Running head: COLLECTIVE INVESTMENTS IN INFRASTRUCTURE: THE EU EXPERIENCE 1 COLLECTIVE INVESTMENTS IN INFRASTRUCTURE: THE EU EXPERIENCE

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1 Running head: COLLECTIVE INVESTMENTS IN INFRASTRUCTURE: THE EU EXPERIENCE 1 COLLECTIVE INVESTMENTS IN INFRASTRUCTURE: THE EU EXPERIENCE John J. Forrer The George Washington University

2 COLLECTIVE INVESTMENTS IN INFRASTRUCTURE: THE EU EXPERIENCE 2 Underinvestment in global infrastructure has generated interest in public pension fund investments to help close that gap (OECD, 2011). Infrastructure assets could offer pension funds investments that offer economies of scale, stable cash flows, regulated fee structures, inflation linkages, and downside protection (Inderst, 2010). Despite the enthusiasm for the prospects of public pension funds to find infrastructure investments attractive, numerous barriers exist. These include: fees charge by investors that vary widely; time-inconsistency and principal-agent problems embedded in the third party fund management mode; uncertainty over the risk and return prospects compared to alternative investments; the cost of project sourcing; uncertainty of the number of fundable projects; and, lack of confidence in the accuracy of government financial reporting (Inderst & Stewart, 2014; Clark, et al., 2011; Beeferman 2008). In short, the eagerness for public pensions to invest in infrastructure is rooted more securely in public policy goals and less so in public pensions investment goals. One institutional innovation that has emerged to address some of these concerns is the collective investment vehicle (CIV). A CIV is a fund that is operated by a partnership or a fund management company, which is paid a fee for doing so. The CIV invests the members pooled assets directly in projects The fee is usually a percentage of funds under management but it may also be linked to pension fund account performance. The CIV is self-governed by its members. CIVs can be easily confused with other investment approaches and vehicles that may be used by pension funds. First, pension funds do invest directly in infrastructure projects. This means that the pension fund is doing its own investment analysis, using in-house staff, to make a determination of the risk-and-return associated with the project and negotiates directly with the investment project team. This approach gives the pension fund more autonomy and control over its investment decisions.

3 COLLECTIVE INVESTMENTS IN INFRASTRUCTURE: THE EU EXPERIENCE 3 For example, in the U.S., The LBJ Infrastructure Group has provided roughly four-fifths of the total financing for a transportation project in Texas, or approximately $2.21 billion of the total $2.7 billion needed for total project. The LBJ Express highway is anticipated to cost $800 million to operate and maintain during the course of its 52-year lease to LBJ Infrastructure Group under the Comprehensive Development Agreement with the State of Texas. Such operation and maintenance costs will be the sole responsibility of the LBJ Infrastructure Group. The innovative public-private partnership enables taxpayers to leverage $490 million in public funds to receive more than four times the value in infrastructure enhancements and traffic relief. A public pension, The Dallas Police and Fire Pension System (DPFPS), committed $160 million as an equity investment (Samuel, 2009). For another example, in 2011, The California Public Employees' Retirement System (CalPERS) only had one infrastructure investment that year and it was a direct one. the board of the $204.4 billion system approved committing up to US$157 million to acquire a 12.7% equity stake in London Gatwick Airport from Global Infrastructure Partners (Jacobius, 2010). At the same time, direct investing has it s down-sides. Retaining a qualified investment analysis team as part of CalPERS staff is very expensive, and there are a limited number of projects to consider. Plus, if you do not decide to make an investment in an infrastructure project after it has been analyzed, it is, in essence, a waste of public dollars and can leave pension funds open to criticism. Second, pension funds do co-invest in infrastructure projects. This means pension funds may work with other private or public equity investors and decide to make investments in projects that those investors have identified as being investable. Co-investing can reduce the cost of the financial analysis for the pension fund that is used in deciding whether or not to

4 COLLECTIVE INVESTMENTS IN INFRASTRUCTURE: THE EU EXPERIENCE 4 invest, but it also puts the pension fund at some risk. The investment strategies and goals as well as the risk tolerances of the co-investor may not align well with those of the pension fund. And the time and effort that would be required to try to discover any such discontinuities would off-set the cost-savings advantages of co-investing. CIVs combine these two methods in a formalized relationship that allows CIV members the best of both worlds. CIVs offer public pension funds an interesting alternative to private equity funds and direct investing opportunities. Public pension funds that create CIVs to coinvest share the benefits of not having to pay the traditional 2 and 20 private equity fee structure and of having more control over choosing which infrastructure projects to invest in and the terms of those investments. They also share the benefits of the reduced costs of sourcing and deal analysis compared to each public pension incurring their own costs when they direct invest. However, there are risks to co-investing, which include: (Inderst and Croce, 2013): Overly optimistic demand projections and overvaluation of assets; Risk allocation (e.g. demand and patronage risk) and risk management (e.g. liquidity and leverage risk); Volatility of listed infrastructure funds (the old Australian model ); Governance and fee issues of infrastructure funds; and, Underestimation of the resources required. Australia and Canada have been the two leading countries when it comes to their public pension funds co-investing in infrastructure through CIVs. Perhaps the best know example is Borealis Investments. Borealis Investments is an international investor in large-scale infrastructure projects, managing a diversified global portfolio with an enterprise value in excess of $60 billion and backed by Ontario Municipal Employees Retirement System (OMERS). Since

5 COLLECTIVE INVESTMENTS IN INFRASTRUCTURE: THE EU EXPERIENCE 5 its formation in 1999, Borealis has been investing in infrastructure assets on behalf of OMERS, one of Canada's largest pension plans. The OMERS pension plan has approximately 440,000 members and net assets in excess of $65 billion (Candaian) (Borealis Infrastrucure, n.d.). Two conditions have led to the increased interest in public pension fund CIVs across the world: the need for greater investments in infrastructure and the low returns to pension funds due to the Great Recession. First, to support the infrastructure required to accommodate a future global population of 9 billion people, an estimated US$ 5 trillion per year needs to be invested in global infrastructure over the next two decades (Required Infrastructure Needs, n.d.). There is no reasonable expectation that governments will be in a position financially or politically to allocate the funds needed (Kaul et al. 2003). Second, the financial returns for most pensions funds have been well-below targets due to the Great Recession. For example, during the period between June 30, 2007 and June 30, 2009, California State Teachers pension (CalSTRS) lost $54 billion, about 30 percent of its asset base. Such poor performance was typical during that period. More recently financial performances have improved for public pensions in the last two years, but the losses in past years have left a large legacy of losses from lost compound interest. The substantial investment gap in infrastructure and the tenuousness of returns to pension funds achieved through private equity funds has raised the profile of CIVs as an interesting option for public pensions. CIVs in the EU 1 1 These descriptions draw directly from the following sources: Hua, T. (2012a). British, Dutch forge paths for infrastructure. Pensions and Investments. Retrieved from Hua, T. (2012b). EU economies tap pension funds as financing source. Pensions and Investments. Retrieved from Pooling of Institutional Investors Capital-Selected Case Studies in Unlisted Equity Infrastructure. (2014). OECD Publishing. Retrieved from

6 COLLECTIVE INVESTMENTS IN INFRASTRUCTURE: THE EU EXPERIENCE 6 Governments throughout the EU are looking to tap into pension fund assets as a potential source of financing infrastructure investments. Not all the initiatives fit neatly into the category of CIVs. Some efforts involve both public and private pension funds or may reflect the earliest reforms in pension investments overall that are pointed in the direction of adopting the CIV approach. The European Union and the governments of Ireland, the U.K., and the Netherlands, are implementing initiatives to tap into countries' large pools of pension assets to invest in infrastructure and stimulate the concomitant economic growth. A brief summary is provided of the recent efforts in the U.K. and the Netherlands U.K. In the U.K. five major pension funds have committed to the program, called the Pensions Investment Platform (PIP). They are the 36 billion BT Pension Scheme; the 18 billion Railways Pension Scheme, the 11.2 billion Strathclyde Pension Fund, the 9.4 billion BAE Systems Pension Scheme and the 8.9 billion West Midlands Pension Fund. Creation of (PIP) was the result of a Memorandum of Understanding between the Government and UK pension funds signed in November 2011 in which the parties agreed to develop an investment vehicle to help UK pension funds invest more in UK infrastructure assets. UK pension funds have historically invested relatively small amounts in infrastructure assets. This is because most UK pension funds lack the capacity and in-house expertise to invest directly and assess the risks of infrastructure projects. As a result, UK

7 COLLECTIVE INVESTMENTS IN INFRASTRUCTURE: THE EU EXPERIENCE 7 pension funds invest an estimated 1% of their total assets in infrastructure. This is low compared with overseas pension funds in Australia and Canada where an estimated 8-15% of assets are invested in infrastructure. The PIP is intended to help UK pension funds overcome these traditional difficulties by providing a platform for UK pension funds to cooperate and accrue the advantages of pooled investing in infrastructure. As of March 2013, the platform had secured ten founding investors and reached 1 billion of investment capital. PIP has attracted some criticism, particularly surrounding the extent to which Government intervention was necessary to encourage pension funds to invest in infrastructure projects. Some have argued that the proposed barriers to pension funds investing in infrastructure are as powerful as some assert, so the efficacy of the PIP remains an unanswered question. The Netherlands Similar to other governments around the world, the Dutch government is under pressure to reduce spending amid the ongoing need to improve and maintain infrastructure, sources said. For example, at least 10 billion is required over the next several years, according to estimates. In the Netherlands, the government is leading efforts to allow public-private partnerships to make investments in infrastructure projects can be financed by inflationlinked debt suitable for pension funds. By this approach, the Netherlands is taking a different tactic than the U.K. The Dutch Ministry for Infrastructure and Environment selected a public-private partnership for a pilot program to expand and maintain the N33

8 COLLECTIVE INVESTMENTS IN INFRASTRUCTURE: THE EU EXPERIENCE 8 highway over a 20-year period. The investment manager is PGGM which is owned by the 118 billion pension fund Pensioenfonds Zorg en Welzijn, Zeist (PFWZ) and is an equity holder in the partnership. About 80 million, or 70% of the highway project's debt financing, will be financed by APG Asset Management using inflation-linked debt EU Initiative Another interesting initiative is the The Marguerite Fund launched in It was established with the participation of six major European financial institutions to make long- term investments in infrastructure projects in Europe. Support of the initiative was encouraged by the need to stimulate the economy as part of the economic recovery form the Great Recession. Each of the six Core Sponsors has committed 100 million to the Fund. Core members include Caisse des dépôts et consignations (CDC), France; Cassa Depositi e Prestiti (CDP), Italy; the European Investment Bank (EIB); Instituto de Crédito Oficial, Spain; KfW, Germany; and PKO Bank Polski SA. The Marguerite Fund is an independent entity investing in greenfield infrastructure: new projects and facilities, with typical development risks largely mitigated (minimum of 65% of the Fund) and brownfield infrastructure: replacement, modernization and capacity enhancement of existing assets (maximum of 35% of the Fund). The Fund is targeting approximately equal capital deployment across (i) transport, (ii) energy and (iii) mature renewable sectors, and selecting opportunities across Europe. The Marguerite Fund aims to secure additional capital investments from public pension funds and insurance companies. One example where this was accomplished is the 1.3 billion Butendiek offshore wind farm project. Two Danish pension funds have coinvested with Marguerite. This was the largest greenfield renewable deal closed in 2013

9 COLLECTIVE INVESTMENTS IN INFRASTRUCTURE: THE EU EXPERIENCE 9 in Europe. Other innovative investments were realized in 2013 with the first waste to energy PPP in Poznan, Poland and the first non-recourse project finance loan in Romania. Conclusion The opportunities for attracting public pension fund investments in infrastructure are enhanced by the possibilities associated with CIVs and their variations. However, public pension funds have not been attracted to adopting this model except on the rare occasion. Some have argued that the risk and return characteristics of infrastructure projects are well-suited to the long-terms goals and strategies of public pensions. The lack of investments in infrastructure projects should indicate that this proposed compatibility should. The attractive of infrastructure projects as an investment do not stand on their own, but are assessed compared to alternative investments available. When compared to real estate, infrastructure projects as an asset class can show higher demand risks and lower project returns. In addition, infrastructure projects can take years before there is income generation. Finally, greenfield projects carry a lot of development risks. Infrastructure projects may be important to advance economic and social policies, but compared to other investment opportunities, they may not be so easy to defend as good investments A lesson to be taken from the U.K. experience is another inhibitor to pension fund investment in infrastructure: the in-house analysts have limited experience assessing and pricing risk. Infrastructure projects include a set of projects that are highly diverse. That means the cost of the project analysis can be prohibitive. CIVs address both these issues. By co-investing and direct investing at the same time, fees can be reduced dramatically, and thereby lowering the investment hurdle for

10 COLLECTIVE INVESTMENTS IN INFRASTRUCTURE: THE EU EXPERIENCE 10 projects, when they are compared to the costs associated with working with equity investment firms. The in-house expertise can be developed because the costs can be shared by partners in the CIV, nurtured, and developed over time. CIVs offer public pension funds real advantages, but they have yet to gain popularity in the EU.

11 COLLECTIVE INVESTMENTS IN INFRASTRUCTURE: THE EU EXPERIENCE 11 References Beeferman, L. (2008). Pension Fund Investment in Infrastructure: A Resource Paper. Occassional Paper Series No. 3. Retrieved from: df Borealis Infrastructure, A Direct Infrastructure Investor. (n.d.). Retrieved from Clark, G.L., Monk, A., Orr, R., Scott, W. (2011). The New Era of Infrastructure Investing. Retrieved from the Social Sciences Research Network: Government welcomes first injection into Pensions Infrastructure Platform. (2012). In HM Treasury Newsroom and Speeches. Retrieved from Hua, T. (2012a). British, Dutch forge paths for infrastructure. Pensions and Investments. Retrieved from Hua, T. (2012b). EU economies tap pension funds as financing source. Pensions and Investments. Retrieved from Inderst, G. (2010). Infrastructure as an Asset Class. EIB Papers, Vol. 15, No. 1, pp Retrieved from Inderst, G. & Della Croce, R. (2013). Pension Fund Investment in Infrastructure: A Comparison between Australia and Canada. OECD Working Papers on Finance, Insurance and Private Pensions, No. 32, OECD Publishing. Inderst, G., & Stewart, F. (2014). Institutional Investment in Infrastructure in Developing Countries: Introduction to Potential Models (Working Paper No. 6780). Retrieved from The World Bank Financial and Private Sector Development Global Capital Markets and Non-Bank Financial Institutions. Jacobius, A. (2010). Lots of Opportunity, Few Takers. Pensions and Investments. Retrieved from Kaul, I., Conceição, P., Le Goulven, K., & Mendoza, R. (2003). Providing Global Public Goods: Managing Globalization. New York: Oxford University Press.

12 COLLECTIVE INVESTMENTS IN INFRASTRUCTURE: THE EU EXPERIENCE 12 Pension Funds Investment in Infrastructure: A Survey. (2011). OECD Publishing. Retrieved from Pooling of Institutional Investors Capital-Selected Case Studies in Unlisted Equity Infrastructure. (2014). OECD Publishing. Retrieved from Institutional-Investors-Capital-Unlisted-Equity-Infrastructure.pdf Required Infrastructure Needs. (n.d.) In World Economic Forum: The Green Investment Report. Retrieved from Samuel, P. (2009). Cintra-Meridiam-Dallas Cops group chosen by Tx-DOT for $1.6 billion of N Tarrant Express toll Lanes. Toll Roads News. Retrieved from billion-of-n-tarrant-express-toll-lanes