Ever since George Osborne’s 2011 autumn address, UK infrastructure and how to fund it has been the plat du jour for Trustees and their advisors. A day doesn’t go by without some governmental entity reminding us all that the key to the UK’s, neigh the world’s, salvation is somehow intrinsically linked to getting institutional investors to provide the long term financing that banks can no longer provide.
Easier said than done.
Leaving aside the notion that this is the answer to recovery, and dare I say, growth, for economists to fight over; infrastructure, by virtue of its general characteristics, should be a natural fit for pension schemes.
“At CPPIB, you have to remember that we’re a long-term investor. And we’re investing in order to fund liabilities that are multigenerational in nature… And when you think about that, and then you compare it to the infrastructure asset class, there’s a great alignment for us in investing in infrastructure”
– Mark Wiseman, President and CEO of the Canada Pension Plan Investment Board
But why have UK pension schemes, for the most part, shunned the asset class?
There are a number of factors at play here.
Up until the financial crisis, the only way UK pension schemes could really access infrastructure was via a project’s equity (as banks usually provided the senior debt piece). This structure was more akin to private equity, with comparable leverage and fees to boot, and the financial engineering of the underlying cashflows reduced the appeal of the asset class for many Trustees. It also represented a potential misalignment of interests as fund managers would usually sell their holdings at the end of the fund’s life to meet target IRRs… a pension scheme would have probably preferred holding the equity indefinitely (or until the project ended).
Fast forward to 2012/3 and asset managers are adapting – with many new products/funds coming to market – including infrastructure debt which seems, for the time being, to be the most interest to pension schemes.
However, the majority of these target the entire infrastructure spectrum, which is vast to say the least. This ranges from core to social infrastructure; and can take the form of secondary loans purchased from banks to greenfield projects, which involves construction or refurbishment risk. Each of these brings its own idiosyncratic risk/return profile, and requires a certain level of expertise to assess and manage. Considering the likely size an allocation will have relative to the entire portfolio, and limited governance budgets, can you really blame Trustees for seeking lower hanging fruit elsewhere?
So was George Osborne’s statement calling on UK pension schemes to simply replace banks a little misguided? Possibly, as it made the somewhat heroic assumption that the majority of UK schemes have the internal expertise and governance in place to do so – this is sadly not the case. Granted some of the larger Australian and Canadian schemes are cornerstone investors on many an infrastructure project (including some in the UK), but they’ve been active in the market for decades and have a great track record, and in-house expertise.
So what’s the solution? Truth is I don’t know. But whatever it is, it won’t involve a paradigm shift in the way infrastructure is funded, in the short/medium term anyway. UK pension schemes are ill equipped to assess and even take on construction risk (as it is currently structured) and do not have the in-house capabilities to do so (yet).
So until they do, why not allow pension schemes to take on the risk they are designed to take on, and let banks take on the risk they have the expertise to deal with?
Banks have all the in-house expertise to fund construction risk. They’ve been doing it for a very long time and, whatever you have to say about them, they tend to do this pretty well.
Problem is they can no longer hold the debt to maturity as Basel III has made this capital intensive. Pension schemes, on the other hand, positively adore long dated, secured, contractual cashflows, but don’t want construction risk….
Am I the only one connecting the dots?
In a series of blogs, I will be exploring a number of ideas/thoughts/musings aimed at (trying) to solve the UK infrastructure quandary, as well as highlighting some of the options available for pension schemes wanting exposure to the asset class.
Who knows, maybe one of these strikes a chord somewhere.