Unfit for the long run

In a report released earlier this year, the World Economic Forum (WEF), a Swiss-based non-profit organisation, stated that long-term investments were under threat, even though demand for long-term capital was at an all-time high.

Sound paradoxical? According to WEF, it can be explained quite easily through a combination of regulatory and accounting requirements that are tying the hands of those most capable of entering into long-term investments: pension funds and life insurers.

One of the culprits hindering investors is mark-to-market accounting, defined by the Swiss-based organisation as “the current market value of an asset irrespective of whether the investor has locked in his price by selling the asset”. In other words, mark-to-market accounting is the practice of tying assets’ valuations to the present time – namely, to whatever markets think they are worth at any given moment.

Pensions ‘pushed away’

The downside of this approach is that it “may encourage investors to focus on near-term changes in market value, rather than the long-term prospects of an investment,” explains WEF. Worse: “Mark-to-market accounting and pension regulations, combined with a general fall in pension sponsor appetite for pension fund risk, are pushing pension fund managers away from long-term investing,” the organisation concluded.

But it was Angelien Kemna, chief investment officer for Dutch pension fund manager APG and a member of the report’s steering committee, who brought the problem home for those keen to invest in infrastructure, whether directly or through listed vehicles:  

“Having to account for mark-to-market price changes for assets that we do not intend to sell for many decades makes it harder for us to hold these assets through a market downturn,” she told the BBC, following the report’s release.

Before we go any further, it’s worth noting that, whether legitimate or not, complaints about mark-to-market accounting are not exactly new. Newt Gingrich, a Republican candidate to the US presidency in 2012, was very vocal in 2008 on the need for regulators to suspend mark-to-market accounting, which he identified as one of the main factors exacerbating the global financial crisis because of the volatility it introduces.

But Kemna’s comments raise a legitimate question:  What is the best way to account for infrastructure assets that you plan to hold on to for 30 or more years? Is it through a method that will expose them to every single bump in the road?

Keith Pickard, infrastructure director at InfraRed Capital Partners, the management team formerly known as HSBC Specialist Investments and advisor to the UK’s first listed infrastructure fund, HICL, commented:

“For some institutional investors, mark-to-market accounting acts as a deterrent and we’ve had some investors telling us this. We see mark-to-market as just another piece of information which allows investors to find out exactly what an asset is worth at a given point in time. It’s true it introduces some volatility, but infrastructure is much less volatile than other asset classes.”

Certainly, one of the main problems with mark-to-market accounting is that “by not distinguishing between those investors with short-term liability profiles and those with long-term ones, these moves have had unintended consequences for long-term investors and, in turn, for financial markets and the economy more broadly,” WEF claims.

An example of the sort of unintended consequences the WEF report is alluding to comes courtesy of another piece of research issued recently by the Organisation for Economic Cooperation and Development (OECD), the economic policy group for the world’s developed countries:

Encouraging pro-cyclicality

“Regulations sometimes also exacerbate the focus on short-term performance, especially when assets and liabilities are valued referencing market prices. As an example, the use of market prices for calculating pension assets and liabilities […] appears to have aggravated pro-cyclicality in pension fund investment during the 2008 financial crisis in some countries such as Denmark, Finland and the Netherlands.”

The report shows that pensions, despite their theoretical propensity for long-term investments, are increasingly more “short-termist” in their investment strategies, reinforcing Kemna’s point about pensions not being encouraged to hold assets with long-term characteristics.

“Signs of such growing short-termism include the fact that investment holding periods are declining and that allocations to less liquid, long-term assets such as infrastructure are generally very low and are being overtaken in importance by allocations to hedge funds and other high frequency traders,” the report adds.

At this point, unlisted infrastructure fund managers will probably raise their hands and highlight that institutional investors have only to invest in infrastructure through their vehicles to avoid the perils of mark-to-market accounting, which they are not obliged to apply. Indeed, as Andy Thomson indicates in his accompanying feature on page 18, unlisted infrastructure fund managers will typically use a valuation methodology based on discounted cash flows.

But investing only through unlisted infrastructure vehicles would greatly limit the flow of institutional investor capital to infrastructure, especially since an increasing number of large institutional investors prefer to target infrastructure directly.

As it stands, mark-to-market accounting does little to help certain public sector initiatives – such as the European Union’s and the European Investment Bank’s Europe Project Bond 2020 – which are trying to turn institutional investors into direct providers of infrastructure debt.

As InfraRed’s Pickard points out, infrastructure debt is actually more vulnerable to the volatility introduced by mark-to-market accounting, adding that HICL’s investment in a debt facility for UK utility Thames Water had experienced significant value fluctuations at the height of the financial crisis. 

A possible way around the woes of mark-to-market accounting is to use it “for the short-term portion of an institution’s liabilities, while more flexible approaches could be adopted for its long-term portion,” WEF states in its report.

Irony

In the end, ‘flexibility’ seems to be the key word. The fact is mark-to-market accounting is part of a long-list of regulations – which also includes Basel III and Solvency II – that are not very friendly toward long-term investors.

The irony of many of these regulations is that they are being implemented to combat the causes that brought the world economy to the edge of collapse in late 2008, while failing to encourage the sort of long-term investments that would serve as an antidote to the short-term culture that was complicit in the worst financial crisis since the Great Depression.

The reality, though, is that until regulators and governments make regulation friendlier for long-term investments, the sort of long-term capital that could contribute substantially to help fund the world’s infrastructure needs is likely to remain frustratingly locked up in institutional investors’ balance sheets.