Investing in infrastructure has been a source of much debate within the LGPS in recent years, although it remains a relatively small proportion of invested assets. Everyone seems to like infrastructure investment as a concept. However, we may all have different perceptions of what it can offer.
At the risk of over-generalisation, LGPS officers and their advisers see infrastructure investment as a diversified source of long-term return that has low short-term correlation to equity markets and the potential for sustainable inflation linked income generation. Fund managers see infrastructure investment as a diversified source of long-term revenue that has low short-term correlation with their liquid asset products and the potential for higher sustainable management fees.
Politicians and central government see infrastructure investment by pension funds as a magic wand enabling desirable capital projects in the UK to be financed at a time of continuing austerity with no burden on taxpayers. Can infrastructure possibly achieve all of these objectives at the same time?
One reason infrastructure is able to appeal to such a wide range of desires is that it is a term used to describe investments with a very wide range of characteristics. We all have an intuitive understanding of what infrastructure is – physical assets that form the plumbing of a modern society. These assets can be essential for the workings of an economy, such as transport systems, energy transmission and telecommunications networks, or for social interaction, such as hospitals, schools and housing. The key, though, is that the asset owner is able to charge for their use, so that the capital investment generates a long-term return that is linked to economic activity.
While infrastructure assets share these common features, the way they are packaged for investment purposes and the underlying risks they represent vary enormously. These risks may be inherent in the asset (for example initial construction costs, future usage, operating costs or pricing power), the contract structure (for example whether or not inflation linkage is contractual, the long-term financial strength of the contracting party or the dependability of a regulatory framework) or the financial arrangements (for example the leverage applied to the income stream). Each infrastructure prospect must therefore be considered in context, balancing the type and scale of the potential risks against the type and scale of the potential returns. From a UK pension fund viewpoint, it is important at the outset to identify what role infrastructure is expected to play within the overall fund.
The primary purpose may be to mitigate liability risks, particularly in terms of UK inflation over decades. If this is the reason for allocating to infrastructure the types of project that will be suitable are likely to have distinctive characteristics, such as predominantly UK based assets with high levels of contractual inflation linkage, high levels of government or quasigovernment patronage, very long contract lives and low levels of leverage. The assets will be illiquid, but they are otherwise very low risk and therefore offer low real returns – although they are still attractive relative to long-dated index linked gilts offering no real return at all. By contrast, the primary purpose could be to diversify sources of return, by which we usually mean taking money out of equities without diluting returns too much. In this case the low return profile of the risk mitigating assets will be unattractive and pension funds will be looking to generate higher returns by taking risks elsewhere.
The characteristics that will appeal may include industry and geographical diversification, higher levels of leverage and greater sensitivity to economic activity. It is also likely that the asset ownership will be for shorter periods, with more ‘terminal value risk’ – the need to sell the asset to another owner after a defined period.
Historically the fund management industry has been more interested in providing return generating infrastructure products. A cynic might argue that this is because higher prospective returns enable them to charge higher fees. However, it also reflects the demands of international investors more generally who have been seeking return generation more than liability risk mitigation. As UK pension funds become more interested in infrastructure as a risk mitigation tool I would expect more products to be created to meet this demand. The continuing efforts of a number of large UK pension funds to create a more suitable vehicle through the Pension Infrastructure Partnership are to be applauded.
And HMG? The scale of infrastructure investment required throughout the developed world is daunting, even excluding high profile projects such as HS2. It is therefore not surprising that any government should want to tap pension fund investment to help carry the burden. The problem is that the LGPS may not want to invest in the projects HMG wants it to finance.
If we are buying risk mitigating assets we don’t want construction risk. If we are buying return generating assets we want geographical diversification away from the UK. The return hurdle we need to jump to justify taking construction risk in the UK may therefore be higher than HMG expects.
John Harrison is a senior adviser with AllenbridgeEpic and independent adviser to four LGPS funds. This article was originally published in Issue 2 of Room151 Quarterly magazine.