Top 40 Money Managers: Why pension funds are turning to non-core infrastructure

“These Canadians own your town,” Fortune magazine declared in December 2015, referring to the massive infrastructure and real estate investments Canadian pension funds have made around the world. But Canadians don’t just own these towns. They’re also increasingly rebuild­ing them and fixing them up.

Why? Because the global competition for traditional infrastructure assets — operational facilities that don’t require improvement — is fiercer than ever. Defined benefit pension funds love these assets because the long-term, steady returns they produce can help cover future obligations to retirees. The returns also provide a great source of income in times of low interest rates, as is the case today. But the intense competition for these assets has driven up their prices and suppressed their returns.

Despite a reputation for being con­servative investors, Canadian pension funds have been embracing the risk of building new facilities from scratch through greenfield projects or snapping up existing brownfield assets that are in need of improvement at lower prices. The strategy is no longer the exclusive domain of sophisticated world-renowned players, such as the $171-billion Ontario Teachers’ Pension Plan.

Read: Despite challenges, Ontario Teachers’ 2015 return climbs

“The asset class is overheated on a worldwide basis,” says Hugh O’Reilly, president and chief executive officer of OPTrust, in reference to core infra­structure assets. Such assets are typically located in developed markets and immune from fluctuations in supply and demand because they’re regulated or protected by contracts.

Jim Keohane, president and chief executive officer of the $64-billion Healthcare of Ontario Pension Plan, feels the same way about current infra­structure prices. “The risk-return trade-off is not very attractive. It’s not to say we wouldn’t own infrastructure; at the right price, we would,” he said at a recent press conference in Toronto. “For the past few years, asset prices have been quite high, and it’s been challenging to find the things we’ve wanted to invest in.”

Ross Servick, head of Canadian distribution at Schroder Investment Management Ltd., is seeing a similar attitude among the Canadian defined benefit pension plans he works with. “A number of plans we’ve spoken to have slowed their investments towards [core] infrastructure because the rates have come down so significantly as asset prices have performed so well that the yields just aren’t what they were,” he says.

To be sure, pension funds are still active in core infrastructure. In February, three major Canadian pension funds won the bid to buy Britain’s London City Airport, a downtown facility primarily serving the city’s business executives. The winning consortium included the Ontario Teachers’ Pension Plan; the Alberta Investment Management Corp., which invests money on behalf of public pension plans in Alberta; and Borealis Infrastructure, the infrastructure arm of the Ontario Municipal Employees Retirement System.

Read: Teachers’, AIMCo and Borealis buy London City airport for £2 billion

The consortium that lost the bid in­cluded PSP Investments, a Canadian asset manager that invests money on behalf of several branches of the federal public ser­vice, including the Canadian Forces and the Royal Canadian Mounted Police.

The price tag for the airport was a hefty £2 billion (about $3.64 billion). The previous owner “paid a third of that price a decade ago to buy the airport,” the Guardian reported. The only way for the new owners to make a return on such a large investment would be to increase fees for the airline companies that operate out of the airport, sources told the Guardian.

O’Reilly says the deal was too expensive for his pension fund, the $18.4-billion OPTrust, which is Ontario’s fifth-largest public pension plan. “We look at infrastructure opportunities with a smaller price tag,” he says. “Because of our size, we’re not competing for large infrastructure projects. We’re more of a mid-market investor.”

Read: OMERS return drops to 6.7% in 2015

The reason core infrastructure assets such as the London City Airport are so expensive is there simply aren’t enough of them to meet global investor demand. There’s about $100 billion of capital that’s yet to be deployed in core infrastructure funds worldwide, according to a 2015 es­timate by Preqin, a provider of alternative asset data.


‘Going out on the risk curve’

As the core space becomes more crowded and costly, some pension plans are “going out on the risk curve” in the realm of infrastructure, says Servick. That means venturing into the non-core, opportunistic area in which invest­ors buy assets that require improvements or build them from scratch.

“We tend, at this point in time, to ad­vise our clients to consider opportunistic,” says Todd Nelson, an investment practice leader in Willis Towers Watson’s To­ronto office. “There’s less competition when you’re buying the asset, so you can hopefully get a better price.”

Also, he adds, if a company decides to sell the infrastructure asset after improving it, it can offer it in the competitive core market at a higher price.

Read: Should Canadian pension funds be investing in Canadian infrastructure?

Billy Bishop Toronto City Airport is an example. Canada’s ninth-busiest airport has a great location in downtown Toronto, but it needs a bigger terminal so it can serve more passengers and accom­modate more planes, says Brandon Prater, co-head of private infra­structure at Partners Group,a Switzerland-based money-management firm focusing onprivate markets. Partners Group was part of the consortium that bought the airport’s passenger terminal last year.

Another challenge at the Billy Bishop airport is the fact that pas­sengers can’t get border clearance there, something the new owners have been working on changing. Having border clearance will allow “somebody who has a meeting in New York City [to] clear U.S. cus­toms and get out on the other side at LaGuardia [Airport], where you can’t land right now,” says Prater. Those passengers will be more willing to fly out of Billy Bishop if it has border clearance and they can thereby bypass the challenges of getting to Pearson International Airport on the edge of Toronto, Prater adds. (The owners may soon get their wish following a recent agreement in principle, announced during Prime Minister Justin Tru­deau’s visit to Washington, that would allow passengers to clear customs at Billy Bishop airport.)

Building from scratch

Building assets from scratch also brings advantages. “If we were to buy an existing renewable wind farm in, let’s say, Texas . . . it would probably be eight- to 10-per-cent gross equity return. If we were to build that, take the construction risk and the time it takes to build it, we would probably get between two and four per cent more return,” says Prater.

“You get that extra return and you can transfer a lot of the risk to more ap­propriate holders of that risk — in this case the people that are constructing it or the wind turbine suppliers,” he adds.

OPTrust believes that risk equa­tion works, which is why it joined a $450-million project to construct the third-largest wind farm in Australia last summer.

Read: OPTrust’s 2015 return shrinks

The pension fund joined up with Partners Group, utility giant General Electric and Britain-based Renewable Energy Systems to supply 75 wind tur­bines for the creation of a 240-megawattwind farm in southwestern Victoria.

The Ararat wind farm is expected to become operational in 2017 and produce enough electricity to supply 123,000 homes, or six per cent of the state’s households, annually. Its life­span will be 25 years.

Prater predicts the return will be five per cent more than an existing wind farm would yield.

The construction team will absorb much of the risk associated with the project, he says. “So it’s delivered to us operational, and if it isn’t, there are a lot of warranties and guarantees. If they don’t perform, we can replace them and get new contractors. And that’s where the risk comes. If you have to replace the guys, you do have a delay and lose some of that pickup in return.”

The project also comes with a guarantee from the Australian capital territory government to buy 40 per cent of the energy produced at Ararat.

Read: U.K. pension funds looking to challenge Canadians’ infrastructure prowess

Ensuring there will be buyers or users before construction starts is key for managing the risks of greenfield infrastructure projects, says Prater. “We wouldn’t build a new toll road somewhere without knowing that a car was going to drive up and down it. So you want a bit of protection, from whoever wanted you to build that road or airport, that patronage would be a caveat.”

Concentration risk

Apart from the obvious risks of not having enough business to justify the investment or paying more than ex­pected to build or fix an asset, investors in opportunistic infrastructure need to be aware of the concentration risk.

That’s particularly true when they use an external asset manager instead of investing directly. “The deals that a manager thinks are attractive today are probably the deals they’re going to find in the next few years. So you’re picking up a sector bias or a geography bias,” says Nelson.

“For example, we see a lot of energy projects as being attractive today. So if you’re investing in an opportunistic strategy, you might say, ‘I like this energy deal.’ If you like that energy deal, there’s another one down the street and you can just keep chasing them. And now you’ve ended up with an unintended bias towards the energy sector.”

Read: Liberals to ‘engage public pension plans’ as part of infrastructure boost

As a result, Nelson suggests invest­ors are better off using different man­agers to get sufficient diversification.

Because of the risks associated with non-core infrastructure, the pension funds that allocate money to it typ­ically have experience with core assets. “It’s very unusual to see any client start with opportunistic,” says Nelson. “[But] core was new and exciting 10 years ago. If you already have core running in your program, it’s definitely not going to be, ‘I need more core,’ because of the competition.”


When it comes to embracing risk, Canada’s defined benefit pension plans aren’t just looking at infra­structure. Chronically low interest rates — and the resulting low bond yields — and anemic global growth are also motivating some to con­sider distressed assets.

Such risky assets typically include securities that produce high returns because credit rating agencies consider them to be below investment grade. The price is usually lower than their market value.

The distressed asset class also includes businesses that have major issues affecting their balance sheets. Investors that buy these companies aim to turn them around. “We’re like firefight­ers in the capital markets,” says Patrick Blott, founder of Blott Asset Management in New York City, a firm whose focus includes distressed investments. “We focus on fixing the company, so it’s more like venture capital.”

The Healthcare of Ontario Pen­sion Plan sees value in distressed and opportunistic assets. “We’re looking at all those things,” said Jim Keohane, the pension fund’s president and chief executive officer, during a recent press conference in Toronto. “A lot of times . . . the asset is high quality, but the seller may be distressed and they sell at attractive prices.”

One of the main risks asso­ciated with distressed assets is company management, something that’s likely “the single most im­portant risk determinant in terms of whether you’re going to make money or not,” says Blott.

“You can take the best com­pany and the best assets in the world and you put the wrong CEO or the wrong team in place and, in very short order, you can ruin that value. You can take marginal assets and put the right person there and do wonderful things.”

But Blott cautions that when investors are assessing potential companies, it can be tricky to fig­ure out how good the management is, particularly if they’re focusing on the low price of the asset.

Yaldaz Sadakova is associate editor of Benefits Canada.

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