Rachel Reeves is not the first UK chancellor to call on its local government pension schemes to become direct investors in infrastructure, and judging by the recent speculation around her future, she might not be the last.
In a keynote speech in November, however, she was forthright, stating that “more often than not, it is Canadian teachers and Australian professors reaping the rewards of investing in British productive assets”, declaring that “that’s not good enough”.
Indeed, those direct investors have had great joy in building up their portfolios in the UK, US and Canada, as well as beyond their respective borders tapping into emerging markets.
The timing of Reeves’ speech was inauspicious. Last year saw turbulent times for some of the major Canadian investors, at least, with OMERS writing off its investment in Thames Water before regulator Ofwat placed the utility under a Turnaround Oversight Regime.
Meanwhile, a week before Reeves’ speech, the entire board of the Alberta Investment Management Corporation was sacked by the state government amid increased operating costs met by lower overall returns.
And in December, CDPQ saw three former executives, including former managing director of infrastructure for Asia-Pacific and the Middle East Cyril Cabanes, charged by US authorities for their participation in an alleged bribery scheme involving Indian conglomerate Adani Group alongside renewables firm Azure Power, in which CDPQ is the largest shareholder.
“The UK, US and Europe might be deep markets, but there is also a deep bench of competitors who are very well resourced, have been there a long time and are far better incentivised”
Former CIO
An Australian superfund
Australia’s superannuation funds have not been immune either, even as several of the country’s largest investors set up offices in London and New York amid a push to diversify their portfolios with overseas assets.
AustralianSuper, which declined to comment for this article, had a couple of high-profile direct investments in private equity and listed equities go sour in 2024, with Australian media reporting that its telecoms towers business Indara has recorded losses according to documents filed with the Australian Securities and Investments Commission.
This is not to say the model is itself responsible for such episodes – but it does highlight the potential pitfalls that surround what Reeves is aiming to replicate.
The push to go direct
The largest investors’ desire to go direct is ultimately driven by a belief that it can lead to higher returns.
It is also driven by the belief that internalising investment management will save on external manager fees, resulting in lower costs overall, which is a particular concern to the highly fee-conscious Australian superfunds.
In addition, going direct gives large funds a degree of control over their investments that they might not otherwise get by deploying through pooled funds or even separately managed accounts.
A majority of Canada’s Maple 8 – comprising OMERS, OTPP, CDPQ, BCI, PSP Investments, AIMCo, CPP Investments and HOOPP – began investing in infrastructure at the turn of the century or in the mid-2000s. HOOPP is the exception, having entered the fray in 2019. These pensions either declined to comment for this story or did not respond to requests for comment.
The Australian superfunds were also among the first in the world to deploy capital at scale into unlisted infrastructure, thanks in large part to the GPs that emerged there and which rapidly became the largest players in the sector globally – Macquarie Asset Management and IFM Investors, among several others, including the now-defunct Hastings Funds Management and AMP Capital. A huge programme of privatisations and asset recycling by successive Australian governments also added fuel to the fire.
“The key question I always ask is: ‘Can you do a better job than a manager that’s got 50 or 100 people specialising in a particular sector? And can you source better assets?’”
Ken Licence
Principle Advisory
The big direct investors Down Under are AustralianSuper, Aware Super, Cbus and UniSuper, as well as the state government-backed investors Victoria Funds Management Corporation and TCorp in New South Wales, with the likes of Australian Retirement Trust, Hesta and Rest also doing direct deals, albeit often alongside an external manager.
As such, the portfolios they all built tended to largely comprise core infrastructure assets, with significant exposures to electricity and gas utilities and distribution, water, airports and ports. When it comes to digital infrastructure, telecoms towers have historically been the most prominent investments.
Over the past several years, though, two things have happened simultaneously: those previously safe-as-houses regulated assets have occasionally proved not to be quite as bulletproof as initially thought, while the wider asset class has evolved and begun to move up the risk-reward spectrum.
All of this has led to volatility in returns for some funds, particularly in Canada, which until recently was unprecedented.
‘Risk was underestimated’
Indeed, OTPP for example is believed to have experienced a write-down in 2023 of its 40 percent holding in Caruna, Finland’s largest electricity distribution company, which it acquired in 2021, following changes in the country’s regulatory framework. This in part led to its infrastructure return falling from 18.7 percent in 2022 to -2.8 percent in 2023.
“When the cycle is at the peak, with higher inflation, politicians distressed and regulators not allowing tariff increases in line with inflation, your asset can go practically bankrupt,” says one source at a leading placement agent. “Thames Water is just the tip of the iceberg.
“That’s the political cycle of regulated assets. I think the risk in regulated assets was underestimated, and a lot of people bought those assets saying it’s just coupon clipping.”
A former CIO at an Australian superfund, who requested anonymity to speak more freely, said the direct investment model makes sense for a fund when it is deploying capital into relatively low-risk assets in its home jurisdiction, where it truly understands the market and can be on top of risk management more effectively.
But going overseas is “absolutely” more difficult, this person says.
“In Australia, going direct is fine – we can all do old-school infrastructure here, and it becomes a cost-of-capital shoot-out for a lot of assets. But going into new markets – particularly emerging markets, but even in developed economies like the US or the UK – how do you compete with the big managers who have been there for years?
“Direct investment gives us more control and… influence over the governance… of portfolio companies”
Kyle giumelli
UniSuper
“The UK, US and Europe might be deep markets, but there is also a deep bench of competitors who are very well resourced, have been there a long time and are far better incentivised.”
Aware Super is one of the most active direct investors in infrastructure in Australia, to the point where the fund now has no mandate to make new GP commitments in the asset class, instead pursuing direct deals alongside occasional, more passive co-investments alongside managers. Its total infrastructure portfolio sits at just under A$20 billion ($12.6 billion; €12.1 billion), with a little over half that in direct investments, and a further percentage of the portfolio classified as ‘semi-direct’ (ie, co-investments or managed accounts).
Most of it is in Australia, but the fund has also been making a significant push into the UK, opening its first overseas office in London in late 2023.
“The easiest thing for us to do is make direct investments in our own backyard,” Aware Super’s head of infrastructure Mark Hector says. “That will always be the market that we understand most from an infra perspective and we have certain competitive advantages here, such as in tax for example. We’re also considered by government to be a trusted local owner of sensitive assets, which can be beneficial for GPs looking for an Australian source of capital.
“But the world is a big place and our goal is to produce the best possible return for our members. The reality is the Australian superannuation system grows at a faster rate than Australia’s overall economic growth, so that we gradually get bigger and bigger – it then makes logical sense for us to also deploy capital overseas in order to find the best returns.”
Managers’ role
Where do managers fit into these funds’ strategies?
Many look to partner with GPs to deploy capital into deals, even if they are not able or willing to make commitments to their pooled funds.
“The key question I always ask is: ‘Can you do a better job than a manager that’s got 50 or 100 people specialising in a particular sector? And can you source better assets?’” asks Ken Licence, CEO of Sydney-based investment consultant Principle Advisory.
“You might have a friendly investment banker who comes to you with a nice asset wrapped up in string, but you could be number 43 on their call list. Are you necessarily getting access to the highest-quality deals? Sourcing is hugely important, so investors have to ask themselves if they can replicate those skills. In some cases, they won’t be able to.”
This is where investors, even the very largest, still look to develop strategic partnerships with GPs – to access deals in markets or sectors where they may not be best placed to do it themselves.
In many cases, the investment itself will still be managed in-house, but the fund will get access to a deal that it might not have been able to without the external relationship – and for the GP they get an extra source of willing capital to allow them to take out bigger-ticket deals.
“Direct investment gives us more control and allows us to exercise influence over the governance, management and strategy of portfolio companies,” explains Kyle Giumelli, senior investment analyst, private markets, at UniSuper. “We are open to investing directly alongside GPs and have active relationships with a select number of ‘smart partners’ – experienced high-quality institutional investment managers we work with to access global dealflow and enhance asset management, leveraging our size as well as capacity and speed to deploy.
“Our model allows us to consider the entire universe of unlisted opportunities – we’re not concerned about labels, so we can pursue the assets that we think provide the best risk-adjusted returns.”
UniSuper still has a bias for traditional core infrastructure assets, he says, but the fund looks at higher-risk core-plus investments opportunistically, often investing alongside its aforementioned “smart partners” depending on the asset.
Hector echoes this: “We could theoretically just invest in a bunch of pooled funds and SMAs, but we are sophisticated and experienced enough to make some direct investments on our own, and we also know there’s enough dealflow out there for us to work as a genuine partner alongside a variety of different GPs, particularly on some of those larger and more complex deals where they need equity partners before their pooled fund LP base.
“That means we don’t see a whole bunch of consistent dealflow from each of these individual GPs – but it’s not our goal to see every single deal from every single manager. We are a tiny fraction of the total global capital that needs to be invested in infrastructure every year – our goal is just to deploy a certain amount each year, in ballpark terms around a billion dollars per year, that’s manageable, and we are confident we can deploy that on a direct basis.”
On the other side of the world, the Investment Management Corporation of Ontario has quickly adopted the direct investment model since its establishment in 2016. Head of infrastructure Matthew Mendes says about 55 percent of its infra portfolio is direct investments, with a target to reach 70 percent by 2027 – implying there will still be a role for GPs.
“It’s a bit of a stretch to go into everything by yourself and that’s certainly not the way we’ve tried to approach building out our portfolio,” he says. “Funds will continue to be a really important part of our portfolio. They can access things that we can’t, they add diversification, they add skill sets and jurisdictional knowledge that we won’t have.”
Tackling problems
Of course, some investments do still go awry. For example, IMCO saw a $400 million investment – partially made through its infrastructure allocation – in Swedish battery manufacturer Northvolt upturned recently, when it fell into administration in November.
“We try to be humble, introspective and learn. We take our wins seriously, we take our losses seriously,” Mendes says. “We think governance is really critical and is one of the cornerstones of investing on a direct basis. We are really spending time enhancing our asset management capabilities and hiring a lot of people on that side and building up systems and processes.”
Hector concurs and says reputational risk is “absolutely paramount”.
“But the fact we are still going down this path means that we’re obviously prepared to accept that greater level of reputational risk relative to indirect investments for a broader set of benefits,” he says.
Of course, the direct investment model itself is not necessarily the problem when an investment goes wrong. In the example of OTPP and Caruna, the fact that a further 40 percent of its equity was controlled by a GP like KKR perhaps proves this – but it does raise the question of whether direct investors are disadvantaged when it comes to addressing issues.
David Scaysbrook, co-founder and managing partner at energy transition and renewables specialist Quinbrook Infrastructure Partners, points out that the private markets investment model, broadly, has been built on the fact that investment managers have “skin in the game” – which direct investment professionals at LPs, who usually do not earn carry and are subject to lower bonuses, do not have in the same way.
“Does that make a difference?” asks Scaysbrook. “Well, fund managers lose money too – this isn’t an LP versus GP conversation. It’s all about what you need to be a successful direct investor.
“Is it a generalist opportunity where the skill set is sufficiently available to enable you to competently invest? Or are you in areas of specialism where you have to ask yourself: do I know enough, or can I find the people with the right experience to be stewards of capital and assess investment opportunities? We see that more of those generalist infrastructure strategies are being managed in-house, even directly, and then the specialist stuff is embracing partnerships with GPs more.”
Andrew Claerhout – a partner at Boston Consulting Group who previously worked at OTPP for 13 years, serving as its head of infrastructure from 2013 until his departure in 2018 – suggests outsourcing asset management in the event things go wrong.
“Rather than building a large, diverse asset management team that is ready to deal with any tricky situation, it is generally more effective for investors to build value-creation teams that focus on identifying the work to be done and leveraging outside experts to do the heavy lifting,” Claerhout argues.
“This way, they can bring the best possible talent to bear while converting a fixed cost into a variable cost. Rather than having a fire department ready to be deployed when needed, it is more effective to have a fire alarm with the ability to work hand-in-glove with external experts to add or preserve value.”
This helps get around the ever-present difficulty of trying to build an internal team when faced with the compensation on offer from GPs.
Greater control, greater responsibility
As for creating pension funds that are big enough to deploy capital at scale and direct, the former superfund CIO points out that: “Bigger is better in a lot of asset classes – but it [all depends] on how the funds are merged and how their governance works.
“Mergers of equals have not often worked well at all in Australia. So, it all comes down to ensuring you have the right expertise, and therefore the right investment committee making decisions, rather than being aligned with any unions or government pledges that could prompt them to make decisions in the best interest of stakeholders over their members.”
Hector says Aware Super has been on a journey for several years to reach the point it has today.
“We’ve worked to build out all our support teams within and outside the investment team, as well as the infrastructure team, to make sure we’ve got the capability and confidence to do direct deals. Once you become a sole or majority investor in an asset, you do have a greater level of responsibility, and that’s not lost on us,” he says.
A partner at a prominent GP raising one of the largest infrastructure funds in market today says they are starting to see some institutional investors, who in the recent past have been explicit in their desire not to make fund investments, turn back towards pooled commitments.
“They’re looking to be on the front edge of that definition of infrastructure,” this source says. “We openly say to our investors that, probably once or twice within each vintage, there is a new, redefined type of asset within infrastructure. These investors still want to push themselves into that frontier of true value-add infrastructure, which they would not be able to access on their own.
“It’s clear that for some funds who have positioned themselves as going direct, things haven’t necessarily played out as well as they would have thought, especially on a peer-to-peer comparison basis.”
And as Principle Advisory’s Licence says of the Australian superfunds: “They are the new mutuals – they act like big banks in many ways and they’re going to have all the issues associated with those same financial services institutions. So they will have painful investments from time to time – but it’s cyclical.”
That lens can certainly be applied to the Maple 8 as well, which participate in financial markets in similar ways.
It also underscores the fact that while the direct investor model has a lot to offer – ability to put larger licks of capital to work at once, having greater control over investments and saving on external manager fees – it still will not be without challenges, and it certainly won’t be all plain sailing.