Pension fund will take on some operational risks by putting money in sector

THE idea of investing in infrastructure assets is striking a chord with pension funds around the world, and the Employees Provident Fund (EPF) is no exception.

In the last few years alone, EPF, the seventh largest pension fund in the world, has invested billions of ringgit in infrastructure assets such as highways and hospitals and waste management.

Why this move? The simple answer is that the pension funds are chasing yields in the era of low interest rates and tepid growth in equity markets.

But there are concerns, a key one being the level of risk that the pension funds will be taking on when buying into infrastructure assets.

Secondly, with so many funds now chasing for such assets, is there likelihood of inflated asset prices, which in turn will depress the expected yields?

For the EPF, the fund recently said it plans to invest more in infrastructure, property and private equity. The target is to raise the allocation from these asset classes to 10% of 6% at present.

Infrastructure assets alone will make up 3% of total assets.

“EPF’s investments in the real estate and infrastructure assets collectively yielded a return on investment (ROI) of 8.9% in 2015.

“The ROI for the same asset class was 9.6% in 2014. The difference in performance between 2015 and 2014 arise from the higher base as EPF pursued more new investments in real estate and infrastructure in 2015,” the EPF deputy chief executive officer (investment) Datuk Mohamad Nasir Ab Latif says in an email interview.

The EPF had earlier acknowledged that it was only looking at so-called brownfield assets “with an operational track record in an environment with a strong regulatory framework”.

The fund says it is looking at investing directly in infrastructure assets, ranging from power plants to ports and highways as long as the projects carry a minimum target of 10% internal rate of return (IRR).

The IRR is a widely-used formula to gauge the expected returns of an investment a project could generate over a period of time.

Nasir says investments made in infrastructure assets have performed in line with this targeted IRR.

UOB Kay Hian head of research Vincent Khoo says: “Good brownfield assets, back by their operational track records, have higher visibility of achieving their target IRRs compared to investing in projects that have yet to be built.”

He reckons that under current market conditions, there are not many assets t available in the market that could provide relatively high returns at moderate risks for pension funds like EPF.

“Mature infrastructure assets such as highways provide strong cash flows with a steady growth rate. At the current low yield environment, such assets are more attractive to invest into.

“But of course there are also a lot of other local and foreign parties eyeing the same asset class. Compared to years ago highway operators can now demand higher valuations,” he says.

New investment strategy

In the early 1990s, pension funds like the EPF only needed to rely on fixed-income instruments such as bonds and loans which gave good returns. Then came a stock market boom in the mid 1990s that saw pension funds shifting their portfolios to invest more in equities.

During that period of strong growth, the EPF had dished out handsome dividends to its members of between 7% and 8% range.

Things began changing in early 2000. Pension funds realised that they were no longer protected from the risks of lower interest rates and stock market volatility.

EPF’s dividend payment dropped to below 6% from early 2000 to 2010, going as low as 4.5% in 2008.

That in turn led to a major shift in EPF’s portfolio. They shifted some investments into overseas equities, private equity and real estate. And that bore fruit.

The EPF managed to increase its dividend payout to more than 6% per annum over the past five years.

“The EPF started allocating a portion of its assets to private markets investments, specifically private equity (PE) and real estate, beginning early 2000.

“Our approach at the early stages has been to focus largely on domestic real estate and PE fund investments. We have only come to include infrastructure as an asset class in 2011,” Nasir says.

Although the size of EPF’s allocation in infrastructure assets is relatively small, EPF has stakes in four highways in Malaysia and a waste-management operation.

Nasir says that as for now the current allocation of 3% of the EPF’s total assets for infrastructure assets, is sufficient and would be reviewed in the next three year.

“Given that the asset class is relatively new, the allocation is currently sufficient as we have yet to fully utilize the funds allocated for infrastructure investments. The EPF’s strategic asset allocation is reviewed every three years,” he says.

The four highways are PLUS Expressway and the Cheras-Kajang Highway, where the fund has 48% stake each as well as the New North Klang Straits Bypass Expressway (NNKSB) with 37.5% stake. The most recent acquisition is a 40% stake in Duke Highway phase 1 and 2 for a total of RM1.13bil from Ekovest Bhd. The deal is expected to complete in first quarter next year.

The market is speculating that the EPF is set on increasing its highway investments.

After Duke, the next infrastructure EPF is eyeing the Eastern Dispersal Link (EDL) expressway in Johor Baru and is said to be looking at Lingkaran Trans Kota Holdings Bhd (Litrak).

Litrak operates the Damansara-Puchong Expressway (LDP) and the Sprint Highway.

Previously, pension funds like the EPF only limited their exposure to the infrastructure sector by acquiring equity in listed companies that operate such assets.

But now, the EPF is going for direct ownership in assets such as highways and waste management.

This allows the fund to tap into new sources of return and hedge against the turbulence in the capital market.

For instance, Litrak reaped a net profit margin of 40% in its latest financial year results.

But why then would highway operators want to sell such assets, if the assets are so lucrative? For some operators, selling the assets would lighten their debt load considerably, allowing them to unlock fresh funds to undertake new projects.

Whereas for the pension funds, they could avoid risks associated with the construction phase by buying up mature assets.

No traffic guarantee

There are about 28 highways in Malaysia and some highway concessionaires had undergone debt refinancing.

For instance, take the Sistem Lingkaran-Lebuhraya Kajang Sdn Bhd that saw lower traffic than the projected numbers. Its bondholders had to take a hair cut when the papers were restructured in 2009.

But now the highway’s cash flows has improved significantly and it has been takeover target although it is incurring high debts.

Meanwhile, New Pantai Expressway and the Besraya Expressway have yet to declare any dividends for shareholders even after 15 years of concession.

The risk to be borne by the EPF when buying mature highway assets is that there is no guarantee traffic volume and higher operating cost.

As such according to Nasir, the EPF has put in a safeguard mechanism on the recent purchase of a 40% stake in Duke highway.

“There is no guarantee that the traffic flow in Duke would double in ten years.

“However, there is a safeguard mechanism put into place to ensure that EPF’s requirement for a minimum 10% of IRR from the investment is fulfilled,” he says.

He says that the EPF conducts stringent due diligence prior to any decision to pursue an investment project.

Nasir says that the first phase of Duke Highway 1 is already operational and its cash flow is in positive position.

He says that the main challenge, when it comes to private market investments (including infrastructure), is to develop internal capacity and the capability to source, execute and manage opportunities and investments. “The capability to source, execute and manage opportunities or investments are also pivotal in ensuring that we have the first look at any opportunities that arise, and in identifying those that could potentially provide the best risk-adjusted returns that meet our expectations,” he says.