needed worldwide in the next 15 years to develop infrastructure networks. The role of the private sector is increasing but bringing projects to fruition is complex. Some investors believe the lack of large and timely opportunities will inhibit portfolio positioning.
Investment outcomes are heavily determined by access to deal flow. To maximise opportunities, it helps to work with experienced managers within carefully defined boundaries. Their contacts form a vital element in originating high quality assets. ‘Infrastructure’ can capture opportunities in utilities, transport, energy and social infrastructure but definitions vary. Setting out the asset types, sectors, credit ratings and tolerance for inflation establish the opportunity set clearly for faster implementation.
Ian Berry, head of infrastructure equity, Aviva Investors
Column sponsored and supplied by Aviva Investors