‘New Conservatism’ sounds a bit like an oxymoron, but in several ways it captures the mood prevalent in the UK today. In the wake of a general election that granted them a surprise majority last May, Tory ministers are borrowing people and ideas from their Labour counterparts. The move is reminiscent to the approach embraced after 1994 by former Prime Minister Tony Blair, who strived to broaden his party’s agenda by rebranding it as ‘New Labour’.
Meanwhile the country’s pension funds and insurers – investors of the conservative kind – are looking for new solutions to put their money to work at a time when a plethora of liquidity is making it hard to achieve desired returns. This is leading them to consider investing in asset classes they’ve seldom explored before, while limiting downside risks.
The ‘old and new’ theme extends to the discussion Infrastructure Investor is about to chair on a sunny October afternoon. As we prepare to quiz four infrastructure leading lights on what the autumn’s new developments mean for the investment industry’s future, we can’t help noticing that the meeting is taking place a stone’s throw away from the Museum of London – a temple of the city’s past.
Little time is spent admiring the view. There’s too much to talk about: George Osborne, the UK’s Chancellor, earlier in the week announced a flurry of infrastructure initiatives about which everyone is keen to comment. They included the creation of a National Infrastructure Commission (NIC), a body responsible for analysing the country’s long-term infrastructure needs and advising the government on key projects.
The idea, the brainchild of a review of UK infrastructure planning commissioned by Labour, is not new. But it is nevertheless welcomed by all participants in our roundtable, for whom the explicit recognition that the long-term nature of infrastructure projects doesn’t fit so well with five-year political cycles is a good step forward. “That was the right thing to do,” says Dominic Helmsley, managing director for infrastructure at SL Capital Partners. “It shows a willingness to make hard decisions.”
Michael Ryan, chief executive and partner at Dalmore Capital, echoes this sentiment. “The NIC should be a positive forum. It will bring a renewed focus on infrastructure development and more coordination of infrastructure policies.” Yet all agree that details still have to be fleshed out.
Guillaume Fleuti, head of infrastructure and energy at Lloyds Bank, in particular wonders how independent the body is going to be. Still, he believes the cause is worth pursuing. “It’s only normal that infrastructure decisions remain with politicians, so the Treasury should retain control of the public purse. But the commission should help lengthen their vision to a 20- to 30-years horizon.”
IN IT TOGETHER
Our panellists also respond with cautious optimism to Osborne’s announcement that the UK’s 85 local government pension schemes would be merged into six British Wealth Funds with £25 billion (€33.8 billion; $38.4 billion) minimum of assets each. “It’s very good news in the medium term. But it will lead to a period of figuring out for individual pension schemes in the short term,” says Ryan.
The UK pension market being very fragmented, Helmsley argues the policy is no doubt a sensible move: the announcement is in line with other initiatives seeking to bolster domestic investment in infrastructure, such as a £10 billion partnership formed by the London Pensions Fund Authority and the Lancashire County Pension Fund as well as the Pension Infrastructure Platform, a two-year old scheme aiming to raise £2 billion from UK institutions.
But he reckons implementation and execution may take effort and time. “The government has observed that a lot of pension fund capital is going into the UK but that very little of it is UK money, so consolidation is the right way forward. But in the short term, few decisions will be made. There’s a lot of wait and see, on the part of UK pension funds, regarding what Local Government Pension Scheme consolidation is going to look like.”
That’s all the more probable given that many pension funds rely on external advice to carve their alternative asset allocations, observes Ian Berry, head of infrastructure fund management at Aviva Investors. “We manage a lot of capital on behalf of defined-benefit pension funds, and most of these clients are very proactive in their investment decisions. But a larger number of pension funds tend to be led by consultants who, like the institutions they advise, are often very conservative in the face of new opportunities.”
Still, like his peers, he notes such announcements show the government has “the right focus”. That may not be perceived as true of every field the Conservative party has started legislating on since coming back to power last spring. Take low-carbon energy, where fresh subsidy cuts across sectors such as onshore wind and solar photovoltaic power have been described by industry observers as “a frontal attack” on the renewables industry.
Our panellists’ reaction is more sanguine. “The main difference between what happened in Spain and what’s going on here is that the UK is only looking forward,” Fleuti says. “DECC [the Department for Energy and Climate Change] and the government have been very clear about the fact that the cuts will never be retroactive. So if you’re a debt provider and you’re not happy with the changes, you can just decide not to do a project.”
Still, Berry thinks the signal being sent is not so great. “If you’re a specialist like us, you understand the details and you can assess the risks. But it’s really negative for asset allocators looking to make their first allocations and who know very little about renewable assets. They’ve been told by the government ‘we won’t change the rules’ and that’s not what they see.”
That doesn’t seem to be deterring Lloyds too much: renewable projects now represent nearly half of the bank’s pipeline in value, Fleuti reckons, whereas uncertainties about subsidy regimes in general and the Contract for Difference framework in particular meant the sector accounted for close to nil 12 months ago. And while Dalmore’s sweet spot remains social infrastructure, Ryan doesn’t exclude potential deals in the space either.
“We’re seeing opportunities with renewable portfolios developed by people who are not long-term holders. But the market for these is quite competitive, and pricing is quite challenging.” He has few qualms about the regulatory context in which these assets operate, which he reckons still ranks among the most stable in the world.
Helmsley also underlines competitive pressures in the sector. “We have deliberately stayed away from offshore wind given the development risks. On onshore wind, pricing is tight and yields are being pushed down, especially when listed infrastructure groups get involved. Still, onshore wind remains attractive.”
This has not been lost to institutional investors themselves, a subset of which, Berry says, now like the type of risk/return profile offered by the renewables sector more than they used to. But he warns these assets don’t suit everyone. “For many debt investors renewables aren’t a perfect fit. With a 15-year amortisation period on average, they’re slightly too short term. Whereas for equity and in particular for our clients, unleveraged equity, they can be a much better match.”
Another traditional magnet of infrastructure investment in the UK doesn’t seem to be winning quite the same plaudits. Asked how the public-private partnership (PPP) market is doing these days, Fleuti quips: “Is there one?”
Ryan partly agrees, but wishes to qualify this observation. “There’s still a market for buying operational assets. And increasingly it’s a market dominated by pension funds. This is good news: it’s taken 20 years to get there, but now PPPs are owned by people who want to hold on to the assets. It will surely decline, however, as the primary market’s been declining for some time. Social infrastructure is not the focus of the current government.”
Where Fleuti sees booming activity is in the area of refinancing. Sponsors that first raised debt in years where liquidity was more expensive, priced at LIBOR +250 basis points, say, are now making the most of possibilities to refinance at LIBOR +125 or 150 basis points. “There’s sometimes some friction between private sponsors and the local authority, when there is a service to the public sector,” he admits, however.
In a number of cases, adds Ryan, existing sharing provisions mean most of the savings generated by a refinancing will be pocketed by the public sector. Which doesn’t imply such transactions shouldn’t be pursued by project sponsors: developing good relationships with local authorities can in due course pay significant dividends.
One area where this can apply is greenfield infrastructure, where the right level of government guarantees can make large-scale, risky projects attractive even to traditionally cautious investors. Ryan cites the example of London’s Thames Tideway Tunnel, a £4.2 billion ‘super-sewer’ in which Dalmore owns a stake.
“Investors are going to receive income streams from the start, and sharing mechanisms mean the impact of construction costs is deferred. It’s been put together in a very conservative way: if the project ends up overshooting construction costs by 50 percent, for instance, the impact on investor returns is limited. But that was necessary to convince pension funds to invest.”
The experience may well be repeated, he says, as project costs are now expected to be lower than first anticipated. “The competition resulted in a project that is good value for money. The government made the right choice by de-risking first.”
Fleuti observes that a promising flow of greenfield projects is shaping up in the energy sector. Encouragingly, he reckons those are not limited to very large schemes. “There’s more interest in bigger ones, which get a lot of press. But in truth it’s really a mix.”
But aside from greater government protection, investor appetite for greenfield also results from another phenomenon: higher pricing and pressured returns in mainstream segments of the market. “The days when you could achieve 12-15 percent IRRs on core European assets are over,” says Helmsley. “Return expectations and fees are slowly adjusting.”
Berry has a different view. “People’s return expectations aren’t actually changing very much. But their assumptions are: if you have raised capital on a certain basis, you can’t influence the former, but you can affect the latter.” Fleuti similarly notes that business plans these days leave “very little margin for error”. And that’s on the back of fairly sparse historical data, adds Helmsley. “There’s been very few realisations compared to private equity. And some funds have been extended.”
Not that greenfield is immune to optimistic assessments by sponsors, Berry says. “These days, greenfield risk is very rarely priced in.” He also believes evaluations of asset performance en-route remains a tricky endeavour for limited partners. “How do end investors know how a fund manager is doing? Are they receiving true yield or are general partners investing in sweating or wasting the asset?”
THE MISSING LINK
Yet institutional investors so far seem undeterred. SL Capital, which is currently on the trail to raise its debut infrastructure fund with a £500 million target, is seeing demand from markets across the globe. “Allocations to real assets are increasing. In Canada, for instance, there are about 600 small to medium pension schemes that understand infrastructure. Europe is also fertile ground: there’s an obsession with yield, especially from insurers.”
Other continents offer interesting prospects – though raising money in Asia, he explains, remains “a very slow burn”. “Our team often jokes that we’re raising a lot of money for our second fund.” Fresh allocations also continue to come from the UK. But there, he points out, progress has remained frustratingly slow: commitments from corporate and local authority pensions are still heavily intermediated.
“Fundraising is always difficult and the UK is not an easy place to do it,” Berry concurs. “Interest in infrastructure rises, but action doesn’t: it takes ages for UK institutions to invest. But once they do, they’re very loyal. We have some clients that have re-upped three or four times.”
What’s less of a problem, it seems, is raising local debt. “Banks have repaired their balance sheets,” Fleuti says. “Several of them are now under pressure to deploy it. And you also have new institutional investors playing an increasingly important role.” Whereas spreads on corporate bonds have been widening since June, he believes the opposite has been happening with bank margins. “They’re simply getting tighter and tighter but the decoupling between bonds and loans cannot go on forever.”
That’s putting the onus on investors to remain disciplined, Ryan says. “In 2006, when bank pricing was at LIBOR +50 basis points and ratios were going down towards 1.1, we as borrowers didn’t want such low ratios. It’s hard to see how banks could have been pricing risk properly with margins and ratios like these.” The good news, however, is that they’re now able to choose how to finance projects from a wide, sophisticated range of products.
If only the pipeline could follow, he concludes. With prospects for PPP looking a little weak in the UK, he says Dalmore is now considering broadening its strategy to the rest of Europe.
Berry has other misgivings. “There’s a tremendous amount of UK capital available for infrastructure investments, but most of it still hasn’t made the first step of investing in the lower-risk projects. The problem is that easy PPPs and easy renewable deals don’t really exist anymore at returns that encourage a first step into a sector.”
Some clearly are – but as the TTT example shows, it may be up to the UK government to help domestic institutions climb on the first step of the infrastructure investment ladder. Here lies the verdict of the market: if it wants the novelty effects of its policies to last beyond its mandate, the Conservative party needs to further innovate.