Encouraging Pension Fund Investment into Infrastructure
Pension Funds are a major source of capital in the investment markets, especially the listed investment sector in many countries. One of the major sources of capital for National Standard Finance are Pension Funds. A study conducted by the Organisation for Economic Development and Cooperation (‘’OECD’’) in 2011 revealed that Pension Funds, although major providers of capital, were not major players in real estate and private equity, and most certainly in infrastructure. Our own experience confirms this. In most African countries, Pension Funds hold large amounts for investment. However, the allocation towards infrastructure is generally disappointing, accounting for less than 5% of Pension Fund assets in developed Pension Fund jurisdictions such as South Africa.
The reasons for limited investment in infrastructure are the many barriers that exist in this asset class that is generally not known. The OECD report notes that infrastructure investing offers different characteristics from other asset classes which could represent barriers to entry to potential investors. They cite high upfront costs, lack of liquidity and the long asset life that require significant scale and dedicated resources to understand the risks involved. We believe that Pension Funds, being predominantly long term investors and holding high capital resources that many other investors’ lack, are one of the most suited to infrastructure investment.
Governments and responsible market players such as sponsors of projects need to recognise the major barriers to investment in this asset class and create an environment that promotes Pension Fund investment. Many factors including the lack of well-prepared and bankable investment opportunities, lack of clarity on the few investment opportunities that may be available, lack of political commitment over the long term, regulatory instability, regulatory barriers, lack of transparency, fragmentation of the market among different level of governments, negative perception of long term value of infrastructure and high bidding costs involved in the procurement process of infrastructure projects make Pension Funds perceive infrastructure investment opportunities as too risky. There is also perception of mis-alignment of interests between infrastructure funds and Pension Funds in addition to shortage of data on performance of infrastructure projects and the lack of benchmarks for measurement of performance. Other Pension Funds do not invest simply because they lack scale and expertise.
In creating a supportive environment for infrastructure investment by Pension Funds, the results of the investigations of the OECD show four key factors that lead to increased infrastructure investment by Pension Funds. These are the availability of investment opportunities for private finance capital and, therefore, for Pension Funds; the maturity and size of the pension fund market; pension fund regulations that may require Pension Funds to hold infrastructure investments; and increasing knowledge of infrastructure risks and returns as an asset class.
In the industrialised countries of Europe, North America and Australia, the involvement of the private sector in the provision and operation of infrastructure rapidly increased over the past 30 years, with both history of privatisation and public policy in those countries leading to models such as Public Private Partnerships attracting Pension Fund investment. In Australia for example, as the number of infrastructure transactions grew, so did the availability of financial instruments, predominantly infrastructure funds, providing investors with access to infrastructure investment opportunities, leading to the development of investor understanding of infrastructure.
The maturity and size of the pension fund market plays a key role. In most of Africa, the Pension Fund industry is developing and still very young. Apart from South Africa and a few other countries in North Africa, there is limited investment by African Pension Funds into infrastructure. But Africa can still benefit from the allocations made by Pension Funds in the other more developed markets through foreign direct investments as long as the risks are well managed and the returns are commensurate with the risks. National Standard uses this model to provide foreign direct investment from Pension Funds into infrastructure.
Regulations relate to both those regulations encouraging pension savings, thus directly influencing the size of the Pension Fund market and the overall institutional capital available, and those regulations directing where those savings must be invested, thus directly influencing the amount of institutional capital available for investment into infrastructure. Most countries’ institutional investors’ traditional exposure to infrastructure has been through bonds with some regulations requiring investment into Government bonds that may then be used in infrastructure development. Most recently, dedicated infrastructure bonds have been issued in some countries but to a very limited extent.
As knowledge of this asset class increases, what is needed is consistent investment by Pension Funds both directly and indirectly. Direct investment requires exceptional knowledge as infrastructure investment involves a steep learning curve given the unique nature of each investment. Investing in the asset either directly or through an infrastructure fund, requires a long lead time to complete due diligence, educate the Pension Fund sponsors and set up the appropriate structure for investment and risk management. The OECD report notes that active Pension Fund investors who have made several investments are more likely to have separate allocations for infrastructure as programmes mature. The research shows that infrastructure is commonly treated as a separate allocation in the overall Pension Fund portfolio in Canada and Australia while it is in most cases a subsector of real estate or private equity for European and American investors. In the still maturing Pension Fund industry in most of Africa, this distinction is generally not made.
The OECD report concludes that the major reforms required to promote infrastructure investments by Pension Funds include: 1. Government support for long-term investments by designing policy frameworks that are supportive of long-term investing, which would include long-term policy planning, tax incentives and risk transfer mechanisms that may be required to engage investors in less liquid, long term investments such as infrastructure; 2. Reforming the regulatory framework for long term investment, which would require policymakers to promote greater professionalism and expertise in the governance of institutional investors, as well as addressing the bias for pro-cyclicality and short-term risk management goals in solvency and funding regulations, and ease quantitative investment restrictions to allow institutional investors to invest in less liquid assets such as infrastructure; and 3. Improving conditions for infrastructure investment and creating a transparent environment given that investment in infrastructure by Pension Funds is a relatively new investment which entails a new set of challenges for them. This is exacerbated by shortage of objective and comparable information and quality data to assess the risk of infrastructure transactions.
Russell Duke is Chairman & Managing Principal at National Standard Finance, LLC. Mr. Duke can be reached at RDuke@NatStandard.com.
Michael Tichareva is Principal & Managing Director of Africa operations at National Standard Finance, LLC. Mr. Tichareva can be reached at MTichareva@NatStandard.com.
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