By Dr Hendrik Snyman, chief investment officer of Gaia Fund Managers
National Treasury’s draft amendment to pension fund asset allocation limits places infrastructure at the centre of future investment decisions. Dr Hendrik Snyman, an investment professional, argues that infrastructure as an asset class will benefit those retirement funds utilising it as the core of their holdings over the long term.
Investing in infrastructure is a novel concept in South Africa with limited investment opportunities for discretionary and retirement savers. Renewable energy projects and toll road concessions are examples where private sector money found its way into infrastructure as an asset class. Yet, South Africa is catching up with developed markets where private savings are frequently used to build infrastructure. These investors recognise infrastructure as a separate asset class given that investments have unique risk-return characteristics in comparison to the traditional asset classes of bonds, property and listed equity.
Government’s proposed changes to Regulation 28 of the Pension Funds Act – which sets asset allocation limits for retirement funds – prioritises infrastructure as an asset class. The proposed amendment introduces a 45% maximum allocation to infrastructure through a mix of investments in debt instruments, equities, immovable property, hedge funds and private equity. Private equity funds have, so far, been the dominant vehicle to access infrastructure. However, the lack of trade-ability of the units and their short-term investment horizon versus the long-term view of the pensioner and opportunity cost associated with the small asset class allocation has meant most pension fund advisers have largely dismissed this.
South Africa has a significant retirement savings pot, estimated at R4,6 trillion according to a PwC asset management survey. Should current draft amendments be accepted, it will release around R1,8 trillion for investment in infrastructure. Although, it is unlikely pension funds will suddenly shift allocations to this asset class because of a dearth in investable projects in South Africa. This fits the mandate of being classified as public infrastructure and within the low-risk operational phase of its lifecycle. The government has, with these draft amendments, placed its trust in the private sector to fund infrastructure rather than following the route of prescribed assets. Hopefully, that debate has been put to rest. Let us look at the growth of infrastructure as an asset class.
Young and (mis)understood
In Europe, around 60% of electricity infrastructure is funded by private investors with the balance financed largely by government pension savings. Infrastructure as an investable asset has been well understood in the developed markets for the last 60 years. South Africa has belatedly joined this party.
Historically, governments constructed large infrastructure (particularly on the scale that renewable energy is rolled out in South Africa) and funded these by issuing government bonds. Investors analysed the creditworthiness of governments that issued bonds (the issuer) rather than the underlying infrastructure projects to evaluate this asset class. When investing directly in an infrastructure project, an investor is required to scrutinise the business differently than when buying government credit. As South African infrastructure investments are a nascent asset class, it demands a broader skill set from analysts. This includes teams of professionals to scrutinise the books, machines and off-take agreements. It is crucial for teams to supplement the knowledge of financial and legal experts with technical engineering and transacting skills to evaluate the transaction and assist in running and monitoring the project.
A sudden shift of billions of retirement savings to infrastructure projects will not happen overnight. It will likely take several years as traditional investment houses develop the internal engineering and transacting skillset to support their financial expertise.
The domestic Renewable Energy Independent Power Producer Procurement Programme (REIPPPP) launched in 2011 in response to the 2008 nationwide power outages and the Integrated Resource Plan of 2010. An office was set up by National Treasury, the Department of Energy, and the Development Bank of Southern Africa to co-ordinate the bidding process to supply renewable energy to the power grid. During the first five bidding rounds (bid windows), 91 projects were approved at a total cost of R209,7 billion; R41,8 billion of which came from abroad, according to the IPP Office’s latest quarterly report. The original project developers required an exit to recycle their capital into new projects and these interests in operational projects fit the investment requirements of pension funds of delivering stable, uncorrelated, dividend income.
A healthy core
There is a crucial benefit for retirement funds to include infrastructure in their holdings. In South Africa, government debt – the traditional way of funding infrastructure projects – forms a core for most retirement funds, partially owing to Regulation 28 prescripts and because it is traditionally viewed as a safe asset class. Foreigners hold around a third of domestic government bonds and the increased price and yield volatility this generates; so, the view they are safe and predictable is tapered but an alternative local asset class with the same risk profile (bar low-yielding cash) is hard to obtain.
This is where infrastructure comes in with its appealing risk-return investment. There is a huge shortfall in infrastructure spend in Africa. The Boston Consulting Group estimates an annual investment gap for privately financeable infrastructure of $12,6 billion. As renewable energy in South Africa attracted R209 billion over the last decade, enormous scope remains for private sector and retirement fund investment to fill the shortfall. As Boston Consulting Group points out, severe challenges remain which hampers private participation as no regulatory framework exists within, for example, the water and sewage infrastructure sectors.
Challenges aside, the available investable infrastructure projects in South Africa demand more attention and fund allocation from retirement funds. The benefits include long-term predictability of stable earnings and cash flow through dividends; a lower and consistent risk profile once the project has been commissioned and is operational; returns not correlated to general market movements; portfolio diversification; and hedging against inflation since off-take prices are usually indexed to consumer price inflation.
Infrastructure as the core of a retirement fund is a more profitable alternative, especially when a government issues debt rather than capital investment to fund its operating expenses, which is currently the case in South Africa. The predictability of returns has vanished in the government bond market as concerns about the affordability of debt servicing costs reared its head. The sell-off in the bond market saw yields skyrocket and prices plummet after international credit rating agencies downgraded the investment quality of South Africa’s debt at the beginning of last year. The subsequent investor flight as Covid-19 simultaneously struck bears testimony to the volatility of domestic government debt. Once commissioned and operational, infrastructure does not demonstrate this type of unpredictability.