The Caisse's Greenfield Revolution?

Scott Deveau of Bloomberg reports, The $4.9 Billion Railroad Being Built by a Pension Fund:
Caisse de Depot et Placement du Quebec, Canada’s second-biggest pension fund, has developed a unique model for infrastructure investing in its home province of Quebec. The Caisse has struck a deal with the local transit authority in Montreal to develop a 67-kilometer (42-mile) rapid transit network, known as the Réseau express métropolitain (REM), in conjunction with funds from the provincial and federal governments. It’s a unique project for the pension fund, which usually invests in mature infrastructure assets. This time around, the Caisse is building the rail network from the ground up. The whole project is expected to cost C$6.32 billion ($4.88 billion), with the first trains scheduled to run in early 2021. Michael Sabia, chief executive officer of the Caisse, discusses the project, the bumps it’s already encountered, and how the pension fund plans to mimic REM in other jurisdictions, including in the U.S.

Scott Deveau: How does this investment differ from the other infrastructure investments the Caisse has made?

Michael Sabia: It’s the first time a pension fund has ever done this. There are two differentiating elements here. The first is that this is an entirely greenfield project. I’ll give you the history. The government did not have the financial wherewithal to pay for two projects it initially presented to us as something that needed to be done. The one was a link from the South Shore suburbs to downtown, and another one was a link from downtown toward the West Island. We looked at that and decided that wasn’t the best solution and that the best solution was to build a new integrated network that would run from the North Shore to the South Shore and from downtown to the West Island to the airport. It was an entire network that we proposed to build and connect to the existing Métro system—much bigger than the original plans. Our role was from conception, development and planning, financing, and overall overseer and project manager. We will build it. We own it. We will operate it. It’s from nothing to an operating transit system, and we’ve been responsible for the total span of that.

Differentiation No. 2 is in the financing of it. There we’ll have 53.5 percent of the equity in the business, and the two levels of government [provincial and federal] will have subordinated equity both in the amount of 23.3 percent each. The way that works is that we are able to earn a return of something of the order of 8 percent or 9 percent. The two levels of government earn a return of up to approximately 3.8 percent each, which is significantly higher than their cost of borrowing. Typically, governments finance these things as an expense where they get no return whatsoever and they borrow the money to do it.

Pension funds usually prefer to buy assets that are mature, or so-called brownfield assets, because it removes the risk associated with building the infrastructure. So why have you decided to go for greenfield assets?

Because it’s not the only thing we’re going to do. In other parts of our infrastructure business, we continue to do more traditional brownfield. But we think that the market is changing. Having conceived, planned, developed, owned, and operated infrastructure is an important differentiator for us in the years ahead. It’s in effect new product development. It’s what we’re doing to differentiate ourselves in a market that we think is increasingly commodified and where brownfield assets are becoming very expensive to prohibitively expensive.

The 8 percent to 9 percent return is typically a little smaller than what you would get on an infrastructure investment, isn’t it?

Well, no, I wouldn’t say so. There are brownfield deals being done at astonishingly low rates of return. There have been recent things in the market getting done at 5.5 percent or 6 percent. That sort of demonstrates the extent to which investor interest in infrastructure is bidding down brownfield returns. That’s why we want the capability of delivering greenfield because we do believe there is a significant dividend so long as you believe you can manage the risks. Those are the capabilities we are developing.

Those lower returns are a function of increased competition and billions of dollars chasing the same assets, I presume.


Have you had to do fairly dramatic changes internally to accommodate this shift in strategy?

Yes, we’ve had to build an entirely new team that [is capable of] project planning, project management, engineering, and tender process management. We’ve had to build all those skills in an entity that will become a subsidiary of the Caisse, an operating subsidiary.

Outside of Quebec, is there an opportunity to export this model?

We have had a great deal of interest in the United States from both mayors of major cities and governors of major states. I can’t go further than that, because those conversations remain confidential. All I can say is there has been a great deal of interest and we are actively engaged in at least two or three conversations with respect to doing this in the United States.

Will you have to prove out the model before those projects proceed?

I don’t know yet. But I’ll tell you how we think about this. Before we embark on another project of this kind, we will want to have made some meaningful progress in the actual construction of the network here. We want to stay focused on making sure we deliver here, because this project has always been proof of concept in our mind. We’re using a market that we know well—Montreal—that’s right in our backyard, to prove out the concept, and then we want to take that concept in effect on the road and export it. I’m convinced there’s a very interesting market out there for a pension fund like ours to do these projects elsewhere. There’s also interest, a little less advanced than in the U.S., but we’ve also had expressions of interest from other provinces.

Some of the risks associated with building this project have already manifested themselves: It’s gone over budget and been delayed by about a year. Does that concern you?

We said pretty much from the beginning it would be about C$6 billion to C$6.1 billion, and we’re at C$6.32 billion now. That’s with firm turnkey proposals from the two consortia [led by SNC-Lavalin and Alstom SA] that are going to build this thing. We had some negotiating to do as of November, and to get that done at the prices we wanted, which we have now done, imposed a three- or four-month delay. We had said our hope was to have the first trains running on one of the lines we’re going to build by 2020. Now it will probably be in the winter or very early spring of 2021.

Wasn’t the original budget meant to be about C$5.5 billion?

No, that was before the final configuration of the network. We added three stations from the initial proposal to better connect to the existing network. That and some other adjustments in the network itself [were made] to make it go a little farther west.

Do you have any concerns about the pace of progress?

No, to be honest, this whole thing has gone better than we had expected in terms of the process of getting all this stuff approved and the financing we needed from two levels of government and the tender process, which was a very complicated process. We did have to do some negotiating to get the prices in a zone that we thought was appropriate and would protect our returns. But at every turn this thing has gone reasonably well.

There seemed to be a lot of enthusiasm around the project, but lately it appears to have become a political punching bag. The Montreal mayor has called for greater trans­parency on the terms of the deal, including its fees and noncompete clauses, and the provincial separatist party, the Parti Québécois, has even called for it to be scrapped. What do you make of these complaints?

There’s a lot of misunderstanding around this. I’m not going to comment on the political situation in Quebec. You can draw your own conclusions. We’re just in the business of building an infrastructure project, and the political class will do and say as they wish in the election season that is under way here. We will be releasing the texts of these agreements, and I think people will see there has been a lot of miscommunication, so we’re going to put them out publicly. This concern about incremental costs hitting the municipalities, there’s no issue there. We have said for the last year or year and a half that this project will cost the totality of the municipalities—all of them—something like a potential increase of C$40 million to C$60 million annually. But that’s it. They will have an entirely new transit system for that incremental expense over what they’re paying today. The more recent concern is that it will be higher than that. No, it will not be higher than that. Period. Full stop.

In terms of this sort of noncompetitive thing, this is how the transit authority here works. It’s not just for us. It’s for other transit systems as well. The objective is really no more complicated than if we’re going to build a rail system over the Champlain Bridge and into downtown—it’s to protect us from somebody starting a competing bus service. If that were to be the case, then we can’t fulfill our fiduciary duties to our depositors because, all of a sudden, there’s a competitive system running parallel to ours. It throws off our revenue and traffic projections. There’s been people here saying that it means they’re not going to be able to build any more transit systems in Montreal. That is wrong. There’s nothing in the agreements we’ve signed with the province or the transit authorities here that would preclude the development of any transit system across the Isle of Montreal.

You’ve had to make some tough decisions already. The decision to award train manufacturer Alstom the train car and related equipment came as a surprise to many in Quebec because it’s a competitor to Quebec’s Bombardier Inc., whose rail division the Caisse has a significant investment in. How did you come to that decision?

Because we ran a competitive process, and Alstom won. We’re an investor in a lot of companies, and many of those companies were involved in the bidding on this project. So we thought from the very beginning it was important to create a tender process that was beyond reproach. We set up very specific criteria for which the bidders would be judged. We set up a process whereby two external auditors audited everything that was done and attended virtually every meeting we had with the bidders. Then we set up a committee chaired by a former justice of the Supreme Court to oversee the whole thing so there could be no concern around conflict of interest or anything else. We went through that whole process, and our experts went through all the bids. The people who won on the rolling stock won on the merits of their bid.

It’s sort of interesting this project was being developed outside of the federal government’s Canada Infrastructure Bank, which has been set up to help finance projects like this across the country.

Well, yes and no. We wanted to secure the federal funding in a manner that allowed us to keep to our schedule. The federal government made a commitment to this in the amount of essentially C$1.3 billion with the option—and we’re working on this right now—in effect transferring that investment from the federal government to the Infrastructure Bank itself. So it may be that that funding comes as one of the investments or potentially one of the first investments from the Infrastructure Bank.
The last time I discussed the Caisse's REM project was in February when I went over the supposed $300 million cost overrun. You should read that comment to understand the truth behind these cost overruns.

I've discussed this REM project many times on my blog and have stated the Caisse has ventured into an area where no other pension plan in the world has ventured, a multi-billion greenfield infrastructure project which it controls from conception to operation.

If successful, the Caisse's depositors will reap the rewards of many years of annulized returns of 8-9% which doesn't sound like a lot but it's plenty above the actuarial target and it comes with low volatility and huge scalability, especially if the Caisse then goes on to do other similar projects.

In this interview, Michael covers a lot. First, he's right, core brownfield infrastructure assets are being bid up to nosebleed valuations which is why prospective returns are low. When everybody is pouring billions into an asset, any asset, it typically doesn't bode well for future returns.

Second, he discusses the differentiation in terms of financing this project which involves two levels of government. The Caisse will own a 54% equity stake in this project and the provincial and federal government will each own a 24% stake and each earn a return of roughly 4% which is significantly higher than their cost of borrowing.

Third, a greenfield project of this size takes a special skill set. The Caisse built a team from scratch hiring top people who have experience in project financing, planning and management. This isn't the typical "Wall Street let's cut a deal" type crowd who bid on brownfield assets, these people are getting into the nuts and bolts of this project from conception to building to operating it.

One of the guys working on this project is a close family friend. Like Michael Sabia, he's beyond reproach, a straight shooter and highly ethical, I'd trust him with billions and know he's very competent at what he does. His boss is the brains behind this REM project, a tireless workhorse who is involved in every aspect of the project and has singlehandedly carried it to where it is now.

There are plenty of others who I don't know. These people are working very hard on this project and it's not easy work, far from it, it's stressful, you need to meet tight deadlines and you're always under media scrutiny (Quebec's media pariahs as I like to call them, always looking for a scandal even when there are none).

Again, there is no pension fund doing this type of work. The only private fund I can think of that can do this type of work is Brookfield Asset Management, arguably the best infrastructure investor in the world, and even they would find a project of this magnitude and complexity daunting.

I'm going to share something else with you. There will be hitches along the way but the Caisse will succeed in this project and it will open the doors for them on future mega greenfield projects elsewhere. The people working on this project will be highly sought after for their experience and ability to deliver.

In an ironic twist, Michael Sabia's long-term vision is not only tranforming the Caisse's approach to infrastructure, it might be transforming the way pension funds will be investing in this asset class for generations to come.

Not bad for an outsider turned rainmaker.

Sure, Sabia's critics will point out the obvious, he's never lived through a bear market, he "hasn't been tested", but this approach goes so much deeper than that because it's revolutionizing the way the Caisse is approaching infrastructure over the long run, and if successful, it might revolutionize the way cash-strapped governments all over the world approach their infrastructure needs.

In fact, investors all over the world are taking notice and it was recently announced that CDPQ Infra will be part of a consortium headed by New Zealand's Super to build a light rail system in Auckland:
The NZ$38 billion ($26.9 billion) New Zealand Superannuation Fund has submitted an unsolicited proposal to New Zealand's government to form an international consortium to "design, build and operate" a planned light rail network for Auckland, a government news release said Wednesday.

Matt Whineray, NZ Super's acting chief executive, said in a separate news release, "we wish to explore whether a NZ Super Fund-led consortium leveraging our international relationships can fund and deliver the project, on a fully commercial basis."

New Zealand Super "considers the Auckland Light Rail network to be an infrastructure project of sufficient scale and significance to be an attractive prospect for investment," said Mr. Whineray.

The government news release, by Transport Minister Phil Twyford, said NZ$1.8 billion in seed funding had been earmarked for the 10-year transportation plan, which included the Auckland light rail projects.

Local news reports in New Zealand on Wednesday peg the total price for the light rail projects at NZ$6 billion. Danya Levy, senior press secretary for the transportation minister, couldn't immediately be reached for comment.

A spokeswoman for NZ Super said her fund will partner with CDPQ Infra, the infrastructure arm of C$298.5 billion ($232.5 billion) Caisse de Depot et Placement du Quebec on the Auckland project. She declined to provide further details.

The NZ Super news release said other members could potentially be added to the consortium.

The government welcomed New Zealand Super's interest, while adding that it will review "all other proposals in the same way as the Super Fund's proposal is assessed."

New Zealand Super's latest report for the period ending March 31 showed the fund allocating 2% of its portfolio, or roughly NZ$760 million, to infrastructure, and 14.5%, or NZ$5.4 billion, to investments in New Zealand.

CDPQ Infra, meanwhile, would bring light rail experience to the consortium. The New Zealand Super news release said the unit "is responsible for developing, building and operating Montreal's 67-kilometer (41.6 miles) light rail network."

Caisse manages assets of Quebec's public provincial and municipal pension funds.
Obviously, New Zealand Super did its homework and wisely partnered up with the CDPQ Infra on this project.

I would expect other major pension funds and sovereign wealth funds have approached the Caisse to do similar projects and told them: "We like these greenfield projects, want to venture into them but we lack the expertise and would love if you can partner up with us."

Anyway, I'd better stop there as I don't want to get carried away. One thing you need to know about these greenfield infrastructure projects, they carry their own set of risks which is why most pensions avoid them like the plague and they take a long time to come to fruition.

But so far Michael Sabia, Macky Tall and the rest of the folks at CDPQ Infra have done a great job on this REM project managing everything from A to Z, including expectations.

Pay attention folks, there is a greenfield revolution going on in infrastructure, one that might forever change the asset class's landscape and the way governments finance their infrastructure needs.

Below, Montreal's CTV News goes one on one with Michael Sabia, the Caisse's president and CEO (May, 2018). Listen carefully to what Michael and click here if it doesn't load below.

I also embedded the Bloomberg interview Michael gave at Davos at the beginning of the year as I find it interesting in light of recent developments. Watch the interview here if it doesn't load below.