Pension funds in infrastructure: Ideal owners

The Port of Newcastle is a key part of Australia's coal supply chain. Last year 150.5 million tons of the mineral arrived from the mines of the Hunter Valley for onward shipment to international buyers, many of them in Asia. The port has been in operation for more than 200 years and handles over 40 commodities and 4,600 ship movements every year.

In April, the New South Wales government announced a 98-year lease of Port of Newcastle to Hastings Funds Management - which has strong ties to Australian superannuation funds - and China Merchants Group, following a five-month process involving five separate bidders.

The bulk of the A$1.75 billion ($1.6 billion) in proceeds will be recycled into new local infrastructure projects. Before the sale process even began, A$340 million had been earmarked for the redevelopment of Newcastle's central business district. The rest will bankroll projects such as WestConnex, a A$10 billion highway intended to ease pressure on Sydney's existing roads and open up the suburbs.

It is a pragmatic move and one that has worked for New South Wales before. Last year, 99-year leases for Port Botany and Port Kembla were sold for A$5.07 billion, of which Restart NSW received around A$4.3 billion. The buyer consortium included IFM Investors, Abu Dhabi Investment Authority (ADIA) and local pension funds AustralianSuper, Construction & Building Industry Super, HOSTPLUS and HESTA.

"In a climate of falling revenues and our triple-A credit rating under constant threat, the only way we can fix the State's infrastructure backlog is by recycling mature assets on our balance sheet to create the flexibility we need to invest in new ones," New South Wales Treasurer Mike Baird observed, when launching the Port of Newcastle sale.

This recycling strategy is catching on among state administrations that need to service debts and pay for new infrastructure. With willing buyers in the form of local super funds and foreign investors, as well as a federal government willing to cover 15% - or up to A$5 billion - of the cost of new projects funded in this way, momentum will gather. But at the same time, it is just one of a package of reforms needed to fix a wider public infrastructure financing issue.

"It is a good first step in terms of state governments repairing their balance sheets and in New South Wales it is also part of a bigger game plan to get newer infrastructure required for the productive economy," says Paul Foster, head of infrastructure for Australia and New Zealand at AMP Capital. "However, it is still a reflection of the fact that natural long-term owners of these assets - superannuation funds and pension funds, Australian and global - are reluctant to take greenfield patronage risk at the early development stage."

Old habits

Australia's superannuation funds are seasoned infrastructure investors, having participated in deals since the early 1990s, usually acting through external fund managers. Airports and related infrastructure have been a particularly happy hunting ground. Between 2001 and 2004, facilities in Perth, Melbourne, Launceston, Brisbane, Townsville, Mount Isla and the Gold Coast all changed hands.

AustralianSuper had 10% of its assets in infrastructure in 2013, while QSuper and First State Super had allocations through their main defined benefit funds of 7.9% and 7.6%, respectively. These allocations - in percentage terms - well exceed those of the leading US pension funds. The California Public Employees' Retirement System (CalPERS) currently has 2% of holdings in infrastructure and timberland.

The challenge for Australia's superannuation funds has been identifying supply to meet their obvious demand. "If you had asked at any given point in time over the last 15 years, whether there was institutional money to invest in infrastructure, the answer would have been a resounding yes," says Mark McLean, head of Asia Pacific at Morgan Stanley Infrastructure. "The issue is more that there hasn't been a lot of new supply of opportunities coming to market, but that is changing."

McLean estimates that anywhere between A$50 billion and A$100 billion of infrastructure assets will be privatized over the next 2-3 years. Not all of these will fall into the hands of pension funds - Australian or otherwise - but the long-term nature of the assets, delivering low but consistent yields, in some cases protected by regulators, means they are a good strategic fit.

According to AVCJ Research, $27.8 billion in private capital has entered Australia's infrastructure, transportation and distribution and utilities sectors since 2010.

More than one third of this went into three privatizations: Port Botany & Kembla, Queensland Motorways (acquired by Queensland Investment Corporation in 2010, and sold on to Transurban Group this year, with participation from AustralianSuper), and Sydney Desalination Plant (Hastings Funds Management and Ontario Teachers' Pension Plan picked up a 50-year lease in 2012).

These transactions will be dwarfed by New South Wales' electricity distribution and transmission businesses, which are thought to be worth about A$30 billion and will be put up for sale in 2015-2016. Queensland's electricity infrastructure assets are even larger and expected to come onto the market around the same time. Also slated for privatization are ports in Melbourne, Gladstone and Townsville, as well as pipeline business SunWater.

Such is the size of these deals that the buyers are likely to be consortiums of investors, with at least one member either a strategic player or a fund manager with previous exposure to similar assets. AustralianSuper going into Queensland Motorways alongside Transurban is evidence of the former; Port Botany and Port Kembla, with IFM prominent, are evidence of the latter. Another trend is that the larger superannuation players are increasingly seeking to go direct.

"We are now looking to evolve our relationship with our existing managers to allow us to participate directly in investments, rather than simply supporting their pooled funds - our co-investment alongside IFM Investors in the NSW Ports transaction was our first step in this direction," says Andrew Major, general manager - investments, at HESTA. "We are also looking at establishing a small number of new relationships, ideally outside of a pooled fund structure, that will allow us to get access to a broader range of opportunities in the global infrastructure markets."

Superannuation funds are making such moves in the interests of returns and influence: management fees are lower, as an active participant they learn more about the nature of the asset and how the GP is developing it, and good governance and transparency is helpful in a look-through portfolio. The other consideration is scale. Many of these funds are growing rapidly and writing larger checks; targeted direct investments, made alongside a manager or independently, are helpful.

Obstacle course

The recycling of capital from these privatizations into new projects is intended to help fill Australia's infrastructure gap. These new projects - typically structured as public-private partnerships (PPPs) or build-own-operate-transfer arrangements, both of which revert to government ownership after a set period - become the privatizations of the next generation. However, this virtuous circle needs to be supplemented by other efforts to get superannuation funds into greenfield projects.

An EY report on infrastructure financing, commissioned by the Financial Services Council in 2011, identified a string of obstacles. These included a lack of a clear pipeline and government commitment, insufficient specialist expertise available to superannuation funds, sovereign and political risk, regulatory pressures, a lack of suitably structured projects, complex bidding processes, and greenfield project risk. The last three are worth exploring in more depth.

First, for lack of suitably structured projects read the ever-expanding check sizes of the largest super funds. "Equity check sizes tend to be quite small and the demand for infrastructure investment is very large," says Morgan Stanley's McLean. "With large infrastructure investments, the equity checks paid are in the billions of dollars whereas the average PPP the equity check will be less than A$200 million. It takes a lot of PPPs to move the needle when you have so much money looking to get invested in infrastructure."

Second, the length of time between entering a bid for a project and seeing a return on the investment can be off-putting. The bidding process alone takes 18-24 months and there is no guarantee of success. If successful, there is another 3-5 year construction window after which the project starts to generate cash. A brownfield privatization, by contrast, begins with a dressed-up investment mandate package from a sell-side advisor and ends 3-4 months later.

The resource-intensive nature of a greenfield process is just not suited to a superannuation fund that might have no more than three people assigned to direct infrastructure projects.

"Time, cost and uncertainty of participation - particularly in a world where super funds are looking to internalize and have finite resources - is not a great use of resources. Hence the preference to get involved in projects where they can apply themselves intensely, try and acquire an asset, and then deploy their capital and start making returns," says AMP's Foster.

Finally and perhaps most significantly, project risk. Last September, Sydney's Cross City Tunnel entered voluntary administration after failing to refinance its debt, offering a timely reminder of what happens when PPP goes wrong. The asset launched in 2005, supported by A$680 million in debt and equity financing, but slipped into insolvency a year later due to low traffic volumes. New owners came in but couldn't make a go of it.

Several tunnel and toll road PPPs from the early to mid-2000s were undone by optimistic forecasting. As such, if a superannuation fund is going to invest in a greenfield project it expects a higher return for the risk being taken on - capital could be sunk into construction only for the tolls from the operating asset to fall short of the level required to turn a profit. This explains the willingness to back a proven performer like Port of Newcastle, with the certainty of demand that comes from being a staging post in the Hunter Valley coal supply chain.

It would be wrong to say there is no pension fund money in greenfield infrastructure. In the current environment, Partners Group favors the small and mid-cap space where enterprise values are below A$1 billion, as well as new builds in areas such as urban rail services, renewable energy and social infrastructure. It works with long-term institutional investors on these deals.

In addition, the likes of Morrison & Co, Palisade Partners and AMP Capital run dedicated PPP funds that build new projects or buy into existing ones, while a handful of superannuation funds have participated in PPP directly. For example, two years ago HOSTPLUS team up with Lend Lease won the mandate to develop Sydney's new waterfront convention, exhibition and entertainment precinct.

"Everyone talks about filling the infrastructure gap in terms of funding the build-out of new assets and it's a good byline, but we haven't seen too many examples of direct participation in greenfield PPPs by Australian super funds in recent years," says Benjamin Haan, Partners Group's Australia-based head of Asia infrastructure." However, the super funds are consolidating and building up direct teams of their own so I expect it to happen more in the future."

The process could be facilitated by making it easier for the superannuation funds to participate. One option is for state governments to underwrite a portion of the demand risk in order to get investors on board and then exit via a refinancing a few years down the line, once the asset is up and running.

This was one of a number of issues highlighted in a report published earlier this year by the Productivity Commission that called for a comprehensive overhaul of processes for assessing and developing public infrastructure projects. It challenged the argument that private capital would increase capital available for infrastructure, noting that government guarantees and tax concessions come at a cost. "Private financing is not a ‘magic pudding' - ultimately users and/or taxpayers must foot the bill," the report said.

"This is basically their way of saying that the trustees of super funds and the investors of those funds have a fiduciary duty to their unit holders," says Sean Gregory, managing partner in the deals division at PwC Australia. "They are going to invest in things they think meet fiduciary criteria and if PPPs don't meet those criteria then they aren't going to get investment."

Another missing piece in the jigsaw is infrastructure debt, although interest in these assets is on the rise globally in both the senior loan and the mezzanine space. Partners Group is invested in one local PPP where super funds provided funding on teh senior debt side, but Haan describes it as a rare example. Once the base rate started falling in 2012, absolute returns have become too low to generate additional appetite for this type of lending.

A frequently-cited factor is the hold the Big Four Australian banks have over the domestic debt market and the limited range of options available. Developers have typically struggled to secure long-tenure loans that extend beyond seven years because of the risks tied to projects where there is uncertainty over end-user demand. In the US and Europe, tenure can be 20 years or more.

"The infrastructure investment spend over the last 4-5 years and what looks to be coming for the next 10 years suggests that an infrastructure bond market will be much more needed than previously," adds PwC's Gregory. "A lot of infrastructure construction over the last 5-10 years has been private infrastructure for resources. It is really only in the last two years that the debate over public infrastructure, which needs a bond market, has really exploded again."

The giant hand

In this sense, while there are shortcomings in infrastructure financing, the common view among industry participants is that they can and will be addressed. Confronted by an impending wave of privatizations, superannuation funds are focusing on how they can efficiently and effectively participate in these processes, whether it is through a blind pool fund, as a co-investor or as an independent. Once the wave breaks, attention will turn elsewhere.

Recycling capital from brownfield privatizations into greenfield projects is one way of channeling superannuation fund capital into new builds. Indeed, of the various solutions assessed in the EY report, this was enthusiastically received. What it does not do is move the debate forward in terms of creating a financial modeling and reliable demand forecasting for greenfield projects that would make them acceptable to a larger pool of long-term investors.

Nevertheless, these investors remain natural owners of and lenders to domestic infrastructure. And if brownfield assets continue to get bid up then the impetus for reform could come from the super funds themselves as they reassess the risk-return dynamic. After all, the New South Wales ports transactions all traded at heady multiples of 25x forward earnings.

"Logically, from an economic perspective, you would have to think greenfield projects would become more appealing over time as the competitive nature of the brownfield sales processes stays as it is or potentially increases," says Rebecca Maslen-Stannage, a partner at Herbert Smith Freehills. "It might end up making sense for super funds themselves to push for a way to work with governments to mitigate those risks and get into greenfield projects in a way that is acceptable to them."

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Infrastructure
• Infrastructure
• Infrastructure
• Australasia
• Infrastructure
• LPs
• Australia
• buyout
• AMP Capital Investors
• Partners Group
• Morgan Stanley
• HESTA