Australian infrastructure: Changing tastes

"Australian pension investment into infrastructure and infrastructure funds has gone on for decades," Mark Schneider, head of power and electricity with Investec Bank in Sydney, tells AVCJ. "In fact, one could make a case that these vehicles are largely an Australian invention."

The infatuation with infrastructure remains - some LPs commit twice as much to the asset class in percentage terms as their Western counterparts - but not necessarily the interest in accessing it through a partnership structure. Rather than invest in funds pioneered by the likes of Macquarie and Babcock & Brown, Australian superannuation schemes with sufficient scale and resources are looking to enter the infrastructure space directly.

To understand why, however, it's necessary to look back a couple of decades.

In the 1980s, the country's retirement savings system was restructured so that, instead of covering only 10-15% of Australians, it covered them all. The expedient was the enforced savings rule, which mandated that first 3% of all salaries would be deducted as pension contributions. It subsequently rose to 6%, currently stands at 9% and, over the next few years, will reach 12%.

The A$1.4 trillion retirement savings pool that resulted was managed conservatively. Equities were targeted to a disproportionate degree. Even now, this asset class accounts for 53% of aggregate funds under management, according to the Australian Prudential Regulation Authority (APRA), with a further 16% is in fixed interest vehicles, 10% in property, 13% in other assets, and 8% in cash.

Boom and bust

With the onset of the boom years, PE rose on the agenda, including infrastructure funds. It helped that state governments were looking to privatize some of their infrastructure assets, such as freeways, power stations, ports and airports. Although a political hot potato for some time, privatizations gathered momentum, and pension funds were encouraged to embrace more risk.

Macquarie dominated the infrastructure space and was subsequently dubbed the "millionaire factory," one source familiar with the asset class tells AVCJ.

"Macquarie built a series of vehicles that became legendary in terms of the bold way in which they were conceived," the source explains. "Originally, they raised money from their own balance sheet and then sold these vehicles via public listings. They even went international, capitalizing on their first mover status in infrastructure securitization and offering assets to public investors directly."

Unfortunately, a number of these structures - and not confined to those offered by Macquarie - couldn't withstand the rigors of the global financial crisis. Many of the domestic corporate private equity funds found themselves in the same predicament.

At the same time, Australia's public equity markets slumped by about 50%, due in no small part to foreign investors dumping shares in response to crisis-created problems at home, while consumers pulled back, concerned about potential weaknesses in the banking system and its impact on mortgages.

The assumed safety of the superannuation funds' infrastructure holdings - critically dependent on throughput activity to fuel their cash flows, on the number of cars crossing a bridge or going through a tunnel or checking into an airport - started to look anemic.

The government's efforts to protect the man in the street's pension gave rise to MySuper, a program designed to simplify how superannuation worked and push the costs of managing it as low as possible. LPs responded by reverting to the safety of traditional asset classes and taking no risks. The consistent long-term returns offered by infrastructure, stripped of the aggressive structures used pre-crisis, fit the bill.

DB versus DC

However, this return to conservatism isn't the only driving factor. The structure of the Australian superannuation system is also important. In most Western nations (although not the US), large pension plans tend to operate under a defined benefit (DB) model: an employer promises to pay a monthly benefit when an employee retires, based on the individual's salary, tenure of service and age, rather than on investment returns. As a result, capital accumulates in a predictable manner.

About three quarters of Australian superannuation funds are defined contribution (DC), which differs from DB in that benefits are based on employer and sometimes employee contributions plus investment earnings. The approach is less costly, but future benefits are not guaranteed.

The DC grouping is split into three roughly equal parts: union-backed type of industry funds, state government or commonwealth government schemes, and self-managed superannuation funds. The latter of these is growing fastest, but there is little that is standard about the system's makeup. Similarly, individual investment strategies vary widely, including the extent of commitments to infrastructure.

"Australian superannuation funds are not homogenous. For example, retail supers tend to have higher concerns over liquidity, and as a rule have invested less in infrastructure," a spokesperson for Cbus Super, the A$17 billion construction industry superannuation fund, tells AVCJ. "Industry supers, with the default status for members in many industries, have tended to make a higher allocation to infrastructure. And self-managed superannuation funds rarely have sufficient size to enable investment in unlisted infrastructure assets."

There is real competition between some of these funds, especially in the retail and self-managed segments, and to a lesser extent among industry funds. One issue, though, is important to all: liquidity.

During the global financial crisis, there was a spike in DC member transfers, moving from growth or balanced assets to more conservative investment options. This cost the system an estimated A$430 billion, and so today there is a much greater focus on liquidity risk.

Funds have also been spurred to "retailize" their business, leading to frequent price changes and liquidity offerings to facilitate self-managed fund beneficiaries switching between options. In this way, end users are essentially making investment strategy decisions.

"There is a clear shift toward a more retail focus in pension industry design, and certainly in the implementation and practice for many Australians. There's almost an expectation vis-à-vis the retail product," according to one senior private equity executive. "As a result, question marks are unavoidable around liquidity and illiquidity considerations, and assets that are generally hard to price on a daily basis."

Place in the portfolio

What do these liquidity issues mean for infrastructure, a classic illiquid segment but one that accounts for a relatively small portion of most portfolios?

Jason Peasely, head of infrastructure at AustralianSuper, says the goal is to generate "equity-type returns but with bond-like volatility," and the fees paid to managers should be low in order to reflect the long-term commitment. Beyond that, though, the infrastructure space is far from uniform. According to a Citigroup study, Australia needs about A$770 billion for infrastructure projects up to 2018. But getting significant allocations from the vast pool of national retirement savings has so far proven difficult.

Government promotion efforts have met with a mixed response. There are plenty of stories about investors getting burnt after committing to green field projects based on traffic projections that turned out to be overly optimistic. Many superannuation funds are averse to this kind of risk and so they opt for more mature, brown field investments.

Brett Himbury, CEO at Industry Funds Management (IFM), notes there is a mismatch between what the government sees as a successful infrastructure project - i.e. getting it funded, built and in operation - and investors' expectations for acceptable returns within an agreed timeframe.

"Our responsibility is to our investors whose capital it is," Himbury says. "So, we will look both within Australia and globally to prudently deploy that capital. The major challenge for everyone has been the lack of infrastructure equity deals in Australia. We are a relatively small country with a relatively small number of airports and toll roads, yet we have this huge and growing superannuation savings system."

This shortage tends to drive up acquisition prices for assets that do come on the market. The situation is then exacerbated by the Australian predilection for holding such assets for a long time with a view to generating cash flow rather than capital gains. This goes a long way to explain why superannuation funds are increasingly interested in offshore investments. Half of IFM's $11 billion infrastructure fund is committed to overseas assets.

The direct route

The other key trend in superannuation fund strategy is the shift from investing through partnerships to deploying capital directly.

After a few years of parity, partnership structures dominated for more than a decade until the global financial crisis prompted a rethink. In 2009, A$456.8 billion was invested directly versus A$426.5 billion that went to fund managers, according to APRA, and the gap remains. Last year, the direct investment amounted to A$577.6 billion while fund managers attracted $551.6 billion.

Although industry sources say that superannuation funds' exposure to infrastructure is primarily through funds, they are becoming disillusioned with the current state of affairs. "Investor concerns these days are focused on the conflicts of interest that can arise between the interests of the managers and the interests of the fund, such as when managers decide to increase the size of the fund because that increases their management fees," says Investec's Schneider.

There are also concerns about investment banks acting as both managers and vendors of assets into funds, or taking on advisory roles.

In this context, the growing interest in direct investment among the better resourced superannuation funds is no surprise. "We expect to make more direct investments in the future, to retain decision-making power and greater control over portfolio composition," says AustralianSuper'sPeasely. "However, we will remain invested in funds."

Cbus is of a similar view. The expectation is that Australia will evolve along similar lines to Canada, where direct investment increased in tandem with growth in the overall size of pension funds.

The challenge is structuring transactions to mitigate risk. For example, an asset might require operation and maintenance on an ongoing basis, so the investor seeks to outsource responsibility under a fixed-price contract that might last several decades. There has to be certainty that the third-party outsourcer is able to meet the terms of the contract and at the best possible price.

For utilities investors in particular, competition is an issue. A superannuation fund wants infrastructure to deliver predictable cash flows in the long term but prices vary in a deregulated market, so there is additional risk to manage.

In certain cases, it might make more sense to co-invest with a fund manager. IFM's most recent deal in Australia was the purchase of a 50-year operating lease for the Port of Brisbane at a price of A$2 billion. The size of the transaction and length of the commitment required a high level of due diligence.

"It's not every LP that can afford to have a team like that sitting around when they're only likely to deploy it on a deal once every 12 months or so," Himbury observes.

It is worth noting that IFM is actually owned by an agglomeration of industry superannuation funds, which affords it a scale and resource base capable of undertaking such projects. If the industry superannuation funds operated independently, they might not be able to carry out exhaustive due diligence.

Infrastructure investing is indeed a costly business because it is labor intensive and requires a great deal of analysis. It takes time to build up a team capable of handling the workflow and this, combined with the general climate of caution, will have an impact on superannuation funds' commitment to the asset class, whether investing directly or through fund managers.

Several industry participants point out that Australian institutions have a history of struggling with exotic investments and the risks they entail. As a result, executives are wary of putting their name on new projects. This isn't necessarily true of some of the big offshore funds and they may increase their exposure to Australian infrastructure with a view to leveraging strong economic growth, vast natural resources and a proximity to emerging Asia, where demand for commodities is only going to rise in the long term.

The irony is that Australian pension funds may, in the end, largely miss out on this building boom, while more perceptive foreigners prosper. The key differentiating factor, according to one private equity manager, is that overseas infrastructure investors haven't been crippled by the cost phobia currently gripping their Australian counterparts.

"I think the status quo amounts to an epic opportunity for overseas investors to come here and take excellent positions while the Aussie guys are traumatized," he says.

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