The Department for Communities and Local Government has doubled the headroom limits for Local Government Pension Scheme (‘LGPS') funds investing in partnerships from 15% to 30%.
This means LGPS funds will have greater flexibility to invest in infrastructure projects in the future.
Infrastructure projects are the public services of everyday life including everything from airports to education, and from electricity networks to hospitals.
They are a good fit for most pension schemes, including LGPS funds, because there are very few index-linked instruments available to pension schemes.
Index-linked investments are an appropriate asset for pension schemes as most liabilities are index-linked (as pensions in deferment and payments increase to enable them to match liabilities).
The main downside of infrastructure investment is its illiquidity. This is because of the typical transfer restrictions contained in the infrastructure funds partnership documents.
Infrastructure assets can therefore be difficult to dispose of in the secondary market.
LGPS funds will be looking to invest for the long-term and are likely to have a well-diversified portfolio of assets which match different liabilities so this is not necessarily a major disadvantage.
There two main ways of financing infrastructure projects, through taxation or private financing. By doubling the investment limits that LGPS funds are subject to, the Government has shown that it is eager to finance infrastructure projects through private financing.
George Osborne announced in the 2011 Autumn Statement that he was aiming to get £20bn of additional pension scheme investment into infrastructure projects. By using private sector finance for public projects the Government is able to spread the funding requirements and limit the operational risk.
There are two types of infrastructure investment available, greenfield or brownfield.
Greenfield investment opportunities are those at the pre-operational or construction phase, without an income stream.
As there are significantly more risks because of the unknown factors involved, investors have the chance to realise a greater return and the opportunity to influence the infrastructure project in a greater way.
There are two main risks when making investments in greenfield infrastructure opportunities – completion risk (construction delays and cost over-runs) and usage risk (insufficient demand for the service once provided).
Brownfield investment is the operating stage of the infrastructure project.
Pension schemes typically prefer to access investments at this stage as completion and usage risks should be reduced.
The infrastructure project will have an established track record and history of cashflows.
It is most common for pension schemes to access infrastructure opportunities through limited partnership vehicles.
Limited partnership structures have been used for infrastructure funds for about 10-15 years. They are an effective and flexible business medium which provides a degree of legal certainty, including limited liability.
The main difficulties with such arrangements are that they can be too expensive (such arrangements may have private equity fee structures which are unsuitable for infrastructure investments).
There can be governance issues, for example, replacement of the infrastructure fund's general partner, such as occurred in respect of Babcock & Brown in 2009.
This type of investment structure also allows LGPS funds to pool their assets.
Pension schemes are generally looking to diversify their risk in infrastructure investments just as they diversify risk in other asset classes.
Funds which are diversified internally providing 20 to 30 investments with one provider are more attractive to pension schemes.
Pooled infrastructure funds are typically a mix of Greenfield and brownfield investment opportunities as well as a mix of different types of infrastructure facility. In this way, such a pooled fund can provide an appropriate aggregation of risk while retaining the potential for growth.
Pension schemes are exploring the possibility of directly investing in infrastructure projects.
Although this has the potential of reducing the fee arrangements, the exposure to underlying investment is increased as the fund would be a principal lender.
The Pensions Infrastructure Platform (PIP) is being set up by the National Association of Pension Funds (NAPF) in partnership with the Government.
The aim is to build a fund of £2bn. There are currently between eight to 10 investors, each providing seed commitments of £100m each. The PIP is being established to:
Increase investment opportunities for pension schemes.
Ensure that risk parameters may be tailored to pensionschemes.
Reduce competition for opportunities, which may add a premium to investment opportunities, and in doing so drive down fees.
The increased headroom for investment in partnerships for LGPS funds means that those funds will have increased access to infrastructure investment through the traditional limited partnership arrangements.
LGPS funds may prefer to invest in this manner rather than exploring other means of infrastructure investment such as direct investment.
Ian D'Costa is an associate at Sacker & Partners LLP