You are the general counsel of a company that is the corporate sponsor of a substantial defined benefit pension scheme. The trustees of the scheme consult the company in relation to a revised statement of investment principles. You notice that the statement proposes substantial investments in infrastructure assets. You want to know what risks this may present to the company. What are some of the questions you might what to ask the trustees in order to appropriately assess the potential risk for the company?
If the UK government’s plan to increase pension fund investments in infrastructure projects becomes reality, this scenario may become commonplace for in-house lawyers. This article addresses some of the key issues that in-house lawyers will need to consider if the company’s defined benefit scheme decides to invest in infrastructure projects. These include:
- The legal structure of the proposed investment;
- The typical risks that infrastructure projects pose;
- How these risks affect the corporate sponsor; and
- How the corporate sponsor can manage those risks.
GOVERNMENT’S INFRASTRUCTURE INVESTMENT PLAN
Commercial lenders are currently less willing and able to supply the debt required for costly infrastructure projects than they have historically been.
Given that UK pension funds currently invest only about 2% of the £1tn under management directly (as opposed to indirectly through intermediaries such as infrastructure funds) in infrastructure projects, the coalition government hopes that private sector pension funds will finance a big chunk of its £150bn national infrastructure plan by providing long-term investment by pension funds.
The initiative that has received the most attention is the deal the government has struck with the National Association of Pension Funds (NAPF) and the Pension Protection Fund (PPF). Under this deal the parties have agreed to work together to help establish an efficient and appropriate investment platform to allow pension funds and the PPF to make investments in UK infrastructure. At this stage the Memorandum of Understanding signed by the parties is fairly vague. Further detail is expected in advance of the chancellor’s 2012 Budget statement on 21 March 2012.
WHY ARE INFRASTRUCTURE PROJECTS ATTRACTIVE TO PENSION FUNDS?
Infrastructure projects have an appealing risk/return profile for UK pension schemes, many of which, because they are closed or closing, have crystallised their liabilities and are therefore seeking low-risk, inflation-protected income streams that match those liabilities. Infrastructure projects generally offer low risk assets with reliable returns. In addition, they offer the right investment for a pension scheme – a long-term stream of income to cover cash flow requirements.
WHY IS AN INVESTMENT PLATFORM NEEDED?
Why are pension funds slow to invest in infrastructure projects?
Lack of capacity to assess project risks
Trustees are required to understand the specific risks of the assets they choose to invest in. Infrastructure assets bear risks that go beyond the volatility of returns. For example, the income stream may often be linked to performance, so there is an element of ‘availability risk’ where a pension fund’s income will reduce if some parts of an infrastructure facility are not available. Small- and medium-sized schemes simply do not have the in-house capacity to conduct risk assessments of high-end infrastructure projects.
Lack of resources to make direct investments in complex structures, such as new infrastructure projects
Direct investments in infrastructure projects require a lot of attention by specialists – from the construction phase through to the operational and management phase. The team required will range from technical advisory through to financial, legal and insurance specialists. Small- and medium-sized schemes therefore do not consider direct investment in infrastructure to be a realistic option.
Absence of a clear benchmark for measuring the investment performance of infrastructure projects
Trustees are required to monitor investment performance. Infrastructure assets are only valued on a quarterly (or longer) basis, and do not offer the same amount of daily market price information of other traded assets.
The risk/return profile of ‘primary infrastructure’ (that is, financing the start-up phase of an infrastructure project) is not a good fit for pension funds seeking to match their assets with their liabilities
The start-up phase of infrastructure projects is similar to high-risk venture capital projects. It is the operational, revenue generating phase of an infrastructure asset – so-called ‘secondary infrastructure’ – which offers the reliable long-term returns that pension funds typically seek when pursuing a liability driven investment strategy. However, traditionally secondary infrastructure is an investment category that only sophisticated financial institutions with adequate resources can manage.
The problem of scale
UK pension funds (bar the very largest, such as the Universities Superannuation or BT schemes) do not generally have the resources to buy up wholesale large infrastructure projects such as the HS1 St Pancras to Channel Tunnel rail project, as a joint venture of two large Canadian schemes did in 2010 (for £2.1bn).
Currently it is unclear how HM Treasury will seek to tackle these issues. The government is aiming to encourage the pooling of investments to tackle the problem of scale, and indeed some pooled infrastructure funds do already exist. It will be interesting to see whether it will be able to create a platform for infrastructure projects in such a way that they offer low risk, predictable income streams – especially when most private sector UK pension schemes are mature and are seeking to de-risk.
At the time of going to press, the latest information is that the pension infrastructure platform will be set up by Infrastructure UK, a unit within HM Treasury. This will bypass traditional fund managers and allow schemes to club money together to buy infrastructure directly, with charges capped at 0.5% – lower than the amount charged by many fund managers.This potential conflict of interest could be challenged by external fund managers. There are also some suggestions in the industry that the government may be developing a new class of infrastructure bonds. We will need to wait and see what the government comes up with.
WHAT LEGAL STRUCTURE IS TYPICALLY USED FOR DIRECT INVESTMENT IN INFRASTRUCTURE PROJECTS?
The private finance initiative (PFI) (which is currently under review following a number of reports from, among others, the National Audit Office) is the most common method of using private capital to finance public infrastructure projects. Under a PFI, a project sponsor establishes and invests equity (usually a thin layer) in a special purpose vehicle (SPV) to carry out the project. The SPV then finances the project almost certainly with the help of bank borrowing and, post-construction, will agree to maintain and operate the project for a set duration. During this operational term the public sector end-user will pay a monthly charge, which will pay down the construction, financing and maintenance costs.
However, if the government proceeds along the lines of a platform established by HM Treasury, it is likely that a different vehicle will be used. The precise details of this are not yet known.
WHAT RISKS DO SUCH INVESTMENTS POSE?
Infrastructure projects and companies pose a number of risks to investors. The level of risk to which the investor will be exposed depends on whether the investment is made in primary or secondary infrastructure.
Primary infrastructure concerns the financing of the construction phase of an infrastructure project. Key risks in this phase include, for example:
- Financial risk: if the central government is party to the PFI concession agreement, the risk of default is de minimis. However, a statutory corporation that has no government guarantee must meet its own liabilities with the revenue it generates and the assets it holds. Change of control, assignment and statutory successor clauses should be carefully reviewed.
- Construction risk: failure by the SPV to finish construction on time, according to specifications and within budget will pose a considerable risk to the investor and possibly lead to termination of the project before the income-generating operational phase.
- Supply chain default risk: supply chain agreements need to be drafted tightly and the covenant strength of both main contractor and key sub-contractors acceptable. The caps and limitations on liability also need to be set appropriately.
- Environmental risk: the potential extent of liability for environmental damage caused by the infrastructure project constitutes a real risk for investors and requires extensive due diligence.
- Political and social risk: the government of the day may change direction or policy and pull the plug on the project altogether.
The start-up phase of an infrastructure project therefore carries a far higher risk than once operations have commenced.
The operational phase of infrastructure projects poses a lower risk to investors. However some risks do remain. These include:
- Operating risk: whether or not the PFI project will offer stable returns in the long-term depends largely on whether the SPV has found a contractor that has the resources and expertise to operate and maintain the infrastructure asset. Poor performance could lead to deductions from the monthly payments and a subsequent dilution of the income stream.
- Gearing risk: given that PFI projects are typically highly leveraged, there are interest rate risks (although these are often hedged against) and downgrade risks to consider.
- Regulatory risk: consumer fare rises, such as road tolls or train fares, may fall behind the level originally envisaged when the project commenced due to a change in government policy.
Pension schemes are more likely to invest in secondary infrastructure, due to its bond-like risk/return profile. However, the infrastructure projects proposed as part of the national infrastructure plan are new projects, which will obviously require a primary phase before secondary phase investment is possible. The hope is that HM Treasury, with the help of the NAPF, will create an investment vehicle that will allow pension schemes to invest in riskier primary infrastructure, with some of the risks identified above removed (eg by means of the government underwriting some of the risk).
HOW DO THESE AFFECT THE CORPORATE SPONSOR OF A PENSION SCHEME?
Ultimately, it is the corporate sponsor of a pension scheme that bears the risk that an infrastructure investment will not perform. This is because the sponsor must meet the balance of cost of providing members’ benefits. Therefore, the riskier the investment, the more risk there is for the corporate sponsor in terms of funding a potential deficit in the scheme.
HOW CAN CORPORATE SPONSORS MANAGE THESE RISKS?
The trustees of an occupational pension scheme are legally obliged to prepare and regularly revise a statement of investment principles (SIP) (s35(1) of the Pensions Act 1995). The SIP governs how trustees make investment decisions. Before preparing or revising an SIP, trustees are required to consult their sponsoring employer (Regulation 2(2)(b), the Occupational Pension Schemes (Investment) Regulations 2005 (SI 2005/3378) (the Investment Regulations)). The essence of ‘consultation’ is the communication of a genuine invitation to give advice and a genuine consideration of that advice (Pitmans Trustees Ltd & ors v The Telecommunications Group Plc [2004]).
This is where an in-house counsel comes in. You can inform the trustees that, before committing trust assets to an infrastructure project, they will need to consider the risks identified above. This will protect not only them, but also the company from funding risk.
Trustees are under the following specific duties under the Investment Regulations, each of which has a bearing on a potential infrastructure investment. Therefore, ask yourself the following questions:
Is the investment prudent and is it in keeping with the trustees’ duty to diversify?
Trustees are required to invest prudently. Also, Regulation 4(7) of the Investment Regulations provides that assets of the scheme must be properly diversified in such a way so as to avoid excessive reliance on any particular asset, issuer or group of undertakings, and accumulations of risk in the portfolio as a whole.
If the infrastructure investment represents more than a certain proportion of scheme assets, the trustees could be in breach of this duty.
Is the investment in the best interests of the beneficiaries?
Generally, this means a beneficiary’s best financial interests. As such, trustees are required to achieve the best return for the trust when making investments, while always acting prudently and safely.
Have the trustees considered the potential returns to the scheme from this investment, in comparison with other potential investments?
Have the trustees applied portfolio theory?
Portfolio theory assesses the risk level of the portfolio as a whole, rather than the risk level of each investment on its own. Accordingly, Regulation 4(3) of the Investment Regulations provides that the powers of investment, or the discretion, must be exercised in a manner calculated to ensure the security, quality, liquidity and profitability of the portfolio as a whole.
The illiquid nature of infrastructure investments should be a concern for some schemes, especially if the proposed investment structure does not allow for trading on secondary markets.
Is the investment admitted to trading on regulated markets?
The assets of a scheme must consist predominantly (but not exclusively) of investments admitted to trading on regulated markets (Regulation 4(5) of the Investment Regulations).
Have the trustees obtained proper advice?
Trustees must obtain and consider proper advice on the question of whether the investment is satisfactory, having regard to the requirements set out above (s36(3) of the Pensions Act 1995).
Will the trustees be obtaining this? It would be prudent for the corporate sponsor to see a copy.
What procedures do the trustees have in place to ensure that infrastructure investments are properly reviewed?
Trustees are also required to review their investments at regular intervals and to consider whether such review requires further advice.
CONCLUSION
At a time when schemes are increasingly trying to de-risk, but yields from gilts are depressingly low, investment in infrastructure projects may offer an attractive alternative for pension schemes. But the alternative is not risk free – either for the scheme or for the company.
Unfortunately, the role of the corporate sponsor is limited when it comes to trustees making investment decisions. However, you can influence the trustees’ investment strategy by highlighting the risks involved and by reminding them of their investment duties as part of the SIP consultation process.
By Hugh Gittins, senior associate, pensions, (with input from Richard Birks, partner, infrastructure), Eversheds LLP.