The UK is facing a growing infrastructure bill. While the political will to attract private capital is strong, actual allocations to the asset class remain low. Mona Dohle looks at what is holding schemes back.
The UK is the first major economy to commit to a zero carbon emission target by 2050, which requires a fundamental change in the way the country produces energy. A laudable, but ambitious project for a cash-strapped nation; after more than a decade of austerity, local authorities struggle to fill their potholes, let alone invest in wind farms.
The funding gap is significant; some £483bn is needed, according to the UK governments’ National Infrastructure Delivery Plan 2016-2021. And with the government unlikely to increase its spending plans, it has set its hopes on private capital, and in particular pension funds, to meet the shortfall.
But the uptake remains slow. Since 2006, UK-unlisted infrastructure funds attracted £50.8bn, according to Prequin, a fraction of the £4.8trn in investable assets held by UK institutional investors. At the same time, almost half of all institutional investment in infrastructure is in renewable energy, highlighting that investors can potentially play a crucial role in the UK’s energy transition. But the average infrastructure allocation among defined benefit (DB) schemes hovers just under the 4% mark while defined contribution (DC) scheme investment in infrastructure is virtually non-existent. What is holding investors back?
DB – IN IT FOR THE LONG RUN?
DB pension schemes have traditionally been the focus for policy-makers looking to attract infrastructure investment and it is easy to see why. Besides sitting on a significant pool of assets, their cash-flow requirements align neatly with the returns offered by investing in sectors such as energy generation, transport and social housing, which promise stable cash-flows and returns uncorrelated to equities and bonds. More than 60% of DB schemes in the UK are closed to future accrual. Almost half of all such schemes aim to achieve their financial targets over a five-to-10-year horizon. Only a small minority, 5%, are planning for more than 20 years, according to Aon’s recent Global Pensions Risk Survey. Consequently, there is now growing focus on managing cash-flows, infrastructure investments are set to play an increasingly important role in that.
Over the past year, DB schemes in the UK have significantly cut their equity exposure and simultaneously doubled their investments in cash-flow matching assets to 20% as of July 2019. Infrastructure accounted for around a third of schemes cash-flow driven investing (CDI) allocations, a 10% year-on-year increase, according to a poll conducted by Fintech provider RiskFirst.
A lot of infrastructure funds essentially buy something, improve it and sell it, but we wanted to get hold of these assets for the long term.
Jonathan Ord, GLIL
More than half continue to access the asset class through funds, while only 19% chose to invest directly, according to Prequin, an alternative asset data provider. But investing through third-party funds has its challenges, says Jonathan Ord, investment director at GLIL. The £1.8bn open-ended infrastructure fund, initially backed by Lancashire County Pension Fund, Merseyside Pension Fund and West Yorkshire Pension Fund, was set up in 2015, prior to the government’s local government pension scheme (LGPS) pooling initiative. “One of the frustrations that we encountered when investing in infrastructure was the shortterm nature of some of the funds that were out there. As a pension fund we are very much long-term investors,” he adds.
“By launching GLIL we were able to design a fund and a way of investing in infrastructure that suited us. A lot of infrastructure funds essentially buy something, improve it and sell it, but we wanted to get hold of these assets for the long term. We focus on the core, low-risk part of the market, rather than the value segment,” Ord said.
The launch of GLIL in 2015 could have influenced the thinking behind the government’s initiative to pool LGPS assets, which was announced in the same year. But four years on, it is still work in progress. In most cases, infrastructure remains the asset class which has not been pooled yet.
The ACCESS pool, for example, is less than 2% invested in infrastructure. London CIV and Border to Coast are due to announce their first infrastructure investments later this year, but there has not yet been a significant uptake in investment in this area.
Meanwhile, accessing infrastructure as an individual scheme has its challenges. Centrica’s £8.5bn DB scheme has a strong focus on liability and cash-flow matching. Infrastructure is seen as one important element of CDI, rather than a separate category in the scheme’s portfolio, says chief investment officer Chetan Ghosh.
“Infrastructure is one of the assets we are sourcing to get that long-dated cash-flow. We are interested in infrastructure assets where we hold the whole asset, things like renewables, biomass, solar and wind have been a big part of our CDI strategy. We see the risk-return and cash-flow generating profiles of these assets as suitable for our goal of having long-term cash-flows to meet pension payments,” he stresses.
At the same time, Ghosh highlights two key challenges to increasing the scheme’s infrastructure exposure: finding assets in the right format and managing their liquidity. As a scheme with a relatively long investment horizon, Centrica invests in assets directly rather than owning them through a private equity structure. Then it comes down to sourcing suitable assets. Bigger is not always better, warns Ghosh. In many cases, there is a risk of overcrowding in assets which might already be on the top-end of the price range. But lack of scale might be an obstacle for consultants. “The question is how much can the fund management industry invest for pension schemes. If that number is quite small, then it does not become commercially attractive for consultants to go and scope out whole industries. If they can’t scale it, they can’t offer it to their whole client base,” Ghosh warns.
ILLIQUID ISSUES
And while the growing importance of CDI can be an opportunity, the fact that many schemes are positioning themselves for the endgame could also be an obstacle. “This is not really an asset you would want to be holding if you were to position yourself for the endgame, say, a move towards a buyout,” Ghosh adds.
While Centrica is far off from considering a buy-out, liquidity remains a concern. “Let’s not forget that we have a lot of liability hedging derivative exposure,” Ghosh says. “To back those derivatives, we need a core amount of liquidity in our portfolio,” he adds. “While it is a fantastic asset in theory, we have the operational challenges as well. If we had no boundaries on liquidity, we would quite happily hold another 5%. If we are not comfortable with illiquidity you might see 0%, any number in between is possible.”
This ties into a broader criticism of pension scheme investment in infrastructure. Trustees could face a potential conflict of interest between that of their members and the investment needs of the nation. LGPS pools, in particular, have been heralded by former Chancellor George Osborne as British wealth funds, similar to the infrastructure-focused A$166bn (£88bn) Australian Future fund. Yet the inconvenient truth is that the assets in British LGPS pools do not belong to the British public, but ultimately to scheme members.
While Unison’s general secretary, Dave Prentis, is open to infrastructure investments in principle, it sees a potential conflict of interest. “Pension funds are supposed to invest for the benefit of fund members and should not be used as a substitute for investment that should be coming from the public purse,” Prentis says.
DC INVESTMENT
The situation is even more complex for DC schemes, where restrictions on costs and regulatory challenges remain a key obstacle to investing. Yet they have the potential to play an increasingly important role in infrastructure investment as their assets are expected to grow to £1.68trn by 2030, according to the Law Commission. As of 2016, about 4% of DC scheme assets were held in alternative investment classes, but only a fraction of that was in infrastructure.
A lack of daily pricing is one obstacle. Many DC schemes operate through third-party platforms which offer daily pricing. However, while DC schemes generally have to comply with higher levels of transparency on pricing. Daniela Silcock, head of policy research at the Pensions Policy Institute, highlights that there is currently no legal impediment for investment platforms to disclose prices daily.
If we had no boundaries on liquidity, we would quite happily hold another 5%.
Chetan Ghosh, Centrica Pension Schemes
Making infrastructure more accessible for DC schemes and retail investors is also on the agenda of the Financial Conduct Authority (FCA). The regulator has launched a consultation eaimed at making illiquid investments and patient capital more accessible to unit-linked funds. The regulator highlighted that the fund industry still had a lot of catching up to do in order to offer more competitive prices to DC workplace pension schemes.
Investing in infrastructure property tends to come with additional costs, such as valuation and solicitor fees as well as stamp duty. While these costs are excluded from the 0.75% charge cap applicable to all DC investments, they will have to be passed on to members. To make matters worse, the government is now considering including these costs in the charge cap, which would make it challenging for DC schemes to invest in illiquid assets.
Silcock argues that the government could play an important role in making infrastructure more attractive for workplace pension schemes. “Clearly set out and impartial, verifiable evidence from an independent body, such as government or trade bodies, that long-term return from illiquid and alternative assets would provide a level of investment income above compensation for any extra costs and charges might go some way to overcoming these challenges,” she adds. While multi asset or diversified growth funds could be a way of circumventing these challenges, Silcock warns that DC schemes might find it hard to convince private equity funds to cater for their needs.
Mark Fawcett, chief investment officer of government-backed DC scheme NEST, argues that infrastructure fund providers should put more effort into catering for the growing DC market. The DC fund has announced more than £1bn of commitments to three private credit funds in September and October alone. Amundi’s global real estate debt, BlackRock’s global infrastructure debt and BNP Paribas AM’s diversified global private credit fund are now included in NEST’s portfolio.
Stephen O’Neill, NEST’s head of private markets, says fund providers should note the growing importance of DC schemes. “We are long-term investors – our youngest member is just 16 and she could be investing with us for more than 50 years.”
Demand for cash-flow assets and longer investment horizons offer room for growth in infrastructure. It is up to the regulator and the fund industry to offer the right vehicles to encourage further investment.
