If you want a trophy asset, you have to pay

Pension funds need to invest for inflation-linked returns in relatively low-risk assets and governments need a source of funding for infrastructure development. Some governments have made the connection.

Last year, George Osborne, the UK chancellor, called for UK pension funds to invest in UK infrastructure projects and they appear to have heeded his words.

“There’s been a lot of pressure,” says Pete Drewienkiewicz, head of manager research at consultancy Redington. “The government’s very keen to see increased interest in the area, but it would be good for them to consider what pension funds are really looking for.”

The reality, inevitably, is more complex than pension funds simply doing as they are told. Pension investment in infrastructure has been rising for at least the past four years, according to an annual survey of allocations to alternatives by consultancy Towers Watson. However, in that time, the sector has experienced similar tribulations to the rest of the world.

“The political angle has only been there for the past three or four months,” says Duncan Hale, senior investment consultant at Towers Watson.

Prior to the financial crisis, infrastructure managers were able to offer substantial returns based partly on leveraging their investments with easily available debt. When the crisis hit, they were unable to meet client expectations and in some cases aroused ire because of their pricing structure, which was based on the private equity pricing structure of a 2 per cent management fee and a 20 per cent performance fee. “Fees have not always served to best align the interests of managers and investors,” says Mr Drewienkiewicz.

In the aftermath of the crisis, investors are more discriminating about where they invest, both in terms of assets and terms agreed with fund managers.

Managers have started to lower their fees and offer discounts for larger allocations, says Elliot Bradbrook, who manages infrastructure data for Preqin, an alternative investment specialist.

Performance fees are still standard, but there is more of a general understanding that performance can be hard to measure during the lifecycle of an infrastructure asset. Mr Drewienkiewicz emphasises the importance of “fully understanding how assets are being valued”, and ideally “only paying a performance fee when the assets are fully transferred [sold by the fund]”.

Infrastructure investments can be broadly divided into two categories, core and opportunistic. Core refers to mature assets that are already in use so their expected cash flow can be reliably assessed. Examples of this might include a toll road in Germany or a train service between a city and its main airport.

The alternative is funding greenfield developments. While the latter has attractive capital growth potential, it is less likely to offer the desired income stream in the short term. It is also likely to be in developing countries, where there are perceived to be higher political and regulatory risks.

As a result, many pension investors, particularly where mature defined benefit schemes are involved, are looking to core assets for their infrastructure allocations, and this is pushing prices up. “If you want to get the trophy asset, you have to pay up,” says Mr Hale. By trophy asset, he means one that is fully functioning and yielding a predictable, index-linked, income stream.

Because many pension investors in developed markets are looking to infrastructure assets to offset their liabilities, they are likely to look mostly at their domestic markets to avoid adding currency risk to their calculations.

There is one exception to the trend of focusing on core infrastructure, which is also the exception to the rule that infrastructure funds tend to be highly diversified.

Energy is the only area funds are likely to specialise in, and the particular sub-sector they are most likely to focus on is sustainable energy.

However, because the concept is relatively new, the relevant assets are likely to be in the process of development. Different geographic regions are at different stages, both in terms of the pools of capital available and in terms of the assets available for investment.

“Europe is the centre of the market globally,” says Mr Bradbrook. North America presents a mixed picture – Canada has an established tradition of pension funds investing in infrastructure, but the US market is just at the beginning.

Earlier this month, Calstrs, the Californian State Teachers Retirement fund, announced a $500m mandate to Australian infrastructure manager IFM, which it described as “one of the largest single US fund management commitments made in infrastructure”.

In Asia, growing pools of capital are forming the exception to the general rule of a focus on core infrastructure, as investors look to support development within their domestic markets. Australian investors are more likely to look abroad, since the market there is possibly the most mature, as its pension funds (known as superannuation funds) have been investing in infrastructure for some time. “In Australia and Canada, lots of quality assets are already owned [by investors],” says Mr Hale at Towers Watson.

Despite the challenges, pension funds are likely to continue their interest in infrastructure investing for reasons laid out clearly by Harry Keiley, chairman of the Calstrs investment committee.

“What the recent economic crisis demonstrated was the need for greater diversification in our investment portfolio, in areas that would also serve as a hedge against inflation. This type of investment aligns our goals as patient long-term investors with both the jobs generation and infrastructure improvement our economy needs.”

This reasoning must be music to a government’s ears.