Investing in Infrastructure – Combining Responsibility with Returns

Redington 13-15 Mallow Street London EC1Y 8RD T. 020 7250 3331 www.redington.co.uk

TUC Member Trustee Network Annual Conference 2011

Investing in Infrastructure – Combining Responsibility with Returns

November 15th 2011

2

Investing in Infrastructure – Combining Responsibility with Returns

Why invest in infrastructure? • Earn high-quality, long-dated inflation-linked cashflows at attractive real yields • Obtain returns no longer offered by traditional asset classes • Reach full funding with lower risk • Support projects which provide high value add for society

What to consider when investing? • How will you access infrastructure returns:

Choosing the right structure to make infrastructure Flight Plan Consistent

What are the advantages of bespoke investment structures?

Which risk profiles are acceptable?

Which opportunities are available? • Wide range of attractive opportunities with different risk/return profiles, such as:

Social housing Private Finance Initiatives Water infrastructure

3.0

3.5

4.0

4.5

5.0

5.5

Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11

%

30-year gilt yield

30-year swap rate

The markets we are in: declining yields

Long-term yields have fallen, pushing up the value of pension funds’ liabilities...

Why Invest in Infrastructure?

The markets we are in

3

1

Source: Bloomberg, Redington

31-Oct11

40

60

80

100

120

140

160


Reb

ase

d a

t Ja

n 0

7 =

10

0

FTSE 100 Emerging markets equity* Developed world equity**

4



The financial crisis has set equities on a rollercoaster ride with low and volatile medium and long-term returns. Risky assets have increasingly failed to deliver adequate outperformance.

2


The markets we are in: underperforming equities

*Emerging market equity = MSCI Emerging Markets Index **Developed world equity = MSCI Developed World ex. UK

31-Oct11

-0.25

0

0.25

0.5

0.75

1

1.25

1.5

1.75


%

Yield on 30-year inflation-linked gilt

30-year real swap rate

5




Real yields have declined, making it more difficult for pension funds to access attractive and secure long-term returns that will allow them to reach full funding.

3

The markets we are in: low real yields

31-Oct11

75%

85%

95%

105%

115%


Fun

din

g Le

vel (

Ass

ets/

Liab

iliti

es)

Funding level

Full funding

250

300

350

400

450


£ b

n

Assets Liabilities

The effect on pension schemes: declining funding levels


The effect on pension schemes

1. Falling long-term yields 2. Risky assets underperforming 3. Declining real rates

FTSE 100 companies’ aggregate pension assets and liabilities Aggregate funding level of FTSE 100 pension schemes

As asset performance failed to keep pace with rising liabilities, funding levels declined.

Pension funds must therefore focus on making the right decisions to achieve full funding in a difficult environment.

Source: Aon Hewitt Pension Risk Tracker, Redington Source: Aon Hewitt Pension Risk Tracker, Redington 6

31-Oct11 31-Oct11

Full funding

Getting the returns you need

Current position

Infrastructure assets can help schemes achieve full funding because they offer...

• Attractive rates of real return • Inflation linkage • Long-dated, high quality and often secured

cashflows

Pension funds must find ways to: • Earn attractive long-term real

returns sufficient to achieve full funding

• Obtain inflation-linked cashflows

• Strike an attractive risk/return

balance

• Consider where you want to be positioned in the capital structure (debt or equity) • Determine the return you require and the level of risk you are comfortable with to choose the

right type of infrastructure asset to invest in

Making the best of infrastructure

7


Getting the returns you need

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

GB

P M

illi

on

s

Liabilities Path Actual Liabilities Assets Path Actual Assets

Liability Basis

Contributions & Asset Returns

Time Horizon

The Flight Plan is an effective tool for making focussed asset allocation decisions and identifying the best opportunities.

It allows schemes to identify the assets which contribute most towards their progress to full funding – we call them Flight Plan Consistent Assets.


Flight Plan

8

The Flight Plan

• Maps out the path of a scheme’s assets and liabilities from their current position to full funding

• Requires three key

variables to build: the assumed rate of return on assets, the cash contribution schedule, and the target date for full funding.

9

Growth

“Flight Plan

Consistent Assets”

Matching


Flight Plan Consistent Assets

Fuel efficiency: achieve an efficient risk/return balance

10

-6

-4

-2

0

2

4

6

8

0 5 10 15 20 25 30

GB

P M

illi

on

s

Years

Initial investment

Attractive real returns

Inflation-linked cashflows

Providing a match for liabilities

Inflows

Outflows

Source: Redington

Flight Plan Consistent Asset – Example Cashflow Profile



Key Characteristics

Flight Plan Consistent Assets • Enable schemes to

access attractive real returns and long-dated inflation-linked cash flows .

• The attractive real returns are the result of a significant illiquidity premium

Key Characteristics

Attractive real returns and inflation-linked cashflows

High-quality, often secured cashflows

Illiquid

Varying degrees of complexity/might be difficult to access

Infrastructure

• Take advantage of attractive yields on long-term secured property leases

• Yields may be in excess of yields on corporate bonds issued by same borrower

• Long-dated index-linked cashflows

Secured Leases

• Ground rent created when freehold land or building is sold on long lease

• Typically “pepper-corn” rent for land only (not buildings)

Ground Rents • Low-cost rental housing provided for disadvantaged people in

need of housing

• Generally provided by local councils and housing associations

Social Housing

• Investing in public sector projects through, for example, Private Finance Initiatives (PFIs), bespoke investments structures or by purchasing a suitable infrastructure asset

• Wide range of possible assets, from roads to power generation

Traditional Infrastructure



• Offers long-dated, inflation-linked cashflows from secured borrowers (i.e. housing associations) with quasi-government guarantee

• Long-term, potentially inflation-linked revenue streams

• Offers attractive returns, limited credit risk and high level of security

Other Flight Plan Consistent Assets

11

We will focus on Social Housing and Traditional Infrastructure to illustrate the different factors that need to be taken into account.

• Pricing mechanism: availability vs. demand

• Stage of development: infant vs. mature

Traditional Infrastructure

• Redington is cooperating closely with third parties

with strong infrastructure expertise and resources to provide attractive investment solutions for pension funds.

Social Housing

• Redington has been a pioneering force for turning

Social Housing into an investable asset class for pension funds.

Accessing infrastructure

What to Consider when Investing?

Accessing infrastructure

Investing in infrastructure is usually relatively complex. It is essential to focus on getting the details right to ensure that the actual returns and cashflows meet the pension fund investor’s expectations and requirements.

Specific Risk/Return Profile of the individual asset

12

• Capital structure

• Solution type: bespoke vs. pooled

Investment Structure Used to access the returns and

cashflows

1

2

• Social housing

• Private finance initiatives

• Water infrastructure

Examples of infrastructure assets

3

Making infrastructure Flight Plan Consistent


Making infrastructure Flight Plan Consistent

13

Pension funds must be clear about the way in which they want to access infrastructure investments.

Before the financial crisis • Infrastructure investments have historically been

structured with little equity and high levels debt provided by banks. Pension funds often invested in the leveraged equity as a growth asset with relatively low security of returns and usually no inflation linkage.

After the financial crisis • Banks have increasingly withdrawn from providing debt

financing. Pension funds have increasingly stepped in to replace bank financing. Smaller schemes have focussed on investing in infrastructure debt.

• Large pension funds have purchased whole infrastructure assets (100% equity) to obtain full ownership and enjoy all benefits such as inflation-linked and high-quality returns.

• Full ownership allows pension funds to make infrastructure assets Flight Plan Consistent.

The Right Structure to Earn the Returns You Want

90% Debt Whole

Business 100% Equity

10% Equity

Provided by banks

Pension funds

Before the financial crisis After the financial crisis

Pension funds

Flight Plan Consistent

North America

• The UK’s largest pension fund – the BT Pension Scheme – has invested over £300m in renewable energy infrastructure.

• A number of other large UK schemes, such as the Universities Superannuation Scheme (USS) and the Railways Pension Scheme (RailPen) have infrastructure allocations.

United Kingdom

• ABP – the pension fund for government and education employees and the largest in the Netherlands – allocates 2% of its €242 billion assets to infrastructure.

• To facility this, it has opened offices in Hong Kong to gain access to Asian infrastructure projects.

Continental Europe

• The largest US pension fund – the California Public Employees Retirement System (CalPERS) – adopted a new investment policy in 2008 with a target allocation of 3% of assets or $7.2 billion in infrastructure.

United States

• The Ontario Municipal Employees Retirement System (OMERS) and Ontario Teachers Pension Plan (OTPP) are large players in direct infrastructure investment.

• They succeeded in joint bid for the UK High Speed Rail 1 for £2.1 billion.

Canada


What other pension funds are doing

• They now hold a 30-year concession to own and operate the rail line.

• Other large infrastructure investors include Danish pension fund ATP, which among has invested in toll roads and ports around the world.

Europe

14

• As part of this strategy, CalPERS took a 12.7% stake in London’s Gatwick Airport.

Bespoke investment structures


Bespoke investment structures

15

Source: Evolution Securities, Redington

Asset Manager

• Manage day-to-day operations and supervise financial performance of each investment/provide operational fund management services

Investment Manager

• Provide financial analysis and investment, origination and structuring expertise

Example Bespoke Investment Structure

Investment Consultant

• Support for evaluating and structuring investments

• Ensure investments’ risk/return profile and investment structure are in line with Fund requirements

Pension Fund

Tailored Investment Structure (e.g. Fund/Special Purpose Vehicle)

Development 1 Development 2 Development 3

Equity/Debt Investment

Housing Association

Portfolio

Equity Investment

Risk profiles

Most Risk

Pricing mechanism

Least Risk

Sector

The risk that an infrastructure investment fails to provide liability-matching returns depends on several factors.

• An asset that earns a

return simply because it is available for use will be less risky than an asset where the return depends on actual demand

• “Infrastructure” covers a wide range of different assets which can be exposed to a wide range of risks such as

‐ availability risk ‐ construction & performance risk ‐ political & regulatory risk (e.g. changing regulatory

regimes) ‐ environmental risk (e.g. pollution) ‐ technological risk (e.g. obsolescence, technical

challenges) • Pension fund investors must therefore thoroughly assess

the risk profile of the asset they want to invest in

Infrastructure Sector

Availability Regulatory Demand Economic Price

Most Risk Least Risk

Pricing Mechanism

• Investors will be exposed to

more risk if they invest at an early stage of development, but can also expect a higher return

Development Stage


Risk profiles

16


Which Opportunities are Available?

Private Finance Initiatives

Example: Private Finance Initiatives

Private Finance Initiatives are a form of Public Private Partnership where private firms provide funding, construction and operations services for public sector projects.

17

• Contracts are long-dated and cashflows typically inflation-linked

• Revenue streams backed by quasi-government guarantees and secured on underlying assets

• Illiquidity gives rise to a premium return over gilts

• Large scope for socially responsible investment and creating wealth for both beneficiaries and the wider community

• Bank balance sheet contraction has increased the universe of opportunities for pension funds to provide debt financing

Private Finance Initiative investment features

Defence: Future Strategic

Tanker Aircraft

Health: Queen Elizabeth

Hospital, London

Typical investment structure:

Government

Pension Funds (Investors)

Special Purpose Vehicle (SPV)

Capital

Interest payments

Build & manage through private

contractors

Cash flow generated from

assets

• Bought by HSBC in August 2011 (for warehousing)

for £74m

• Provides water for 300,000 people in Cambridgeshire

• 2010/2011: Revenue of £20m with profits of £7m

before tax with no external debt except for a revolving

credit facility to cover working capital

• Attractive purchase opportunity for a large pension fund or a

consortium of funds

• Redington advised two UK schemes who bid for this asset. However,

although this bid was acceptable on price, it could not compete with

the winning cash bid which had an accelerated timetable and no due

diligence


Water infrastructure

Example: Water infrastructure

The UK water sector provides excellent examples of infrastructure assets attractive for pension fund investors, providing the security, returns and cashflows that pension funds need.

• Economic environment has small impact on returns: water is a necessity and will therefore be demanded irrespective of economic growth.

• Inflation-linked cashflows and returns: water companies ‘

regulatory regime means they can increase prices in line with the agreed price review which in turn is based on a formula related to RPI.

• Low regulatory risk: The regulator’s desire to increase competition in the area could have a negative impact on returns but the Government is likely to block any such move.

Water sector: key characteristics

Case study: Cambridge Water

18


Social Housing

Example: Social Housing

Social Housing is a form of low cost, rental housing typically provided by local councils and non-profit organisations called housing associations.

19

• Housing associations issue inflation-linked debt secured on a pool of housing units to finance activities

• Interest payments are matched by rental income that is typically increased yearly at RPI + 0.5%

• Illiquidity gives rise to a premium return over gilts

• Enjoys a large degree of government support, with rental payments often heavily subsidised

• Combines social responsibility with returns

Social Housing investment features

Background • Traditionally financed by state support and bank loans • Financial crisis imposed losses and higher capital requirements on banks, limiting their ability to lend • The government is burdened by debt and a large deficit, causing it to reduce spending • This ‘funding vacuum’ has given pension funds an opportunity to step in and provide financing

http://www.homesandcommunities.co.uk/homepage

Social housing: risk profile


Social housing: risk profile

• The diagram shows a typical social housing portfolio for a pension fund investor with a blended real return of ca. 3-4% p.a.

• The portfolio consists of different

housing types with specific risk/return profiles

• By adapting the share of the

different housing types in the portfolio, an investor can tailor the portfolio’s return and the risk characteristics so that they fit requirements

Social Housing is typically a low-risk asset class but the returns and the risk on a portfolio can be tailored (to some extent) to meet pension funds’ requirements.

20


Redington Publications

21

Spring Collection Highlights: LDI 2.0, Secured Leases, Ground Rents, Equity Release Mortgages, Social Housing, Insurance-Linked Securities, Infrastructure http://www.redington.co.uk/Redington/media/PDFs/knowledge/Other%20Publications/Redington-Spring-Collection-2010.pdf

Spring/Summer 2011 Collection: Enhanced Matching Assets, Socially Responsible Investing and Long-Term Growth Assets http://www.redington.co.uk/Redington/media/PDFs/knowledge/Other%20Publications/Redington-Spring-Summer-Collection-2011.pdf

Keeping up with the latest in Flight Plan Consistent Assets

Redington publications

http://www.redington.co.uk/Redington/media/PDFs/knowledge/Other Publications/Redington-Spring-Collection-2010.pdf








http://www.redington.co.uk/Redington/media/PDFs/knowledge/Other Publications/Redington-Spring-Summer-Collection-2011.pdf










Contacts

Disclaimer

Disclaimer For professional investors only. Not suitable for private customers.

The information herein was obtained from various sources. We do not guarantee every aspect of its accuracy. The information is for your private information and is for discussion purposes only. A variety of market factors and assumptions may affect this analysis, and this analysis does not reflect all possible loss scenarios. There is no certainty that the parameters and assumptions used in this analysis can be duplicated with actual trades. Any historical exchange rates, interest rates or other reference rates or prices which appear above are not necessarily indicative of future exchange rates, interest rates, or other reference rates or prices. Neither the information, recommendations or opinions expressed herein constitutes an offer to buy or sell any securities, futures, options, or investment products on your behalf. Unless otherwise stated, any pricing information in this message is indicative only, is subject to change and is not an offer to transact. Where relevant, the price quoted is exclusive of tax and delivery costs. Any reference to the terms of executed transactions should be treated as preliminary and subject to further due diligence .

Please note, the accurate calculation of the liability profile used as the basis for implementing any capital markets transactions is the sole responsibility of the Trustees' actuarial advisors. Redington Ltd will estimate the liabilities if required but will not be held responsible for any loss or damage howsoever sustained as a result of inaccuracies in that estimation. Additionally, the client recognizes that Redington Ltd does not owe any party a duty of care in this respect.

Redington Ltd are investment consultants regulated by the Financial Services Authority. We do not advise on all implications of the transactions described herein. This information is for discussion purposes and prior to undertaking any trade, you should also discuss with your professional tax, accounting and / or other relevant advisers how such particular trade(s) affect you. All analysis (whether in respect of tax, accounting, law or of any other nature), should be treated as illustrative only and not relied upon as accurate.

Redington Limited (reg no 6660006) is a company authorised and regulated by the Financial Services Authority and registered in England and Wales. Registered office: 13-15 Mallow Street London EC1Y 8RD

THE DESTINATION FOR ASSET & LIABILITY MANAGEMENT

Contacts

22

Direct Line: +44 (0) 20 7250 3416

Telephone: +44 (0) 20 7250 3331

Redington

13-15 Mallow Street

London EC1Y 8RD

Robert Gardner Founder &Co-CEO

[email protected]

www.redington.co.uk

Scan in the QR code with your smartphone to get straight to our website.

Investing in Infrastructure – Combining Responsibility with Returns

Economy & Finance

Transcript of Investing in Infrastructure – Combining Responsibility with Returns