The government is keen to attract more LGPS spending in UK infrastructure, but what do investors make of it?
From patched up potholes to sewage leaks, UK infrastructure is in desperate need of investment. A decade of underinvestment has left the nation with a £500bn funding shortfall, according to a report by the Institute of Public Policy Research released in June this year. But with government borrowing costs at the highest levels since the late 90s, the chancellor is keen to attract more cash from private investors.
This was a key theme at the chancellor’s latest Mansion House speech held in July. By increasing the pace of LGPS pooling, pushing for a minimum size of £50bn per pool and convincing DC schemes to commit at least 5% of their default assets into private equity, the government claims to “unleash” an additional £75bn into high growth assets.
Going forward, the chancellor would like to see LGPS funds double their average allocation to private markets, a move which is also aimed at bolstering institutional investors in infrastructure. But what do LGPS investors make of the opportunities in the asset class?
Sovereign wealth?
While the traditional LGPS portfolios have historically been equity heavy, improved funding levels combined with persistently high inflation have led schemes to branch out into infrastructure. This trend has arguably been accelerated by the onset of pooling.
After all, one of the key motivations behind the original push for LGPS consolidation was to facilitate greater investment in infrastructure. Many LGPS investors will recall that George Osborne’s initial proposals were for “Sovereign Wealth Funds” rather than pools.
In 2015, prior to the government’s plan for pooling, only £950m of a total £191bn LGPS assets were invested in infrastructure, according to the LGPS Board’s Scheme Annual Report. While these figures exclude pooled investment fund vehicles and are therefore only a partial impression, it is safe to say that infrastructure allocations were marginal. Fast forward to 2022 and infrastructure allocations have grown to £6.6bn out of a total £367.7bn in LGPS assets, a drastic increase, both in relative and absolute terms.
Most pools now have significant infrastructure investments, but they have opted for very different approaches to implement this. The perhaps most well-known example is GLIL, the £3.6bn infrastructure platform, which offers its investors, LGPS North, LPPI and DC Mastertrust Nest, direct access to a concentrated portfolio of predominantly UK infrastructure assets. In contrast, Border to Coast also has a significant private markets allocation which features infrastructure, but it invests through a broad array of funds and is not focused on UK assets.
Meanwhile, Wales Pension Partnership has only last year branched out into private markets but now invests in a combination of closed- and open-ended infrastructure funds including projects in Wales.
Despite these very different approaches, many LGPS investors share their scepticism of government prescriptions on asset allocation. A poll at the PLSA Local Authority Conference in June revealed that a majority of attendees said they were worried about mandatory consolidation and more than half disagreed. Many attendees also expressed scepticism over the government’s push to invest more in infrastructure.
George Graham, investment director at South Yorkshire Pension fund, also expressed scepticism of the government’s ability to make asset allocation decisions. “The last thing we want is the government giving us some good ideas, that is unlikely to result in optimal outcomes,” he warned, speaking at a session on levelling up at Room 151’s private markets forum.
These fears may have been abated to some extent by the publication of the long awaited LGPS Consultation. While the government advocated a doubling of LGPS investments into private equity, it did not impose mandatory contributions into assets such as UK infrastructure.
And for good reason, according to consultant John Ralfe. “It is difficult for the government to force pension schemes to do anything,” he said, noting that it is a matter of law whether “200 years of trust laws” could be overridden. “There would be legal cases for at least five years,” he expects, making intervention “unthinkable”. Ralfe predicts that local government pension schemes would ultimately be taking the lead in infrastructure allocations.
LGPS investors remain acutely aware that their fiduciary responsibility lies with their members, not with the tax payer. “There is a fundamental difference between the LGPS and a Sovereign Wealth Fund, which is that Sovereign Wealth Funds don’t have to pay pensions,” said Andrew Thornton, joint committee member at West Yorkshire.
Obstacles and opportunities
Having said that, many LGPS investors are considering branching out into infrastructure. The strategies by far most frequently pitched are centred on investing in the transition to renewable energy. And for good reason: the government’s Green Finance Strategy sets out a plan to attract more than £100bn in private investment in order to reach net zero.
What holds many investors back is the challenge to quantify risks, explains Leandros Kalisperas, CIO at West Yorkshire Pension Fund. Private market investments in renewable energy infrastructure remained hard to benchmark, he argued at Room 151’s latest Energy Transition Roundtable.
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Another obstacle is the fact that funding infrastructure projects at their early stages was associated with a higher degree of risk. Ralfe questions whether there are enough “genuine projects that are sufficiently advanced, where the government has taken on the early risk”.
He remains wary of infrastructure “start-up” projects, with HS2 an example. “Pension schemes shouldn’t be interested in holes in the ground,” he says. “What are the mature infrastructure projects?”
The government attempts to mitigate some of these concerns with the help of bodies such as the British Business Bank and the UK Infrastructure Bank (UKIB). The latter is a government-owned policy bank focused on increasing infrastructure investment across the UK and represents one option of making early stage infrastructure investments more accessible.
Seeded with £22bn of financing capacity, UKIB aims to partner with the private sector and local government to increase infrastructure investment in the UK, with objectives of tackling climate change and supporting regional and local economic growth.
“Our presence in a deal can help instil confidence with potential investors and we can act as a cornerstone investor in more challenging markets. Through appropriate structuring or the use of our guarantee, we are also able to improve the credit rating of transactions to make them eligible for institutional investment” says Ian Brown, UKIB’s head of banking and investments. Examples include a recent £50m commitment to the Port of Tyne’s regeneration and expansion plans, but also investments in transport water and wate sectors he says.
Much of this push into renewable energy will have to be deployed within the next seven years says Barney Coles, co-head of clean energy at Capital Dynamics, as a renewable energy infrastructure specialist, “The UK will almost double its renewable energy capacity by the end of this decade and needs to spend £70bn to do that. That has driven the government to come out with more policies and legislation to support renewables,” Coles added.
This means that the clock is ticking, adds Rosalind Smith-Maxwell, senior vice president at Quinbrook. She argues that the next the next 3-5 years “will be a critical phase and should reward investors who address the UK’s urgent supply need for low cost and carbon free renewable power”.
Smith-Maxwell also sees a case for a geographic focus on UK assets. “The risk profile is better particularly compared to the Nordic region, in terms of what it could be exposed to. And the return on investment perspective is better particularly compared to Germany and France. In southern Europe there is some equivalence to the UK – private-to-private arrangements are seeing returns equivalent to the UK.”
Smith-Maxwell adds: “The UK recently re-affirmed its position as fourth in EY’s renewable energy country attractive index which rates all countries on their relative investment attraction. Whilst the UK is a smaller market that Europe or the US for example, it does have aggressive decarbonisation targets.”
Potential potholes
If done right, investments in core UK infrastructure could offer stable returns which are relatively uncorrelated from the broader market environment. After all, UK household demand for water and energy is relatively inelastic.
But there are also prominent examples of infrastructure investments gone wrong, as the negative media headlines for UK water companies highlight. In this case, private equity’s tendency to accelerate the pace of gearing at the expense of sustainable long-term investments has generated scandals around sewage spills and environmental pollution. It has also left investors exposed to potentially hefty fines. This is likely to be a real concern for investors such as GLIL, which owns a 7.5% stake in Anglian Water. For private equity investors in UK infrastructure, significant engagement and stewardship efforts will be required in order to avoid scheme members being exposed to regulatory risks.
Another risk is rising interest rates, particularly for infrastructure firms that are heavily geared and are now struggling to refinance, as the case of Thames Water illustrates. The true scale of this problem will only be revealed over time when current credit agreements expire. But there is a flipside to that. For investors with a long-term investment horizon and sufficient cash reserves, struggles to refinance might mean that infrastructure assets become more affordable, if investors are willing to stomach the risks.
Another challenge comes from within the LGPS. So far, rising rates have led to improved funding levels and an increased willingness among LGPS investors to own riskier assets, says Ben Crawfurd-Porter, LGPS investment manager at Ruffer. He notes that while valuations of long-term UK infrastructure assets have been supported by “relatively stable long-term discount rates, despite rising inflation”, should inflation begin to “look entrenched and central banks lose credibility, there is a risk that longer term inflation expectations, and therefore interest rates, rise. This would increase the discount rate and weigh on previously robust UK infrastructure valuations.”
A strong story
But these challenges to not appear to deter LGPS investors. Most pools have significantly ramped up their private market allocations, and are reporting increased appetite for infrastructure from their partner funds. Beyond that, many partner funds continue to place investments into infrastructure projects outside their pool’s remit. This trend may now come under pressure, as the latest government consultation on LGPS pooling has set a deadline on the pooling of unlisted assets.
Nevertheless, perhaps the strongest appeal of UK infrastructure, beyond returns and diversification benefits, remains the fact that investing in local assets is a strong story to take back to scheme members. “Our scheme members are very connected to our places and therefore, doing good stuff in these places is important to us,” concludes Graham.
More on UK investment in infrastructure can be found in the latest Private Markets Profile.
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