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British Wealth Funds could bring clash of objectives

UK chancellor George Osborne recently announced that 89 local authority pension funds are to be pooled into six British Wealth Funds, and used to invest in UK infrastructure projects to help ease the UK's 'infrastructure deficit'. 19 Oct 2015

What Osborne didn't explain was how the boards of these pension funds are to be persuaded to join together in these British Wealth Funds; nor did he say how they will be encouraged to invest in what can be the riskier phases of infrastructure projects.

There is an interesting tension here, with the need to build infrastructure and the need of pension funds to invest to meet their long term liabilities.

On the face of it, infrastructure projects would seem ideal for pension funds, bringing in steady and, ideally, inflation-linked cash flows. But pension funds are generally wary of investing in new build projects such as those Osborne wants to encourage; instead they look for up and running projects that will deliver their steady cash flows.

With the large banks, the traditional funders of infrastructure debt, pulling out of those projects due to the balance sheet pressure of holding these long term commitments, pension funds have generally been happy enough to pick up the occasional project on the secondary market.

Risk management

The investment role of a pension fund is to find the right mix of growth and matching assets to provide pensions, so investment choices will be based first and foremost on those fundamental principles. If that happens to coincide with the government's objective to deliver infrastructure to UK plc, then all well and good.

Infrastructure development, however, can be a speculative and risky business. A new project might overrun; it might hit the buffers half way through development; it might never even get off the ground. Projects can be vulnerable to planning permission and environmental issues, defaulting sub-contractors and to political and economic change.

Construction risk has therefore been a major hurdle for pension funds investing in the 'greenfield' development phase. 

What is encouraging though is that we are starting to see the conversation move on. Not all projects have the same construction risk profile, and in many cases what construction risk there is can be mitigated through careful structuring. Paradoxically, some projects can carry more operational risk once they are up and running. 

This means that pension funds investors, supported by their advisers and asset managers, need to understand the underlying project sufficiently well to manage risk. This will be essential if the chancellor's objective is to be achieved, and even then, the project must deliver on the pension funds' own objectives. 

It will, for example, need to provide a compelling reason for the pension fund to divest out of existing investments in order to achieve a better return and a steady reliable flow of income. 

Nor will most pension funds want to be limited to UK investment. The UK is probably where most prefer to make their initial foray into infrastructure, but if faced with a better opportunity overseas, they will need to justify any decision to stay closer to home.

Combining funds

The chancellor has proposed that the 89 local authority pension funds invest into six wealth funds, without any indication of how that should be done. Blueprints do exist, though, from other examples of pension funds pooling investment resources.

The Pensions Infrastructure Platform (PiP) model is one example that has both public and private sector pension fund investors joining forces to increase buying power, reduce costs and manage risk through acquired expertise.

Local government pension schemes are also showing signs of recognising the power that pooling and partnerships can bring, no doubt prompted by the recent introduction of authorised contractual schemes as a form of common investment vehicle (CIV).

Lancashire County Council, for example, has set up a CIV with the London Pensions Fund Authority to pool their combined assets of over £10 billion, while the London LGPS has developed its own local pool using the CIV model.

Similarly, eight local authority pension funds in south-west England are recently reported to be collaborating to create a CIV. Avon, Cornwall, Devon, Dorset, Gloucestershire, Somerset, Wiltshire and the Environment Agency are working together to improve cost savings and governance.

What is apparent from all these groupings is that they recognise commonly-held investment goals and a broadly compatible risk appetite, while retaining their sovereignty.

This is very much the direction of travel – and not simply as a result of the government's push earlier in the summer with its threat of mandatory pooling.

Compared to these examples, however, what the chancellor is now proposing is on a completely different scale. Bringing 89 funds into six groupings and finding common ground between them is going to be a huge challenge.

None will want to give up their sovereignty, but if funds are pooled then inevitably some will have to compromise on their own, tailored investment strategy.

The suggestion appears to be for regional funds. Does that mean that only pension funds local to that region can invest? Will that wealth fund only invest in its region? How will pension funds align that with their objectives? And will joining be compulsory, or will there be incentives to do so?

Meeting the infrastructure challenge

There is no question that the UK needs investment in infrastructure, and that the right infrastructure projects can provide pension funds with the ideal investment match.

Currently, around 5% of the £192 billion in local government pension scheme assets are allocated to infrastructure, and that could certainly increase: but each project has to be right for the pension fund or managers would be remiss in making that choice.

The immediate reaction to the chancellor's proposals from the local government union GMB was to say that council workers' pension savings are "not to be used as politicians' playthings", and that the reason funds are not already invested in infrastructure is that the risk outweighs the returns.

It all comes back to a fundamental question that each pension fund board will need to ask itself: are we making this investment because it meets our investment criteria, or to underpin UK infrastructure?

It will be interesting to see if pooling assets enables the pension funds to address this question with more certainty, and whether the pooling structure gives them the ability to access the best opportunities, manage risk and invest cost-effectively.

Raj Sharma is a pensions investment expert with Pinsent Masons, the law firm behind

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