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The road more traveled

Looking for long-term investments to match their long-term liabilities, some pension plans are investing in infrastructure projects.

With assets of $150 billion, Stichting Pensioenfonds ABP is the biggest pension fund in Europe, widely admired for its sophisticated investment strategy. Until last year, though, the retirement plan for Dutch civil servants had never made an infrastructure investment. Then in April it bought an undisclosed but reportedly substantial stake in a European infrastructure fund sponsored by Australia's Macquarie Bank.

"Infrastructure is appealing because it is not closely correlated to financial assets and therefore reduces risk," says Robert Coomans, head of special projects at ABP Investments in Amsterdam. "In addition, the yield is similar to that of real estate, but the cash flows are more stable."

Infrastructure finance has been a favorite investment of Australian pension funds since the mid-1990s, when the Australian government privatized much of its road building. Today the typical Australian pension fund keeps 4 percent of its portfolio in infrastructure projects that range from toll roads and tunnels to airports and electricity transmission networks. But U.S., U.K. and European pension funds have only in the past couple of years joined in. Of $14.2 trillion in global pension assets, perhaps $50 billion is invested in infrastructure funds or projects. That compares with virtually nothing just a decade ago.

Looking for long-term investments to match their long-term liabilities, many pension funds invest indirectly, through liquid investment funds sponsored by money managers such as Macquarie. Or they may make less-liquid investments directly by buying stakes in projects through public-private partnerships. Usually, pension funds make equity investments, typically in projects where the construction is complete and cash flows are fairly predictable.

"We began looking for ways to more explicitly link our assets and liabilities in the late 1990s," says Robert Bertram, investment chief at the $64.4 billion Ontario Teachers' Pension Plan, widely respected as a model of diversification and risk management (Institutional Investor, December 2004). "Infrastructure fit the bill. It's a great asset class for a pension fund with long-term inflation-linked liabilities."

Although such leading private equity managers as Barclays Private Equity, Goldman Sachs Capital Partners and London-based Terra Firma Capital Partners sponsor infrastructure funds, the territory is dominated by Macquarie. Its 15 infrastructure funds, all launched since 1996, have equity commitments totaling $15 billion, with 60 percent of that coming from institutional investors in Australia and New Zealand. Macquarie's funds are invested in 67 projects across 13 countries. Among them: the Midland Expressway, the U.K.'s first toll road, a £485 million ($907.8 million) project that was completed in December 2003; Sydney and Adelaide airports in Australia; and the Detroit-Windsor Tunnel, which links the U.S. and Canada.

In December, Macquarie launched its second U.S.-listed fund, the Macquarie Infrastructure Company Trust, which trades on the New York Stock Exchange. The bank raised $535 million from a wide range of institutional investors.

Macquarie's infrastructure fund lineup ranges from its flagship Australian Stock Exchange­listed Macquarie Infrastructure Group, with $5.7 billion invested worldwide, to private partnerships such as Macquarie Essential Assets Partnership, a $377 million fund investing in Canadian infrastructure. ABP's choice, the unlisted Macquarie European Infrastructure Fund, debuted in April 2004. It currently has assets of $1 billion.

The Macquarie Infrastructure Group reports average annual returns of 18.2 percent since inception in 1996, compared with the MSCI EAFE index's 2.7 percent annualized return over the same period. Across 14 funds (all but Macquarie Infrastructure Company Trust), the returns are even more exceptional, averaging 28 percent annually, with a standard deviation of only 6.5 percent.

That performance attracted the attention of Bertram at Ontario Teachers', now one of the leading institutional investors in the asset class, with some $3 billion, or roughly 4 percent of total assets, allocated to infrastructure investments. Within the next three years, it plans to increase that to 15 percent. Ontario Teachers' infrastructure stakes are part of the plan's substantial portfolio allocation to inflation-sensitive investments, which include commodities, real estate and timber, comprising an unusually high 40 percent of assets. Ontario Teachers' also ranks as perhaps the single biggest pension fund investor in hedge funds, with about C$4.1 billion ($3.3 billion) invested in the asset class at the end of 2003.

Bertram is especially keen on real estate and infrastructure investments because they respond to unexpected rises in inflation, unlike conventional bonds, whose nominal rates factor in expected future inflation. The return from a real estate portfolio is based largely on the income generated by thousands of leases that roll over and adjust upward to reflect rising costs. Similarly, tolls on highways, bridges and tunnels tend to increase in line with inflation; this protects the infrastructure fund investor from erosion in the value of its holdings and links well with the liabilities of a defined benefit plan, which are also usually inflation-adjusted to reflect wage increases.

In many infrastructure projects the inflation link is even more explicit. "For us the magic word is 'regulated,'" says Ontario Teachers' Bertram. "Many of our investments are in former government-owned assets where there is an independent regulator. More often than not, the rate of inflation is a key consideration when that regulator sets prices."

Consider the U.K., where the Office of Gas and Electricity Markets (Ofgem) oversees gas and electricity distribution. Says an Ofgem spokesman, "Broadly, if companies are operating efficiently, they can raise prices in line with retail prices."

The longevity of infrastructure assets appeals to Bertram and other pension fund managers whose liabilities may stretch out to 40 years. Looking to better match assets to liabilities, defined-benefit-plan managers seek out long-term investments with some inflation protection. A toll road concession often lasts 30 years or more.

"These kind of long-run, stable cash flows are attractive to investors," explains Jim Craig, lead manager of the European infrastructure fund at Macquarie. "We recognized that with the financing of toll roads in Australia in the mid-1990s, and since then we've broadened the type of infrastructure assets and the geographic spread of our investments." Craig models cash flows for all potential investments over 25 years.

Some pension funds, including Ontario Teachers' and Ontario Municipal Employees Retirement System, have also made direct investments in infrastructure projects, typically through partnerships and joint ventures. Case in point: the acquisition of gas distribution networks in southern England and Scotland last August from National Grid Transco by a trio of investors. Scottish and Southern Energy took a 50 percent stake in the $6.1 billion acquisition, and Ontario Teachers' and Ontario Municipal took 25 percent each.

Ontario Teachers' earliest private deal was in August 1999, when it formed a partnership with the operators of the 407 Express Toll Route, a toll road that encircles Toronto. Ontario Teachers' persuaded 407 International, headed by Spanish construction group Ferrovial, to swap its expensive short-term bank loans for longer-dated index-linked debt. As a result, the company got debt that fit its cash flows and the pension fund got assets that fit its liabilities. The 1999 deal raised $650 million from Ontario Teachers' through a four-tranche bond issue that matures in 2016, 2021, 2026 and 2031. The bonds pay 5.3 percent plus inflation.

ABP has not yet made any direct infrastructure investments, but it is contemplating such a move. "We want to get comfortable with the asset class first, and that is why we have invested in a fund," says special projects chief Coomans. "But as our knowledge deepens, we will look at co-investment projects."

One potential new source of deals: private finance initiative projects, also known as public-private partnerships. In these deals governments access private sector capital to fund the building of schools, hospitals and prisons. In return, private investors receive a management contract to handle the project's construction.

The U.K. has been in the vanguard of PFI, with $112 billion raised for these projects since 1996. But Christopher Elliott, lead manager of a range of funds investing close to $1 billion in PFI projects at Barclays Private Equity, says these sums will in time be dwarfed by deals done in continental Europe.

Barclays typically invests directly in PFI deals at the construction phase, when there is the greatest risk and the greatest potential return. But it also participates in a nascent secondary market in ongoing PFI projects, which provides the project managers with greater liquidity. Barclays launched a $560 million secondary PFI fund, known as Infrastructure Investors Fund, last year with Société Générale.

These days, the sector is attracting a broader range of private equity shops and asset management firms. "Other funds have moved into infrastructure deals faster than we had hoped, and it's sometimes difficult to get the allocations we want," says Ontario Teachers' Bertram. "Returns will likely compress. But these are still attractive assets on a risk-return basis."