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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
Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11
Reb
ase
d a
t Ja
n 0
7 =
10
0
FTSE 100 Emerging markets equity* Developed world equity**
4
Why Invest in Infrastructure?
The markets we are in
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
Source: Bloomberg, Redington
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
Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11
%
Yield on 30-year inflation-linked gilt
30-year real swap rate
5
Why Invest in Infrastructure?
The markets we are in
Source: Bloomberg, Redington
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%
Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11
Fun
din
g Le
vel (
Ass
ets/
Liab
iliti
es)
Funding level
Full funding
250
300
350
400
450
Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11
£ b
n
Assets Liabilities
The effect on pension schemes: declining funding levels
Why Invest in Infrastructure?
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
Why Invest in Infrastructure?
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.
Why Invest in Infrastructure?
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
Why Invest in Infrastructure?
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
Why Invest in Infrastructure?
Flight Plan Consistent Assets
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
Why Invest in Infrastructure?
Flight Plan Consistent Assets
• 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
What to Consider when Investing?
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 to Consider when Investing?
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
What to Consider when Investing?
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
What to Consider when Investing?
Risk profiles
16
Source: Evolution Securities, Redington
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
Which Opportunities are Available?
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
Which Opportunities are Available?
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
Social housing: risk profile
Which Opportunities are Available?
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
Source: Evolution Securities, Redington
Redington Publications
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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
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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.
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Contacts
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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
www.redington.co.uk
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