Benefits and Pensions Monitor
Pension Funds Embracing Infrastructure
By: Felicity Gates
The long-term, stable, yield-dominated return of infrastructure assets make them an ideal candidate for inclusion in pension portfolios. The steady increase in private sector funding sources suggests the timing is right for considering an allocation to the sector. However, there is still a dearth of suitable vehicles for institutional investors seeking to gain access to this beneficial global asset class. Felicity Gates, of RREEF Infrastructure (a part of RREEF, the global real estate and infrastructure investment business of Deutsche Asset Management), discusses some of the characteristics of infrastructure assets.
The rationale for the development of infrastructure as an asset class is embedded firmly in demand and supply relationships. In western economies, demand for the development of transport, power generation, communications, and social infrastructure is driven by growing consumer affluence and increasing consumer awareness and choice. However, supply falls well short of demand due to the combination of limited resources, the scale of required new infrastructure, and the costs needed to replace aging assets.
Governments have addressed the shortfall by either seeking private sector partnerships or privatising public assets to fund or refinance infrastructure projects. An example of this is the recent announcement by Ontario’s public infrastructure renewal ministry that 10 per cent of the budgeted $30 billion in infrastructure projects over the next five years will be funded by partnerships between the public and private sectors.
As private sector participation increases, public sector infrastructure funding is falling.
 Governments appear to be enjoying the ability to fulfil their role of ‘infrastructure service providers’ without having to own or manage the underlying asset. Typically, assets suited to outright sale or privatization are services for which the user is prepared to pay. These assets are known as economic infrastructure and include power, telecommunications, and most transport assets. Typically, the government retains a degree of control through regulatory oversight or contract. Public private sector partnerships (PPPs) are used for social infrastructure projects. These typically include passenger rail, schools, hospitals, and prisons.
Pension funds are increasingly embracing the sector, providing an added boon for governments. Pension funds, like governments, require longevity of the assets and their returns. Their conservative approach to risk places pressure on the managers of infrastructure assets to keep the investor and end-user in mind.
Finally, the public’s general acceptance of the use of retirement savings to ‘invest in the future’ of a community or country has not appeared to damage governments at election time.
All these factors have shaped infrastructure into an available, accessible global asset class that benefits from strong user demand and constrained supply. This imbalance will persist because there are no short-term solutions available to cater for the scale of required infrastructure projects.
Performance Characteristics
Apart from being supported by demand and supply factors, the performance characteristics of infrastructure assets typically include a 10-year minimum lifespan with predictable, sustainable, and high yielding cash flows. Income is usually either government-backed or user-pay which means counter-party risk is low. Also, the significant diversification benefits due to the low or negative correlation of returns with those of other asset classes is well-known and accepted by the investment community.
These characteristics clearly suit long-term institutional investors such as pension funds who are seeking to invest an ever-increasing pool of pension fund savings in good quality, low risk, income oriented investments that are able to match long-term liabilities. In addition, tangible infrastructure assets are easy to describe and easy for investors to relate to, which should help in the education of plan members about the asset class. The social and political benefit that comes with providing support for community and economic development is also easy to explain.
However, achieving the predictable cash flow and low volatility needed by pension funds requires a distinction to be made between ‘mature-stage’ infrastructure assets and ‘development-stage’ projects. This is because established, slow growing economies (where the refinancing of aging assets is a priority) can be a more appropriate investment for most pension funds than fast growing, emergent economies that require new infrastructure development. The key difference is the source of return. For development projects, or projects in emerging markets, return consists mostly of capital growth with a premium for associated risk factors while mature projects are dominated by more stable returns from income.
The success of private sector involvement in infrastructure development and refinancing has been proven in countries such as Australia and Canada.
Australian Market At Mature Stage
Australia’s market is at a mature stage where infrastructure is viewed by investors as a separate asset class. This structure has developed over the last 12 years due to the increase in compulsory pension contributions alongside government action to privatize assets.
Canada’s infrastructure market has similar qualities in terms of the high level of investor familiarity with the asset class, but Canada does not appear to have the range of infrastructure funds that are currently available to Australian investors. Both countries, however, face an imbalance between the amount of money available for investment in the sector and the number of domestic opportunities available.
One solution to this problem is to invest globally. While the United States will soon provide some excellent investment opportunities, we believe the most attractive market for Canadian investors at the moment is Europe. There are more than $300 billion of infrastructure investments currently in the global market with approximately 65 per cent of this value sourced from Europe.
Europe is suffering from a shortfall of private infrastructure private investors compared with the scale of projects required. This is adding to the significant strain on budgets that are struggling to incorporate the requirements of European Union (EU) membership as well as account for increasing Defined Benefit pension obligations caused by Europe’s aging population. Governments are, therefore, seeking private sector participation to help with the refinancing of essential infrastructure assets.
In general, the European regulatory environment for privatisations and trade sales is favourable with different countries at different stages of development. For example, the United Kingdom’s chief success has been incorporating private funding for social infrastructure development through Public Private Partnership arrangements. Since 1992, there have been 400 deals worth £42 billion.
Analysis of the infrastructure markets of 20 European countries shows that the top four in terms of scale, the pressure to refinance, and the maturity of the infrastructure privatization process are the United Kingdom, Italy, Germany, and France. These are also the largest economies in Europe and foreign currency risk is limited to exposure to the Euro and the Pound Sterling.
Specific Opportunities
Specific opportunities in Europe include privatisations and asset sales planned for airports, toll roads, ports, gas, electricity and green energy assets, water, and waste treatment assets as well as desalination plants.
Whilst the UK has completed its utility privatisation program, we are now seeing secondary and tertiary transactions in the sector. The recent sales of UK gas utilities by NGT are current examples of secondary sales.
In Continental Europe, most governments still have ownership interests in their national utility providers but market deregulation will lead to the disposal of these interests in the near term. The Netherlands provides a specific example of this trend as the government is in the process of introducing legislation requiring the separation of ownership of regulated energy distribution networks from the unregulated energy suppliers. This unbundling legislation is likely to lead to a series of privatisations of the network businesses and a round of restructuring and consolidation in both distribution and supply.
The German and Austrian authorities are both in the process of launching programs of public private partnerships in order to finance the development of new roads.
Airport privatisations have recently taken place in Belgium and Bulgaria with further privatisations slated in Budapest, Hungary, Slovakia, Turkey, and France.
As Europe’s investors warm to the idea of infrastructure as an asset class separate from private equity or other alternative investments, the opportunities currently available for astute global investors are attractive. Europe’s infrastructure market provides obvious benefits for Canadian pension funds in terms of risk adjusted returns and portfolio diversification.
Gaining Exposure
There are two main methods for a pension fund to gain an exposure to infrastructure assets:
- direct investment in an infrastructure project
- invest in an unlisted infrastructure fund
We do not believe the bulk of a pension fund’s exposure to infrastructure should be made through listed infrastructure funds because of the market volatility that this type of vehicle imports.
As private sector investment in infrastructure attracts increasing attention, we anticipate a broader range of unlisted infrastructure funds will be made available to Canadian investors. These are likely to be differentiated by their exposure to projects at different development stages and will, therefore, have different compositions of capital versus income return and different risk/return profiles.
In Canada, domestic competition within the sector will place returns under pressure – a situation that can be alleviated by investing in foreign assets. We believe European infrastructure assets provide the best opportunities at the moment and that the announced abolition of the 30 per cent foreign content limit in February’s federal budget could not have come at a more opportune time.
 Felicity Gates is chief investment officer of RREEF Infrastructure, a part of RREEF, the global real estate and infrastructure investment business of Deutsche Asset Management.
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