Infrastructure can deliver on many fronts – offering cash flows and inflation protection, exposure to the climate transition and more. How are pension funds approaching an asset class that is central to the green transition and 'levelling up’ while many are also having to focus on the endgame? 

 

Defined benefit schemes are in need of income as they increasingly turn cash flow negative. Many schemes started investing in infrastructure in the mid-2010s, but the average allocation either remains relatively low or is concentrated in public sector schemes; at the end of 2020, UK DB schemes only held 0.7% in listed and 0.4% in unlisted infrastructure respectively, according to Mercer.  

 

However, this could be set to change; looking across all countries, 18% had plans to allocate to listed and 12% to unlisted infrastructure. The Suffolk Pension Fund approved a £60m commitment to infrastructure with a new manager last year, having invested smaller amounts in 2015 and 2016, for example, while local government investment pool Border to Coast is planning to launch an in-house managed £1.3bn listed alternatives fund this year. 

 

 

  

 

Interest in infrastructure is still there, said Giles Payne, a professional trustee at Capital Cranfield Trustees who has just started looking at a new investment for one of his client funds.  

 

The key thing to be aware of is that infrastructure is not just infrastructure, he stressed, as investments range from almost bond-like returns, to private equity returns with investors taking risks on implementation and design. “There are different ways of fitting infrastructure into portfolios,” and people are getting more sophisticated and more flexible about how they do so, he explained.  

 

Exactly how schemes use infrastructure partly depends on how mature they are, he said, noting that private sector DB schemes are slightly worried about illiquidity; this means “you need to make sure the structure of the remaining part of the portfolio protects you from having to sell that”. The liquidity constraints of schemes moving to buyout could offer an opportunity for a secondary infrastructure market to emerge, he observed. 

 

For large DC schemes like master trusts, bringing infrastructure into default funds is a matter of commercial cost. “People will put more emphasis on cost than future efficiency of portfolio, it’s more tangible,” said Payne, who believes that this will always be an issue in DC, despite most master trusts charging well below the 75 basis points cap on defaults. 

 

DC schemes also sometimes cite the practice of offering daily trading as a barrier to such investments. Liquidity is present in listed infrastructure, but for Paye, this is “not quite the same as buying actual assets”, as volatility tends to be higher.  

 

Paul Watson, another professional trustee at Capital Cranfield, agreed. “My worry is that public behaves more like equity than infrastructure,” at least in the short term, he said, adding: “If liquidity is an issue, then I’d prefer a sustainable equity fund than purely infrastructure equity purely from a diversification perspective.” 

 

The demand for infrastructure over recent years means Watson is sceptical about the margins available to investors and the time they have to wait for capital to be drawn down. “Perhaps the opportunity in infra is now for those larger schemes that are more likely to run off the liabilities over a longer period rather than transacting buyout?” he said. 

 

 

While many DB schemes are targeting buyout, others do want to gain exposure to infrastructure. “There is a lot of interest in infrastructure among clients at the moment,” said Andrew Singh, head of real assets research at consultancy Isio. Funds are increasing their allocations, but there are also new searches, he said, for diversified global mandates, renewables and energy transition mandates. 

 

Some funds that invested a few years ago and whose investment performed well, are asking if they can ‘bolt on’ some renewables now that new requirements on environmental, social and governance have been brought in, while others are looking at impact strategies. ESG has fast become a key driver in these investments and is now “the first or second question from clients”, Singh said – noting that because many projects are linked to energy production, it makes it an "easy sell" in this respect. 

 

Returns have been good, which has in turn meant that fees have held up relatively well despite the general push down on active manager fees. On a base fee of 0.5% to 1% there would be a performance fee that typically has a hurdle, he explained, of roughly around 7%. However, this fee structure is not always well received. “We had a few instances where investors pushed back saying, ‘I don’t understand the fees, I need to get my head around it’,” noted Singh, saying it would be a positive if managers could simplify their fee structures. 

 

Most pension schemes are looking to invest in infrastructure equity, although others invest in both equity and debt, said Singh; the latter tends to be less liquid, with even junior debt seeing lock-in periods of 10 to 15 years and senior debt coming in 30-year funds.  

 

Some of the largest local government funds invest in projects directly to keep management fees low, but this involves higher governance and the investment is “more lumpy”, noted Singh. However, direct investment is becoming slightly more common, as more fund managers have started offering direct investment alongside a fund.  

 

 

While liquidity is one of the top concerns, other risks are leverage, the operational element of infrastructure assets, and regulation. 

 

This is why regulatory predictability is key for investors and features high for fund houses like Newton Investment Management, which invests in listed infrastructure equity. “We spend a disproportionate amount of time talking to regulators,” in order to understand the regulatory construct, said James Lydotes, Newton’s Portfolio Manager of Global Infrastructure.  

 

Regulation is a balance, he said – if it is too favourable for investors it will turn around eventually, but if it is unfavourable, it has a negative impact on returns. “Infrastructure almost needs to be a monopoly because it is so expensive, but you need the regulatory construct to protect consumers,” he added. 

 

The current spike in global energy prices puts this risk into sharp relief, as governments scramble to take pressure off cash-strapped consumers. "In periods of high energy prices, that risk is heightened, you have to be extra focused,” said Lydotes. On the other hand, “that risk could present opportunities”, he believes, for example if the market is overly discounting a risk that does not materialise in the end.  

 

While inflated energy prices bring the risk regulatory intervention, the overall rise in inflation - which in the UK is expected to breach 7% - strengthens the case of infrastructure investment, as assets tend to have inflation-linked contracts in place.  

 

Seeing its benefits, many investors have piled into infrastructure through private markets, but Lydotes noted that the underlying assets in both private and public tend to ultimately be the same. He attributes investors’ apparent preference for private markets to the intermittent pricing of these assets, which makes returns look artificially smooth compared with daily priced public market returns. However, investing in private infrastructure just means joining the back of the queue of hundreds of billions of ‘dry powder’ waiting to be deployed, he argued, when investors could get access straight away by investing in listed equity – where returns have also been higher. 

 

Opportunities can be found in many places at the moment. “From a price perspective, Europe is now affording the best value,” Lydotes said, thanks to growth coupled with an accelerated push to renewables in the wake of the pandemic. The UK’s levelling up plan, which includes a pledge to bring 5G broadband to the majority of the nation and local public transport systems closer to London standards by 2030, could also be interesting, although “the devil is in the detail”, he remarked. 

 

 

The UK government has for some time sought to attract private capital into infrastructure, first with the pooling of local government investments, and more recently with a call by the prime minister and the chancellor for an investment ‘big bang’ from UK pension funds. 

 

Much is made of the potential for pension fund capital to finance new infrastructure, said Anish Butani, a senior director for infrastructure at consultancy bfinance, but “the challenge is that the two are often incompatible”; while pension fund investors seek predictable cash flows from stable assets, building new assets does not deliver immediate yield and involves significant planning and construction risk. 

 

The government is aware of this, however. “Initiatives such as the UK Infrastructure Bank demonstrate that the state is willing to participate in projects, either by taking a 'first loss provision' or fund projects on a matching basis to equity to demonstrate an alignment of interest to the private sector,” he explained, citing the Charging Infrastructure Investment Fund and the Digital Infrastructure Investment Fund.  

 

For the Thames Tideway Tunnel, an upgrade to London’s sewage system that is set to open in 2025, the government managed to ‘tease out’ private sector investment by committing to provide a cash yield during the construction process, he said; the project’s website proudly states that more than 1.7m people have an indirect investment in Tideway through UK pension funds. 

 

Despite the crucial importance of these assets for entire cities or regions, Butani is less worried about risks like nationalisation. “In reality, there have been very few instances of assets being renationalised,” he said, adding that governments – not least because of their soaring deficits – recognise that pension funds have an important role to play in providing financing assets.