Why pension schemes should consider investing in infrastructure

Amid increasingly difficult economic conditions and volatile markets, pension funds, globally and locally, are grappling with diminishing and volatile returns from traditional asset classes, which include treasury bonds and bills, equities, corporate bonds and bank deposits. While they have previously proved sufficient from the return and risk management perspective, recent years have proven that their returns have become less attractive and more positively correlated, resulting in lower returns for pension schemes while losing their diversification elements.

To enhance and protect portfolio returns from such volatility, it is imperative that pension funds begin to look towards alternative investments such as private equity, property and infrastructure.While most local pension schemes are quite familiar with private equity and property investments, infrastructure too, is an emerging asset class which promises huge potential benefits for pension funds with regard to return enhancement and portfolio risk mitigation.

It also enables pension funds to participate in the country’s infrastructure development agenda. In recognition of this, the Government has come out strongly to advocate for pension fund participation in public private partnerships (PPPs).

Already the Government has designated a number of key projects, including the Nairobi- Nakuru- Mau Summit road expansion as a potential PPP project. Investing in infrastructure has the advantage of providing an alternative source of funding,thus reducing government’s dependence on debt to finance infrastructure developments.

Commercial returns

Infrastructure can be classified into two broad categories; economic infrastructure (transport, renewable energy and telecommunications) and social infrastructure (schools, prisons and hospitals). Economic infrastructure is more likely to generate commercial returns on investment and attract private funds. Social infrastructure, on the other hand, is required to meet social needs, which means that returns often do not cover costs. As a result, such investments are typically financed by the public sector.

Investors would generally assess investments in infrastructure like they would any other investment. For any project to attract funding, it must be bankable, that is, the returns must be both competitive and sustainable.

Infrastructure projects can also be classified according to their stages of development, each with varying levels of risk and return. At the highest level of risk and potential return are greenfield projects. These are completely new projects, without constraints of previous developments. Investors bear all the development and execution risk and typically demand higher returns for assuming the risk.

Next is brownfield projects which usually involve modification and/or enhancement of existing infrastructure. The risk is lower than that of greenfield projects and therefore returns also tend to be lower. On the lower end of the risk and return spectrum are mature projects. These are projects that have been completed and commissioned and are cash generative. Since they have been significantly de-risked, the returns are generally lower than the other two.

Investors can get exposure to infrastructure through a number of ways, each with its own advantages and disadvantages. Indirect exposure involves investing in equities or bonds issued by infrastructure companies. A local example is the Kengen infrastructure bond, issued by Kengen to finance geothermal power exploration and development. This route however exposes investors to risks unrelated to the project, including management and operations of the company. Direct exposure on the other hand involves investing in a project via a vehicle solely created to develop and or manage the particular project in question.

This has the advantage of ring fencing the performance of the investment to the project(s) in question and is typically a preferred route by investors. This was the route taken by Britam Asset Managers when it invested in the Athi River Power Plant, which is operated by Gulf Energy Limited, through a vehicle or fund called Everstrong Capital. This investment will give direct access to the return and stability profile of the energy infrastructure sector.

Pension schemes

Infrastructure as an asset class possesses a number of characteristics that make it a suitable investment for pension funds. First, infrastructure assets are long term in nature, often held for between 10 to 30 years, and so are pension schemes, making the asset class a perfect liability match for pension funds. Infrastructure also has a low correlation with the traditional asset classes, thus providing diversification.

Moreover, these projects usually operate as monopolies or oligopolies, providing basic utilities that make them immune to economic cycles. This stability in cash flows and asset value make them an important component of a portfolio, especially in times of heightened volatility. Additionally, cash flows are typically indexed to inflation, thus providing a natural hedge that lacks in other investments like bonds and bank deposits.

While investment in infrastructure has attractive portfolio enhancing characteristics, it is important for pension funds to understand the commensurate risks and take measures to mitigate them.This asset class is typically illiquid with limited exit opportunities. As such, investors should keenly evaluate their liquidity needs before committing their investments. This asset class also exposes investors to political risk. A big number of projects are subject to government regulations and changes in regime could result in changes in policy to the detriment of investors.