PETALUMA, Calif. — Fleshing out an inflation-linked asset class that began taking shape last year, the California Public Employees’ Retirement System is contemplating a new infrastructure portfolio.
At the $247.9 billion fund’s offsite meeting in Petaluma July 23, the CalPERS board considered a report by staff and alternatives consultant Pension Consulting Alliance Inc., Portland, Ore., on establishing a pilot infrastructure investment program. The board didn’t act on the report; instead, the plan for a pilot program will go before the system’s investment committee on Aug. 13, when the panel will decide on whether to implement the plan.
Last month, staff discussed more specifics on bundling commodities, timber, inflation-linked bonds and the new infrastructure allocation in an inflation-linked asset class. The overall allocation probably won’t be determined until November, but it could be in the billions of dollars, said Clark McKinley, CalPERS spokesman. Staff used a 5% inflation-linked allocation for risk-return profile modeling purposes. A proposal submitted to the board in June would allot 40% of that inflation-linked portfolio to infrastructure.
CalPERS would expect an infrastructure target return of CPI plus 5% to 7%, according to Russell Read, chief investment officer.
“We believe we’ll be compensated for breaking out long-term, inflation-linked infrastructure investments,” Mr. Read noted in an e-mail to Pensions & Investments. “This would represent a small percentage of our portfolio (at least initially). We could have an enormous appetite for infrastructure, depending on our ability to locate, source and invest in attractive deals. If we can’t find attractive deals, we won’t do any. There are no guarantees.”
The new investment program would also allow the fund to hold on to attractive investments that otherwise wouldn’t fit into the portfolio, Mr. Read told P&I at the meeting. For example, the fund bought into a high-risk, high-return real estate venture that has evolved into more of an inflation-linked investment, he said. “We would be sellers in this project later this year,” he said. Some private equity investments could also be reclassified to fit into the inflation-linked budget, said Mr. Read.
If approved by the investment committee, the fund’s private equity and real estate staff and consultants would be in charge of the new infrastructure investment program.
Fund officials think the time may be right because infrastructure’s long-range stable cash flows could provide a good match for the pension fund’s long-term liabilities. Officials see infrastructure as an emerging asset class that could reduce the gap between assets and liabilities.
There is also strong demand for cash to flow into infrastructure projects in the U.S. There is an estimated $1.6 trillion infrastructure demand over the next five years. California alone requires $500 billion to maintain existing and build new infrastructure projects over the next two decades, the report notes.
“Demand is being fed by a number of pension funds looking to infrastructure assets for stable, long-term returns that are higher than government bonds,” according to the report.
Pension funds are attracted to the asset class because infrastructure consists of long-life investments such as bridges and tunnels with 25- to 99-year concessions and revenues that are typically linked to the consumer price index. Infrastructure also has a low correlation to traditional asset classes, and it enables pension plans to match plan assets with liabilities, the report noted.
PCA suggested infrastructure investments as an alternative to Treasury inflation-protected securities, mezzanine debt, high-yield debt and lower-risk private equity. PCA and staff recommend initially investing in infrastructure funds and co-investments, according to the report.
U.S. pension funds are new to the infrastructure asset class. Although funds in Australia, Canada and Europe have been investing in infrastructure for a number of years, there is no widely accepted industry benchmark for infrastructure. Returns have been in the double digits but a bit uneven. For example, the C$5.6 billion (US$5.4 billion) infrastructure portfolio of the C$47.6 billion Ontario Municipal Employees Retirement System, Toronto, returned 14% in 2006, less than the 23% return the portfolio earned in 2005.
The PCA report warned that a sudden influx of new infrastructure funds and investors can “cause a supply and demand imbalance within the market.” A large supply of capital could lead to highly contested auctions for projects that would inflate prices. Also, there may not be a way to resell privately held infrastructure investments. They require a lot of capital, limiting ways investors’ exit strategies.
There is also regulatory and political risk. Many infrastructure investments are in highly regulated industries such as transportation and utilities, where there is a risk that regulation changes could affect revenues and growth.
