The long game (weekly)(3)

New breeds of infrastructure investor are looking at the UK market. Short-term uncertainties shouldn’t detract fund managers from planning how to engage with them.

Trouble is brewing in the UK market. Ofwat, the water regulator, will issue its final determination in December, setting the prices water utilities are allowed to charge customers for the period 2015-2020. It isn’t expected to be too lenient on water companies – the latest draft review, published in August, recommended an average 5 percent real-terms cut in customer bills compared with 2010-2015.

Meanwhile pressure is mounting for energy companies to announce price freezes; the Labour party has even reiterated pledges to replace Ofgem, the existing power regulator, with a tougher institution should it come to power next year. Neither is the picture rosy on the renewables front: the Renewables Obligation (RO) regime, the UK’s current green energy subsidy scheme, is to be closed to large-scale solar projects as of April 2015.

It doesn’t help that general elections are due in barely more than six months. The future of a number of planned greenfield projects is in the balance and uncertainty surrounds politically sensitive privatisations. Yet industry insiders see no reason to panic: uncertainty, they expect, will diminish once the election outcome is known. While not exactly enthused by regulatory reviews, they also see them as being part of the game – and as long as they remain reasonable, it’s possible to adapt to the new rules by tweaking models.

More important to asset managers is what happens in the long-run – and on two specific fronts. For one, they’re keen to see the UK remain a very advanced private infrastructure market – and that politicians guarantee the support and stability needed for it to do so. Contrary to what the media discourse sometimes suggests, so far this is not really in doubt: all major parties have expressed their support for an increased investment in infrastructure; the work of Lord Deighton, sometimes nicknamed “the Infrastructure Minister”, is further helping streamline procurement, execution and delivery.

There's still progress to be made on converting high-level initiatives into attractive, investable projects. But some investors see the mere existence of the National Infrastructure Plan and the UK Guarantees Scheme, amid the challenging economic and political climate of the last five to seven years, as concrete proof of the authorities' commitment to provide a clearer pipeline. It is also reassuring that in its revamp of the Private Finance Initiative (PFI) – dubbed PF2 – the government has built on the model designed by its predecessors rather than discarding it wholesale.

This commitment to creating enticing frameworks and a sound investment climate is partly linked to the UK’s reliance on foreign direct investment (FDI), which encourages governments of various political colours – albeit in varying degrees – to maintain an attractive regime for private institutions to invest. Yet, ironically, this openness is tied to the second, long-term topic currently on the mind of incumbent asset managers: the arrival of new classes of investors in the UK infrastructure market.

The most visible of them are large institutions with direct infrastructure programmes. It is no secret, for example, that large Australian and Canadian pensions see the UK as an attractive place to deploy their money; sovereign wealth funds from Asia or the Gulf are also known to have their eyes on the market. But Northern European pensions, such as PensionDanmark, PGGM and APG, are also proving increasingly active. UK pensions are somewhat trailing the trend – but institutions like USS are now following the direct route, too.

These organisations are a source of competition for a number of managers, typically at the larger, absolute-return end of the scale. But another category of investors represents a sizeable opportunity for UK managers: smaller, domestic pensions. Few of them have pockets of capital dedicated to infrastructure yet, and, by some accounts, the actual allocation they have to the asset class stands at only 2 percent. This is true across a number of European countries, where smaller pensions are clubbing together to create dedicated investment platforms because they're not yet happy with what the market is offering them (an example of this is the UK's Pensions Infrastructure Platform). Understanding their needs – particularly in terms of fee structures, duration and strategy – will be crucial for managers seeking to tap new sources of capital.

Further down the line, there is also the possible game-changer that is the move from defined benefit (DB) to defined contribution (DC) pension schemes. Only a minor feature a few years ago, they'll probably be the largest pools of capital seeking to be deployed in the UK a decade from now. And the experience of markets like Australia and Canada, where they are already prominent, has shown that they are looking for very different investment solutions: much like some sovereign wealth funds, they have limited or no liabilities to match and therefore can take a more flexible approach to asset allocation. This represents a big opportunity for infrastructure fund managers – but also one that will need to be carefully prepared for.

The UK infrastructure investor landscape is changing. While the dust settles on more immediate matters, fund managers need to play the long game – and keep their eyes on the ball.