The nimble giant

Sovereign wealth funds (SWFs) come in all shapes and forms. Some derive their resources from the surplus generated by energy exports; others capitalise on non-commodity sources of economic wealth. Liability and pay-out rules differ widely across funds, depending on whether they’ve been set up to help buttress macroeconomic stability, foster development, or safeguard wealth for future generations. Some are limited to investing in vanilla securities while others are making bold steps in alternatives.

What’s recently been most in focus, however, is the sheer size of the SWF club’s prominent members: Abu Dhabi Investment Authority and Norway’s Government Pension Fund are thought to manage a respective $773 billion and $838 billion, for instance. The firepower this gives them – and their increased willingness to pull the trigger themselves – is making life more difficult for other investors. Infrastructure is not immune to the trend: the last few years have seen a rising number of sovereigns outgun rivals in auctions for multi-billion-dollar roads, ports and airports.

By such standards, Australia’s Future Fund appears relatively modest. At the end of March its assets totalled A$97.57 billion (€66.66 billion; $91.39 billion). The fund has also shied away from its home country’s latest mammoth transactions, which saw Port of Newcastle, Queensland Motorways and New South Wales’ Ports Botany and Kembla reach inflated valuations.

What is remarkable, however, is how fast the institution has grown. Launched in 2006 to meet the government’s future liabilities to retired employees, it started its life with $18 billion under management. A large chunk of its growth has been government-sponsored: a budget surplus from the country’s mining boom has allowed the Treasury to wire a cumulative A$60.5 billion to the Future Fund’s coffers. But the sizeable balance suggests the institution has been pretty successful at nurturing the money. And this provides a good reason to take a look at its strategy in more detail.

THE BIG PICTURE

In one crucial respect at least, the Future Fund’s approach differs markedly from that of most sovereigns. “We work very hard to think of our investment programme as being holistic at the whole fund level. None of our strategies and none of our personal alignments are focused on our own sector portfolios,” says Raphael Arndt, head of infrastructure and timberland at the fund.

The philosophy followed by its 40-strong team is termed “one team, one portfolio” – a message you will find on its office mugs – meaning that all new investment ideas are debated against each other regardless of asset type and judged on their capacity to add return or reduce risk to the whole portfolio. In that respect, the fund is perhaps closer to an independent multi-asset manager than a sovereign wealth fund.

Within this framework, however, infrastructure has a more specific role: the asset class is seen as a way to diversify away from the predominant risk of the Future Fund, which largely lies in equities. Infrastructure also brings exposure to inflation – helping the fund reach its mandated return benchmark of Consumer Price Index (CPI) +4.5 percent to +5.5 percent over the long term – as well as to economic sectors harder to target through the stock market.

Beyond these broad guidelines though, the fund’s infrastructure strategy is resolutely pragmatic but also dynamic. “We don’t want to create artificial fences around the definition of what is infrastructure vs. any other asset class. For us, infrastructure could be high risk or low risk, listed or unlisted, emerging markets or developed markets, debt or equity. We keep all the options open,” says Arndt.

And the fund has used this flexibility to the full since creation. Initially focused on core, low-risk infrastructure assets in developed markets, it then reconsidered its position as the financial crisis took hold. “Market prices hadn’t necessarily moved sufficiently to compensate for the lower economic outlook in much of the developed world,” says Arndt. In the listed infrastructure space, by contrast, assets with similarly attractive characteristics were being oversold, so the fund invested heavily in the segment from 2009 onwards.

UP THE RISK CURVE

More recently the fund began realising its listed assets to accrue the profits generated by recovering valuations. Meanwhile, lower competition for Australian assets – as foreign investors retreated and domestic funds found it hard to raise money – justified a domestic push.

But successive waves of monetary stimulus around the world soon pushed valuations of core, long-duration assets back up – prompting a shift towards what Arndt calls “opportunistic infrastructure”. The institution is now keener on shorter-duration strategies, whereby it fixes businesses and sells them after several years or carries out private equity-style roll-outs.

“At the moment they are going up the risk curve because they don’t believe they are getting rewarded by the stuff at the lower-risk, lower-return end of things,” comments an adviser with good knowledge of the fund. “But I don’t think it is a fundamental long-term structural view. It is more of a tactical, shorter-term perspective on what represents a relatively good risk-return profile.”

Provided it gets the management arrangements right – and aligns interests correctly with the managers of said assets – such an approach can yield outsize returns to the institution, he adds.

SMART OUTSOURCING

The Future Fund is much keener on working with external fund managers rather than trying to do everything in-house. That’s in accordance with what Arndt describes as the fund’s “hybrid model”: it strives to be an informed limited partner (LP) with a willingness and capacity to undertake co-investments but which prefers to hire “the best people in the world” to effect its strategies.

“It’s a bit like the 80/20 rule: you probably get 80 percent of the value from making 20 percent of the decisions around should I buy infrastructure or sell it, buy in South America or Europe, be in energy or transport. We make sure we have enough time to focus on those decisions and therefore try not to get bogged down in the day-to-day issues of asset management.”

The seven-strong infrastructure team would rather concentrate on thinking about its exposures to various assets, and what risks that entails, than getting stuck in negotiating refinancing documents or renewing capital structures, for instance. “They have a very thoughtful approach to infrastructure,” comments a placement agent. “Their role – as a relatively small team that outsources a lot of the processes but retains control of the discretion of how it allocates its capital – is a very interesting model.”

This doesn’t preclude the institution from going direct when warranted, however. That indeed was the case when it bought all the portfolio assets of the Australian Infrastructure Fund (AIX) from Hastings Funds Management for A$2 billion in 2012.
This leads some observers to expect more such deals in the near future – and prompts them to wonder whether that may put pressure on some of the relations it has built, steadily and patiently, with its preferred fund managers. Arndt dismisses such fears. “I think it’s a real opportunity for them. Today all of our assets are managed by third parties.” That’s true even for the AIX portfolio, he says, which is now looked after on a day-to-day basis by external managers.

The select group of firms the institution works with – which comprises AMP Capital Investors, Citi Infrastructure Partners, Global Infrastructure Partners, Highstar Capital, The Campbell Group, UBS Global Asset Management as well as listed specialist RARE Infrastructure – suggests a robust commitment to forging a handful of strong relationships with blue-chip managers.

TEAM SPIRIT

Yet notwithstanding its deftness at outsourcing the nitty-gritty of asset management, some observers question whether the fund is appropriately resourced. “Most of the world’s largest LPs face the same problem. It’s just quite hard to source deals overseas when your team remains small and so far away from the ground,” argues an Australian fund manager. Another adviser close to the institution also wonders if there is enough fresh blood going in to generate new investment ideas. “The senior members of each of the teams have been in the same role for some time. There’s been a slowdown in the level of investment that they were able to make.”

The causality link is debatable. As our adviser himself points out, the Future Fund started out with a vast amount of cash to deploy; with this initial capital gradually locked in across various asset classes – most often with a long-term focus – it’s only natural that the pace of investments somewhat abates. And while the fund may benefit from recruiting more internationally – many of its initial hires were investment professionals that had cut their teeth in the Australian market, observers say – an outside observer points out that the team “does travel an awful lot” to keep on top of overseas markets.

Critics also miss a point about how the fund’s tight-knit organisation fits with its overall strategy. “At the end of the day we need to be prepared to go to our investment committee and say infrastructure is really expensive, we can get the same exposure through property or something else so we should sell the portfolio,” says Arndt. “That’s how we would add value to the fund if those circumstances warranted that. The team could then go off and help the property team build their portfolio. So we’re building a more generalist approach internally.”

That is reflected through the fund’s decision-making structures: its various investment committees – at the fund level as well as across the different asset classes – are made up of senior people from the investment teams of all sectors. The infrastructure team itself may grow a little as the portfolio builds out, Arndt says, but he sees it remaining well under 20 people.

KEEPING IT NIMBLE

How the fund manages its people is closely linked to how it thinks of asset allocation, another aspect of its strategy that’s not always understood. “They’ve got a high, heavy exposure to alternatives in general but whether they’ve got the right mix is debatable. I’m not sure how they arrive at their investment allocation decisions,” says a placement agent.

The fund has about 8 percent invested in infrastructure, and a 30 percent allocation target for real assets – which Arndt says would reflect its exposure “on a notional fully built-out basis in a steady state market when all assets are fairly priced”. In practice, however, the fund adapts to different investment climates by retaining a fleet-footed approach to allocations – a position that most observers see as valid.

“This idea of filling a fixed allocation bucket is a dangerous one. It can lead to situations where you overpay for assets or sell them when you shouldn’t be, just because you need to hit your target,” underlines a placement agent.

This point addresses another criticism sometimes voiced against the fund: its alleged propensity to pay too much for its purchases. The case often cited to illustrate this is the fund’s acquisition of a 29.7 percent stake in Perth Airport in 2012, for which it paid A$875 million as part of the AIX transaction. The sum exceeded the highest independent valuations by a reported A$128 million, prompting AustralianSuper to launch legal proceedings against the Future Fund (AustralianSuper claims this hefty premium priced it out of increasing its existing 5 percent stake).

But no insiders polled by Infrastructure Investor for this feature thought the Future Fund had a track record of signing unduly large cheques. One of them judged that the 17.2 percent stake in Gatwick Airport that it bought for a reported £145 million (€179 million; $243 million) in 2010, for example, was very attractively priced. In the case of Perth Airport, Future Fund says it is “confident in its position and will vigorously defend its case”.

What the lawsuit does illustrate, an adviser says, is how distinct the Future Fund is from “the industry superannuation fund complex in Australia”. The institution has a longer-term focus than the country’s supers, another insider argues, allowing it to target less liquid assets, take on greater market risk and be opportunistic. All of which, states the Future Fund in one of its position papers, can help it generate higher returns in the long run.

BOTTOM LINE

The fund’s overall portfolio has been performing relatively well. At 6.8 percent per annum as at the end of March, the fund is somewhat short of its annual target return of 7.2 percent since inception (calculated from its real-return goal of 4.5 percent per annum). But shorter-term benchmarks are more flattering: the fund currently boasts annual returns of 11.2 percent over five years and 9.3 percent over three years, easily beating its respective goals of 7.1 percent and 6.9 percent.

There are positive and negative caveats. The fund started investing as the Global Financial Crisis kicked off; some of its investments will likely pay off in the longer-term. Equally, it has benefitted from the strong rally in world equities that has taken place over the last couple of years.

This may not last forever though. “Markets are relatively buoyant and valuations across most sectors are now looking fairly full,” said David Neal, chief investment officer of the Future Fund, at the end of April. “We are conscious that […] sustainable future returns need to be underpinned by improved economic growth.”

In this context it is worth asking to what extent infrastructure can help the fund reach its target. Arndt is bullish. “As an LP the vanilla way we could have invested in infrastructure would have been to pick a range of funds and to invest capital into those funds, and over the period since inception that would have generated a high single-digit return. Our actual performance has been around double that.”

The coming years, of course, will bring a lot of challenges. Many other large institutions are throwing their heft into infrastructure, so capital won’t be easy to deploy. And as the portfolio continues to grow, the team may have to expand further without losing its edge. But privatisation programmes in Australia and elsewhere, should they gather momentum, could also provide fresh investment targets.

Enough to make Arndt cautiously upbeat. “Since the beginning we haven’t worried about what other people do – although we of course try to learn from their practices – we’ve worried about what would work for us. So far this has proven to be successful but we have to keep working at it.”