Escaping the Establishment

From aiCIO Europe's April issue: Investors are forging ahead in infrastructure—but the innovative ones are going it alone. Elizabeth Pfeuti reports.

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Governments are asking for it. Their coffers can’t pay for it. So why are traditional infrastructure funds still lacking institutional investor capital?

It’s not that their return profiles are unappealing. Asset owner timeframes—by their very definition long-term—align miraculously well with the inflation-linked returns offered by toll roads, airports, and their ilk. Add in the oft-mentioned illiquidity premium and the theory seems almost too good to be true.

So why, then, was only $12.8 billion raised by European unlisted infrastructure funds last year?

The 19 funds that hawked their wares around the continent’s institutional investors in 2013 raised a flat average of just $510 million each, according to data monitor Preqin. If investors are really committed to the long-term, uncorrelated asset classes and steady cash flow over shoot-out-the-lights performance, why are these funds doing so badly?

One word: Control.

“In a fund structure, a fund manager comes with a product, which doesn’t necessarily have your objectives as its objectives,” says Richard Moon, head of alternatives at UK pension manager Railpen. “Infrastructure funds have wide remits in their risk profile and will encompass various projects and sectors. With this mix of risk profiles, it is not clear for each specific investor what their risk profile will be.”

For investors who have become increasingly aware of their risk profile, there are just too many opportunities to fall foul of within an infrastructure fund. Why work to take advantage of the volatility in your equity portfolio and match up your liabilities to your fixed income streams if you are left at the whim of your fund manager and fellow investors when picking your real assets?

“Going through a fund, you may end up with risks to which you already have exposure in another part of your portfolio. You don’t get a choice,” says Gavin Hill, CIO of the telent Pension Fund. “In a fund, you may end up getting exposure to one specific type of asset. Or you may have exposure through equity in one project in one fund and debt in another—you don’t want that same exposure.”

The UK’s telent pension is one of a growing number of investors eschewing the traditional fund structure and ploughing a new path. Using Allianz Global Investors’ infrastructure debt platform, the fund invested £175 million to design, construct, operate, and maintain part of the Scottish road network.

“We wanted some sort of control,” says Hill, “and when you go direct, you can say: ‘We don’t want that deal.’ And you don’t have to have it; circumstances can change, other asset classes can change. There might be a rush of investors into or out of a certain asset class, which means spreads can change. You need a premium to take these direct and illiquid investments on—and you might find out this premium is no longer there, so you don’t want to be there either.”

Railpen, along with a clutch of other UK investors, signed up to the Pension Infrastructure Platform (PIP) in 2012. Its aim was to provide a platform similar to that created by Allianz Global Investors and to bring investors together for specific projects.

The PIP has lost half of the initial investors who committed to the project, but its foundation remains sound, says Moon. “The PIP is a collaboration of a group of similar investors who have come together with similar goals. There is a level of control over the platform, and the money starts to work immediately.”

Even outside of the PIP, Railpen, which has not made an infrastructure investment for more than five years, might consider a co-investment agreement with another large investor, or establish a relationship with a manger or fund and manage the control issue that way.

This push isn’t just a UK phenomenon, either. In Denmark, there has been a similar move towards collaboration.

“The Copenhagen Infrastructure Partners’ first fund was set up with PensionDanmark as the only investor, but this year they’re raising a second fund, and it’s hoping to form a club of four or five Danish pension funds,” says Claus Stampe, CIO of PensionDanmark. The target is to raise DKK 10 billion. Rather than function as a fund per se, the partners form a club and decide on where to invest and all the details that go with it.

One of the European funds that has been striking out alone is Dutch pension manager PGGM—a pioneer in direct investing. With more than €140 billion in institutional assets, its annual allocation to infrastructure dwarfs the amounts raised by fund managers on the continent each year.

But it wasn’t always so.

“PGGM started investing in infrastructure in 2005,” says Henk Huizing, head of its infrastructure team. “We only had one manager and issued a mandate for infrastructure equity investment. It was one of the few options available, and there were very few co-investment options.”

“We then grew the team to three people in September 2008—when I joined—and carried out analysis on the funds’ performance,” he continues. “The results convinced us to do things differently.”

The new portfolio performs very differently to the old one, Huzing says, as does the team. It is now 15-strong and has much better experience. “From the first of January 2009, we focused fully on going direct, except in emerging markets where there is not the scale or possibility to carry out adequate due diligence ourselves, and renewable energy projects, which are very small. Our deal hurdle rate is €100 million.”

And they are not short on deals coming their way. The PGGM team is now offered between 250 and 300 direct infrastructure projects a year, but many are discarded by the in-house team. “They may be the wrong size, in the wrong area, or with the wrong risk/return profile,” says Huizing. “We do preliminary due diligence on the half that does fit what we need, and of that around 25 get extended due diligence. Of those, for around half we make an investment proposal.”

So what happened in 2008 to convince one of the largest institutional investors in Europe to avoid commingled funds? A major issue was that they couldn’t control what was going in there.

“The investor does not have influence over portfolio construction,” says Huizing. “The investor can choose up to a point—whether they opt for energy pipelines or wind farms, for example—but there is no control after that, and this is an important governance concern. Investors have no control over the governance protocols involved in the assets or projects. They cannot see what is going on there.”

North of the Netherlands, few of the Danish investors who started out using funds have remained wedded to them.

“We prefer to do it directly to keep the costs down and obtain the risk profile we’re seeking,” says Stampe. “There’s no leverage, no construction risk, and the investments have to be able to deliver stable cash flows.”

Stampe negotiated directly with domestic power company DONG Energy and was able to sign a fixed-price contract, which meant all the construction risk of building an offshore wind farm miles into the North Sea fell to the supplier.

This role of direct investor and negotiator of terms used to be the reserve of banks, but as the financial crisis continues to cast ripples in the form of capital requirements, these providers of funding have shied away.

“Banks used to be able to lend for the long term with very narrow margins,” says telent’s Hill. “Now they have liquidity and capital requirements, and so it is impossible for them to fund at those spreads. But borrowers don’t have to choose between one or another, there is scope for both types of investors to be involved in the same deal.”

And many of these banks do not want to leave the sector behind completely.

“We worked with a mezzanine debt provider, which ensured Pension Insurance Corporation’s [PIC’s] debt was more senior, and therefore safer,” says Allen Twyning, investment manager at PIC. The specialist pension insurer has taken on a range of direct investments, including two social housing bonds in north-west England. “We have worked with different banks that are willing to lend, it doesn’t have to be long-term. And we can use their due diligence teams to help carry out our analysis.”

A key aspect of the new method of infrastructure investing is, as is so often the case, fee relief. Co-investing partners share the burden of the work and, in return, share the benefits of the deal—all while cutting out the fee-taking middleman.

“In an infrastructure fund, there is usually a management fee of around 1.5%, with a hurdle rate of 20%, this means you’re paying between 2.5% to 3% annually,” says PGGM’s Huizing. “It’s the same price structure as private equity, but where that asset class has gross returns of around 20%, infrastructure has gross returns of between 10% to 13%. There is a significant leakage of gross returns to fees.”

Last year, some 41% of global funds targeted internal rate-of-returns (IRR) of 12% or less, Preqin data shows, and after the 2005 vintage, the median net IRR for infrastructure funds since inception has not broken above 10%.

“With a fund, do you want to be paying relatively expensive fees for low-risk beta assets?” asks Railpen’s Moon. “These fees are difficult to justify and need to be considered.”

Liquidity issues also change when asset owners set up infrastructure outside the traditional fund approach. As a sole investor in a direct investment, pensions take on the illiquidity themselves; the yield, theoretically, should compensate for that. In a fund, this liquidity risk is shared amongst all participants—but it also means you have less control and lower returns.

“Where an asset is illiquid, a fund can add liquidity,” says Hill, “but if we were in a position where we needed liquidity, we would have more control over selling the asset. It wouldn’t just be a case of joining the queue to get out.” Investors may have tie-in periods, but there is nothing much to be done if someone really wants out. Assets have to be sold, or the remaining investors must pitch in to cover the shortfall. And there is no choice of who your bed partner in a fund might be.

“Fund structures have challenges regarding liquidity,” says Twyning. “Some investors may want to get out sooner than others. You get a liquidity premium for buy and hold assets, net of fees. That liquidity premium can be reduced and you have to compare these debt instruments with corporate bonds.”

Getting out is one thing, but getting into a fund can also be frustrating. Initial investors must wait until the fund manager has raised enough capital to start buying assets… and then find the right one to buy. If you are in a pooled structure, the money is only drawn down when a deal is being made. Asset owners must thus leave the money liquid until that point—and cash and/or money market funds are not even beating inflation right now.

“Two years ago, there was a lot of talk about banks selling off loan assets and several funds starting raising capital,” says Twyning. “In reality, not many banks sold off that much, so the money raised by some funds remained untouched for a while.”

Even when a project has been sourced, the time horizons of funds are out of sync, says Huizing. “Funds usually look to last 10 years, whereas many projects—e.g., schools, roads—typically last 25 years. We have one investment with Thames Water in London, and the scope is a lot longer than 10 years.”


PGGM’s Huizing believes that, at its core, the fund structure fundamentally sits at odds with the ethos of infrastructure investing. His fund has committed to road and rail projects in Spain and Latin America worth “a few hundred million euros, with a 15- to 25-year time horizon. This is good alignment,” he says.

“The reason for investing directly in infrastructure is clear: It provides stable, long-term cash flows,” he continues. “Sometimes very long-term. With a fund, the cash flow is negative at the beginning, flat in the middle, and all the returns come at the end. This does not fit with what the client needs.”

Speaking of client needs: What if the investor, or its sponsor, wants out completely? De-risking has been gathering pace, with insurers taking on increasingly large asset pools. Time was that these insurers would only take very liquid—or liquidated—portfolios. Where does that leave an investor that is 10 years into a 25-year project?

“I wouldn’t class infrastructure as a high-risk illiquid asset,” says Hill at telent, which was bought by with PIC in 2007. “If you had to do an in specie transfer, it might be difficult, but it gives confidence that insurers are buying infrastructure assets and that they are acceptable under Solvency II. The regulation is hard to interpret, but it does consider different types of debt.”

Whatever politicians decide, people need roads. They need airports, bridges, and schools. What the capital pools that will fund them need less of, it seems, are established ways of purchasing these assets. No longer do infrastructure funds reign supreme. Europe’s smartest investors, tired of lacking control while paying high fees, are finally going it alone.