The practicalities of infrastructure investment were discussed at a roundtable event sponsored by Hermes Investment Management. Rachel Dalton reports
By April 2018, Local Government Pension Scheme pools must ‘go live’. Most groups of funds are working towards bringing their traditional assets into their pools first.
The government also requires LGPS funds to allocate more to infrastructure assets, although it has not set a minimum amount. These investments will be the next challenge for pools.
Officers and councillors took part in an LGC Investment roundtable in March, sponsored by Hermes Investment Management, to discuss the practicalities of infrastructure investing.
Fiona Miller, deputy s151 officer, Cumbria CC
Anthony Parnell, treasury pensions and investments manager, Carmarthenshire CC
Philip Hebson, senior adviser, Allenbridge Epic
Denise Le Gal, chair of Surrey Pension Fund committee (chair)
Mark Miller, head of institutional business, Hermes
Peter Hofbauer, head of Hermes Infrastructure, Hermes
Duncan Whitfield, director of finance, Southwark LBC
Doug McMurdo, chair of pension fund committee, Bedford BC
Denise Le Gal (Con), chair of the Surrey Pension Fund committee and of the debate, asked Peter Hofbauer, head of infrastructure at Hermes, to outline the methods of infrastructure investing.
Mr Hofbauer said as the infrastructure market has matured, the options for accessing the asset class have multiplied.
“The access models that have prevailed historically emerged from the private equity market,” he said. This meant funds were co-mingled, meaning different investors’ capital was blended together in the fund, and closed-end, where managers raised a fixed amount of capital and then closed the fund to further investors.”
There are more options now, Mr Hofbauer said. Infrastructure funds offer investors segregated accounts, in which their capital is treated separately, and co-investments, in which investors purchase stakes in underlying companies alongside managers as a partnership. Some investors such as large Canadian funds have made the leap to direct investment.
Cllr Le Gal asked Mr Hofbauer whether LGPS funds would be able to find opportunities in a “global and mature market” where there was “no shortage of capital”.
Mr Hofbauer said having capital was not the only requirement to access the market.
Fiona Miller, deputy s151 officer at Cumbria CC and leader of the cross-pool infrastructure working group, agreed. “We’ve had the chief investment officers of the big Canadian, Australian and Dutch pension funds come to talk to us. They were saying this isn’t about capital; if you want to be a serious player in this market, this is about being a credible investor,” said Ms Miller.
“That means one, you’ve got the capital, but two, you’ve got the governance structures that allow you to make and close deals fast.”
Ms Miller said the overseas funds’ experience of infrastructure could provide lessons for UK funds, particularly on the question of building in-house infrastructure teams.
“We were saying, ‘should we build a 200-people strong asset team?’. They were saying, ‘we built it like that because at the time there was no access to partnerships, there were no co-investment structures, so we built what we needed; you are in a different market’,” Ms Miller said.
She added that building an internal team to manage infrastructure could lead to funds carrying “a lot of fixed costs” which might mean “investing in deals that you may [otherwise] have pulled out of”.
Cllr Le Gal asked Ms Miller whether the cross-pool working group believed the LGPS should have more than one point of contact for infrastructure investment.
There has already been discussion within the scheme about how to tackle this. Funds have mooted investing in infrastructure as individual pools; creating a national platform for infrastructure that all pools will share; or the possibility of all pools joining an existing infrastructure platform or vehicle. The Greater Manchester fund and the London Pension Fund Authority created their own infrastructure investment vehicle in 2015 and have invited other funds to use it to fulfil the requirements.
Another possibility would be for all LGPS funds to join the Pension Infrastructure Platform, set up through a memorandum of understanding between the government and the Pensions and Lifetime Savings Association in 2011. It has a number of public and private sector pension fund investors.
Ms Miller explained the current thinking was to create a new infrastructure platform for the LGPS, adding the proviso this was not a plan that had been approved yet by politicians.
“The LGPS is not a big player in this market because there are 89 points of contact, so the thinking is each pool will be a partner in some sort of national construct and the pools will have delegated power from their funds,” said Ms Miller.
“So for Border to Coast [in which the Cumbria fund sits], we will have an infrastructure sub-fund. One of the managers in that sub-fund may well be the national platform, so the infrastructure manager will have full delegated power to contract with that national platform. [Border to Coast] will own a share in the national platform, then you will contract on a deal-by-deal basis.”
A key consideration was the variance between LGPS funds in experience in infrastructure investing and the resource to put into deals, Ms Miller said.
“There needs to be some way where those pools that are going to be all externally managed can engage with the national platform without giving resource to the platforms, so we’re looking at some sort of two-share option,” she said.
Anthony Parnell, treasury, pensions and investments manager at Carmarthenshire CC, believed a national platform would be useful to the Welsh pool. “Less than 1% of our asset allocation is in infrastructure, due to the size of our funds and because we don’t have internal management,” he said.
He added pooling will make possible the Welsh funds’ commitment to an initial infrastructure allocation of 5%.
Phillip Hebson, senior adviser at Allenbridge Epic, asked whether funds felt they had been “coerced” into infrastructure investing but Mr Parnell said the Welsh funds would invest willingly.
Doug McMurdo (Ind), chair of the Bedfordshire Pension Fund committee, agreed funds have a genuine appetite for infrastructure: “If the return’s right, then we’ll do it.”
Cllr Le Gal added the Treasury “did eventually acknowledge” funds could not be forced to invest in any particular asset, and that the infrastructure requirement could not be limited to UK assets.
Ms Miller agreed on the importance of geographical diversification. “Border to Coast’s allocation will be to global infrastructure and then the national platform will have a manager on it providing access to the UK,” she explained.
Mr Hofbauer said diversification was important across more aspects than geography.
“One of the things that makes a very successful infrastructure programme is having a very clear idea of your investment objectives; defining what you’re seeking, which can look at geographical region, but [also] the nature, scale and type of projects and making sure they satisfy fiduciary obligations,” he said.
Ms Miller said aside from the risk of investing too heavily in one geography, funds should consider currency risk. “If you go global, you’ve also got currency to price in,” she said.
“You have currency from local to the fund currency, and then back again, so you can get a double currency whammy if you’re not careful.”
Mr Hebson asked which stage during an infrastructure project presented the best investment opportunity: “A lot of these deals are second- or third-generation ownerships. You’re buying another investor out; it’s not a new, greenfield-type deal.”
Cllr Le Gal agreed the construction phase of an infrastructure asset – generally seen as the having the highest risks and rewards – was not the only phase of interest.
“There are some good opportunities that have arisen in the secondary or tertiary environment in the last five years. You’re getting better value on secondary than primary deals,” she said.
Mark Miller, head of institutional business at Hermes, said investors used infrastructure for different purposes and this would have some bearing on their decision about investing in UK or globally. “[Investors are] saying this could be a growth asset. Others are thinking about this as a sort of alternative matching asset, when you would be looking for an asset that had a high cash yield, some growth income and strong inflation-proofing. That tips you more toward the UK,” Mr Miller said.
Cllr McMurdo asked Mr Miller how he would define infrastructure in the first place.
“In some funds, they see social housing as infrastructure,” said Cllr McMurdo. Cllr Le Gal added the inclusion or otherwise of social housing in the definition had been “a big sticking point with the Treasury”.
Mr Hofbauer said Hermes defined infrastructure as “assets which provide essential services to facilitate a functioning community”.
Ms Miller said: “The government understands social housing as infrastructure. It’s easy for us to have two definitions that we work to; one with the industry and one with the government. So social housing is in the definition that we all agreed in the pooling structures. Several of the funds have got social housing; they badge it as property. It’s not that we’re not investing in social housing, it’s just that this allows us a language that people understand.”
Ms Miller moved the discussion on to whether open- or closed-ended infrastructure funds worked best for LGPS investors. She said many officers on the cross-pool group felt open-ended assets “sit better with the LGPS”.
Mr Hofbauer said: “We have had some clients who had their own liquidity constraints and others that were open to longer duration. We’ve gone for a 20-year fund, which is not open-ended because, ultimately, if you’re acting on someone’s behalf there needs to be some accountability in terms of the asset that needs to be realised. Some of our clients, through segregated accounts, have direct ownership of the asset and can hold it in perpetuity.”
Mr Hebson moved on to the need to balance different funds’ needs for infrastructure within a pool. He noted the London Collective Investment Vehicle had 33 member funds with varying degrees of experience and interest in infrastructure.
He asked Duncan Whitfield, director of finance at Southwark LBC, whether funds in the CIV with no infrastructure wanted to allocate to it or if they would have to be “dragged kicking and screaming to the table”.
Mr Whitfield said he felt the vehicle was focusing on more pressing challenges for the time being. For instance, he said, the CIV had faced a challenge when finding a way to incorporate member boroughs’ investments in passive equities within life funds run by LGIM and BlackRock, because life funds cannot be held in authorised contractual schemes, which the CIV is. Next, the CIV must make fixed income available to member funds.
From Southwark’s perspective, Mr Whitfield said the line between infrastructure and property could blur and this could be problematic.
“We’re the biggest property investor proportionally [among London borough funds]; 20% of our fund is in property. That’s direct property for the most part and we don’t want anyone else playing with that. So if that’s infrastructure, please don’t touch it,” he said.
Cllr Le Gal asked the participants what types of infrastructure assets were of interest to their funds.
Cllr McMurdo expressed an interest in “ports, water and gas”. Ms Miller said Cumbria based its infrastructure investment decisions on elements other than sector, such as whether the asset was debt or equity, or if it relied on favourable tax regimes subject to political change. She added, however, it was important to avoid allocating to a single industry.
Mr Hofbauer said: “We’re sector-agnostic, but what we do from a portfolio construction perspective is [impose] limits, whether it’s by sector, geography or currency, so we don’t have all our eggs in one basket.”
Mr Hebson said investors should beware the risk of infrastructure managers’ bias towards particular industries.
“Certain managers have very specific expertise in niche areas. There’s a danger of having too much exposure in [one] area,” he said.
Mr Hofbauer said this had been a historic problem.
“Pre-financial crisis, there were a lot of managers that simply said, ‘it’s infrastructure’, and a lot of pension funds invested because they thought it was safe and there was significant strategy-drift because it wasn’t properly defined,” he explained.
“When people realised [infrastructure] is not a homogenous asset class, managers said, ‘we will define by sector, so we can’t have strategy-drift’, but that doesn’t deal with the diversification issue. Now [the industry] is saying it’s about investment objectives.”
Mr Hebson raised the issue of individual funds’ role in choosing to allocate to a particular infrastructure asset via their pools.
“It’s crucial for funds to get their heads around their roles and responsibilities, which includes asset allocation. It will be important to have genuinely independent advisers who have only got the interest of the fund at heart,” he said.
Ms Miller said the Border to Coast pool had already met with all of its constituent funds’ advisers to ask their opinion of the pool’s asset allocation template.
Mr Whitfield said in his experience advisors’ understanding of infrastructure had been “very limited”, although he conceded this might have been because of a lack of suitable products on the market.
Returning to access methods, Hermes’ Mr Miller said he expected to see a mixture: “It could be we’re talking about some fund investments for some pools; it could be that we’re talking about separate account-type managed solutions and co-investment platforms. It’s going to be quite complex,” he said.
“That does lead to a lot more cross-pool collaboration. We saw this [among corporate pension schemes] where a lot of informal working partnerships and clubs formed naturally. What we’re seeing in the LGPS is that occurring both naturally and top-down.”
Cllr Le Gal drew the discussion to a close and summarised: “What’s really important is carrying on with the cross-pool working group and staying engaged with the investment managers and independent consultants.
“This will be a matter of trust for a lot of funds. In order to make it work, we need to have people with knowledge. Hopefully we can continue that as we transition.”
Expert comment: Brexit uncertainties and UK infrastructure
With proven abilities to generate long-term, predictable, inflation-linked cash flows, as well as providing attractive real rates of return, infrastructure is understandably attractive to pension funds looking to match liabilities.
The UK, with its long history of public infrastructure funded by private investment, will remain a key jurisdiction for institutional investment.
First, there is a deep and broad range of investment opportunities driven by challenges such as public sector fiscal constraints, decarbonisation policies, security of energy supply, urbanisation and population growth and the productivity gap. Second are the nation’s long-standing, transparent and mature regulatory regimes and the predictability, fairness and independence of its legal system.
While the domestic long-term impact of Brexit is still unclear, the visibility of investable assets, as well as the certainty of the overall investment environment, should help the UK maintain its position as the second largest global OECD market for infrastructure transactions in the long run.
Brexit uncertainties could provide investors in UK infrastructure with considerable upside opportunities in the short term. Reduced appetite from foreign investors may lead to reduced competition, which in turn could allow for higher return premia. This could particularly be the case for large-scale core assets. Ultimately, investors prepared to invest in the UK through this period have the potential to benefit the most over the next couple of years.
To meet investor demand and to address the investment opportunity set, Hermes Infrastructure has launched its second direct infrastructure investment fund, HIF II, which is targeting £1bn to make direct equity investments across core and value added investment strategies. Both pre- and post-Brexit, we expect to deploy £300m-£350m of direct new investment each year (consistent with our historic annual rate) in a number of high quality UK infrastructure assets.
Column sponsored and supplied by Hermes Investment Management
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