Amid increasingly difficult economic conditions and volatile markets, pension funds are grappling with diminishing and volatile returns from traditional asset classes — including Treasury bonds and bills, equities, corporate bonds and bank deposits.
These were previously proven sufficient from return and risk management perspectives. But their returns have become less attractive and more positively correlated, resulting in lower returns while losing their diversification elements. Pension funds should look towards alternative investments such as private equity, property and infrastructure.
Most local pension schemes are familiar with private equity and property investments. But infrastructure, too, is an emerging asset class, which portends huge potential benefits for pension funds with regard to return enhancement and portfolio risk mitigation. It also enables them to participate in the country’s infrastructure development agenda.
In recognition of this, the government is advocating pension fund participation in public-private partnerships (PPPs), even designating key projects, including the Nairobi-Nakuru-Mau Summit road expansion, as a potential PPP.
Investing in infrastructure also provides an alternative source of funding, reducing the government’s dependence on debt to finance infrastructure developments.
Infrastructure can be broadly classified as economic (transport, renewable energy and telecommunications) and social (schools, prisons and hospitals).
Economic infrastructure is more likely to generate commercial returns on investment and attract private funds. Social infrastructure is required to meet social needs, which means returns often do not cover costs. Such investments are typically financed by the public sector.
Investors generally assess investments in infrastructure like any other. To attract funding, a project must be bankable; the returns must be competitive and sustainable.
Infrastructure projects can also be classified according to the stage of development, with varying levels of risk and return. At the peak are greenfield projects — new developments, without constraints of previous ones. Investors bear all the development and execution risk, hence demand higher returns.
Brownfield projects usually involve modification and/or enhancement of infrastructure. The risk is lower than that of greenfield projects and so returns also tend to be lower.
At the lowest end of the spectrum are mature projects — completed and commissioned and cash-generative. Since they have been significantly de-risked, the returns are lower.
Investors can get exposure to infrastructure directly or indirectly. Indirect exposure involves investing in equities or bonds issued by infrastructure companies. This route, however, exposes investors to unrelated risks — such as management and operations of the company.
Direct exposure involves investing in a project via a vehicle solely created to develop and/or manage it. This ring-fences the performance of the investment to the project and is preferred by investors.
Infrastructure assets are long-term, often 10-30 years, and so are pension schemes. That makes it a perfect liability match for pension funds.
Infrastructure also has a low correlation with the traditional asset classes, providing diversification. These projects usually operate as monopolies or oligopolies, providing basic utilities that make them immune to economic cycles.
But while investment in infrastructure has attractive portfolio-enhancing characteristics, pension funds ought to understand the commensurate risks and take measures to mitigate them. This asset class is typically illiquid with limited exit opportunities. As such, investors should keenly evaluate their liquidity needs before committing.
It also exposes investors to political risk. A big number of projects are subject to government regulations and changes in regime could result in updates in policy — to the detriment of investors.
Mr Kaniu is the Chief Executive Officer, Britam Asset Managers. [email protected]