George Osborne’s call for pension funds to finance up to £20bn in infrastructure projects may trigger renewed interest in this asset class from some of the  UK’s largest pension schemes. The UK government has signed a Memorandum of Understanding with the £11bn Greater Manchester Pension Fund, the £4.1bn London Pension Fund Authority, Hermes GPE and Meridiam Infrastructure, to work with the UK Treasury to develop help facilitate investment in early stage greenfield infrastructure such as railways, roads and energy projects. The National Association of Pension Funds (NAPF) and the Pension Protection Fund have also signed up to discuss how they might become involved with the initiative. The new model will offer lower returns, but is expected to be linked to RPI inflation over a long period. Among the proposals being considered are new ‘regulatory asset base’ agreements under which regulators, investors and infrastructure providers agree a fixed rate of return.

While UK pension schemes, holding £800bn of assets, are keen to secure the sustainable strong returns, index-linked yields and the low correlation with other asset classes that infrastructure is supposed to provide, they have remained wary of investing to date. Alan Rubenstein, PPF chief executive and a former pension fund manager, said that currently most UK pension schemes were too small and did not have enough in-house expertise to allow them to invest efficiently. “There’s a lack of appropriately designed vehicles that would allow access,” he said. While Canadian, Australian and Korean pension funds and sovereign wealth funds buy stakes in UK airports and water companies, UK pension funds’ exposure to the asset class is less than 1%, compared with 8-15% in Australia and Canada. Consultants attribute this to UK pension funds’ risk aversion and dislike of leverage, inexperience in striking such deals, lack of resources to manage large infrastructure assets and the disappointing returns in 2007-09.  The Treasury intends to address this by agreeing to establish a ‘pension infrastructure platform’ to provide the expertise and support needed to engage British funds.

To date, mainly larger UK pension funds (principally local authorities, but some private sector schemes such as BA, Pearson and BT as well) have invested. BT is planning to boost its total infrastructure allocation from £500m to £800m, but this still represents only 2.16 % of the £37bn fund.

Substitute for bonds

Many pension funds have experienced disappointing returns having been sold infrastructure as a bond substitute without understanding the risks associated with leverage, timing and pricing. “Infrastructure is a broad term, encompassing many different types of assets and deal structures. It can be accessed through bonds, private debt or private equity. On the private equity side, if cash-flows are availability-based (and assuming the sovereign counterparty is sound) rather than user-pay, held for the long term and prudently leveraged, then one might argue its position as a bond substitute,” says Vikram Aggarwal, Director, Private Markets at bfinance. “However, in general, infrastructure funds often behave in the opposite way, by holding assets for relatively short time periods, using a lot of leverage which is often in the form of short term borrowings, leaving it vulnerable to re-financing issues and real risk of capital loss.”

Mathias Burghardt, Head of Infrastructure Equity at AXA Private Equity, sees infrastructure funds as a complement, rather than a substitute for bonds, saying that both provide current and steady yield to long-term investors and are significantly more resilient to economic downturns than other asset classes. “They are less exposed to sovereign risk as revenue streams are derived from millions of end users paying for essential services, rather than a limited numbers of public entities. This means it is a natural fit with the long-term liabilities of many pension plans.”

Timing

In the run up to 2007, some infrastructure funds were sold on the basis of over optimistic returns as the rush of money which came into the sector put fund managers under pressure to deploy capital.

Simultaneously, interest rates were low and few foresaw the impending financial crisis, making fund managers more aggressive with their assumptions for EBITDA growth at the asset level. They assumed they would be able to re-finance on similar terms (amount and rate) as at the time of entry, which they used to justify bidding at higher levels.

Aggarwal says: “Obviously, in 2008-09, we felt the full force of the financial crisis which also showed that some user-pay assets in certain sectors were actually much more correlated to the wider economy than first perceived, also banks were not willing to lend as much as  previously and what they did lend was at a higher cost which impacted the price of assets.

“However, infrastructure is not homogeneous and so there were very wide variations in the scale of capital value decline from peak, depending on which assets and sectors you were exposed to. An obvious lesson to learn should be to first understand what you are investing in and in particular the risks attached to the cash-flow (volatility and security) and to take a closer look at the capital structures, such as whether it is vulnerable to refinancing issues.”

One of the fastest growing areas in the private equity space is the secondary market, boosted by banks and other institutional investors seeking to offload assets in the wake of the financial crisis. Heiko Schupp, Head of European infrastructure at Pantheon Ventures, says that Pantheon Ventures Global Infrastructure Fof, which targets mid size managers, is roughly 40% invested in secondaries. “We estimate the size of the infrastructure secondaries market to be $5-8bn, based on current capital raised. This presents a tremendous opportunity for us and our clients to access older vintages and to put capital to work quickly and reduce impacts of the J-curve.”

The rise of these secondary buyers has served to turn a very illiquid asset class into a much more tradeable investment arena.  While recent economic turmoil has served to widen discounts slightly and delayed some deals, market experts forecast a wave of large transactions involving distressed companies in 2012.

Fees

Preqin reported in November that quarterly monitoring fees, as a percentage of a company’s earnings before EBITDA, had climbed steadily since the crisis in every category of deal size. Even if investors do not pay for monitoring, there are other costs such as termination fees, fees for one-off transactions arranged by the PE fund, debt refinancing and asset sales. Elsewhere, however, there is downward pressure on fees with 1,728 groups worldwide competing to raise a combined $706bn in capital, according to Preqin. EQT, BC Partners, Cinven and Permira are offering 5-10% ‘early bird’ discounts to investors who commit early.

Despite the UK Government’s drive to attract pension fund support, what investors require above all is a steady stream of appropriately designed and attractively priced vehicles facilitating access, together with political and regulatory certainty for the duration.

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