Some infrastructure fund managers promised private-equity-like returns to investors in the frothy days before the financial crisis. But their failure has not deterred pension funds in North America, Europe and Australia from buying infrastructure stakes in the days since. These investors share a renewed focus on capturing stable income from the assets and communicate this in their meetings with managers.

“There are more conversations about long-term performance and a more conservative risk-and-return spectrum,” says Jason Peasley, head of infrastructure at AustralianSuper. Speaking from the $43-billion superannuation fund’s Melbourne headquarters, he says the phrase “excess leverage” is scorned in infrastructure circles. The fund seeks “equity-like” returns with less volatility from its investments in the asset class, he says.

Investors on both sides of the Atlantic also seek stable income from infrastructure assets instead of the capital growth that private equity managers aim for. Universities Superannuation Scheme (USS), the £32-billion UK pension fund, invests in infrastructure to try to secure income that is linked to inflation and matches its long-term liabilities, says Gavin Merchant, senior manager of alternatives at the defined benefit fund. Infrastructure accounts for about a fifth of the fund’s £5-billion allocation to alternatives. Merchant says the fund plans to increase its commitment to infrastructure in the coming years to between 5 and 7 per cent of its overall portfolio.

CalSTRS, the US$148.9-billion pension fund for teachers in California, also seeks stable, regulated assets providing an inflation hedge and matching its long-term liabilities. Diloshini Seneviratne, head of infrastructure at the Sacramento-based fund, says the investment team took more than two years looking at opportunities worldwide before making an initial allocation last year. It invested in the debut fund of First Reserve Corporation, a private equity firm, which targets energy infrastructure.

Seneviratne says CalSTRS is mulling an increase in its allocation to infrastructure to US$3.5 billion, or 2.5 per cent, of its portfolio. This would see infrastructure comprise half of CalSTRS’ US$1.61-billion investment in inflation-sensitive assets, which also includes global index-linked bonds and Treasury Inflation Protected Securities. CalSTRS aims for returns of consumer price index plus 5 per cent from infrastructure. Industry Funds Management (IFM), a Melbourne-based firm overseeing $30.2 billion, recently landed a mandate from CalSTRS to invest up to $500 million in global infrastructure. Chief executive officer Brett Himbury says institutional investors favour mature infrastructure assets in developed markets. But there is a shortage of deals that ultimately drives up the prices of assets on the market.

“We are seeing our clients increasing their allocations to infrastructure and we are seeing that globally,” Himbury says.

“In many parts of the world the risk-free rates are very low. If you combine that with a high level of capital flowing towards infrastructure assets, there is clearly a risk that prices may be bid up,” he says. “We have more capital than we have deals,” Himbury says.

IFM is owned by 32 industry super funds and manages more than $10 billion in infrastructure assets in an open-ended fund. Its Australian infrastructure fund has returned 12.48 per cent net of tax and fees since its inception more than 16 years ago.

Growing market

The size of the global market for infrastructure investing is between $10 trillion and $20 trillion, according to Pension Fund Investment in Infrastructure, a 2009 working paper by the Organisation for Economic Co-operation and Development (OECD). Alternative investment-industry researcher Preqin says there are 1352 infrastructure investors worldwide and the mean allocation to the asset class is 4 per cent of their total portfolios. In its January report, 2011 Infrastructure Fundraising and Deals, Preqin found that funds typically aim for a mean target allocation of 5.3 per cent. More than a third of infrastructure investors worldwide were public or private pension funds and most are located in the US, UK, Australia and Canada. Preqin also finds that 81 per cent of investors surveyed prefer to invest in unlisted funds and 31 per cent saying that they favour direct investing.

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Bypassing funds managers

AustralianSuper’s preference for investing through funds managers may be starting to change. The fund has alleviated some of the drawbacks of open-ended funds – particularly when investors have different objectives and time horizons – by investing in pooled funds run by IFM. AustralianSuper is part-owner of the manager.

The fund aims to invest 11 per cent of its capital in infrastructure and will maintain this weighting as it grows in size. To do this, AustralianSuper may need to bypass pooled funds and invest directly in assets, particularly in Australia, where it is looking to increase its exposure to core infrastructure, Peasely says.

Some investors, such as Dutch asset manager APG – which manages the investments of the $329-billion Dutch pension fund ABP – have signed co-investment or “club” deals in recent years to avoid hefty management fees. Being closer to its investments, as well as investing with like-minded investors, has also allowed APG to set standards for its infrastructure investments that include improved environmental, social and governance factors and long-term performance benchmarks.

USS also eyes direct deals. The fund wants to get closer to its infrastructure investments, which have typically been in core utilities and transport assets, Merchant says. “Going forward, we are employing a direct investment approach rather than investing through infrastructure funds,” he says. “We are a financial investor that takes its responsibilities very seriously, which generally includes a requirement for board representation. Our preferred approach is to work with like-minded investors – be they pension funds or infrastructure funds – who are aligned with us in how they think about the asset.”

Seneviratne says that direct investing is one of CalSTRS’ long-term aspirations. But the fund will learn from managers it invests with before making that step, he says.

Flawed fees

Himbury says pooled infrastructure funds are not necessarily more expensive than direct investments. IFM’s fee of 45 basis points is cheaper than what other managers covered in the OECD report charge. The report finds that some managers set fees similar to private equity managers – but do not perform as well on average. The OECD found that managers typically charged a management fee of 1 to 2 per cent of assets under management, plus a performance fee that is usually 10 to 20 per cent of returns in excess of an 8 to 12 per cent “hurdle”.

Such costs can spur funds to employ their own investment staff to acquire and manage infrastructure assets. But these funds need to weigh manager fees against the cost of building and maintaining in-house expertise, the ongoing cost of managing an infrastructure asset over the long term, and the fees and costs associated with the transaction itself. Himbury says that much of the alpha of an infrastructure investment is achieved through the ongoing management of an asset, which takes considerable capacity and experience.

Preqin’s report states that fund manager fees have come under pressure – particularly in light of the difficult fundraising environment of the last couple of years. In 2011, the number of deals made by unlisted funds fell to its lowest level since the financial crisis, declining by 49 per cent to $31.8 billion. “The balance of power between investors and fund managers when negotiating terms and conditions has shifted towards the investors somewhat in recent years,” the report’s author, Iain Jones, says. “This means fund managers will have to ensure that their terms – especially those relating to management fees and carry structure – satisfy investors if they are to be successful in this increasingly competitive fundraising market.”

Crisis and opportunity

The aftershocks of the global financial crisis may see more governments and financial institutions put assets up for sale, particularly in Europe and America.

Ireland provides an example of how sovereign wealth funds and private investors may co-invest in infrastructure. The Irish government, through its bailout deal with the International Monetary Fund and the European Union, committed to sell US$2.64 billion in state assets within the next two years. The nation’s sovereign wealth fund, the US$19.38 billion-National Pensions Reserve Fund (NPRF), has been tasked with providing seed capital for a group of funds looking to invest in infrastructure, venture capital and credit for small to medium businesses.

Eugene O’Callaghan, NPRF director, says the fund has already committed US$330.8 million to an infrastructure fund and has sought interest from investors in Asia and Australia to eventually raise $1.32 billion. He denies the NPRF could ultimately be involved in a fire sale of government assets. The Irish government is, unlike other governments around the world, just starting down the path of privatisation, he says. “We are operating on the basis that there definitely won’t be a fire sale but there will be a committed seller, so the assets are likely to be available at reasonable prices.”

Ireland is not the only cash-strapped government aiming to attract private capital. George Osborne, Britain’s Chancellor of the Exchequer, recently called on British pension funds to invest more money in domestic infrastructure projects. The United Kingdom government has flagged an overhaul of investment processes and has called for the industry’s views and feedback on what incentives would make the sector more attractive.

In the United States, legislation has been introduced to the Congress and Senate for a so-called “infrastructure bank”, an institution that would be funded with as much as $30 billion. The proposed bank would aim to partner with private investors for projects of national importance and sell bonds with terms of up to 50 years to support the institution’s ongoing operations.

Himbury says that it’s not necessary for governments to sweeten deals, but simply to provide more of them. “We are not short of capital,” he explains. “We are not short of expertise or interest in the sector. Notwithstanding a bit of a flurry of activity recently, we are short of deals globally.”