A Cautionary Tale For Pension Funds Piling Into Private Markets

Keith Ambachtsheer wrote an op-ed for the Globe and Mail on how the Thames Water crisis offers cautionary tale for pension funds investing in private-market assets:

There has been an unfolding management and financial crisis at giant British water and sewage utility Thames Water. Its owners now face a Hobson’s choice of pouring in billions of fresh capital to shore up the utility, or walking away to leave the British government picking up the pieces. The utility’s owners are mainly pension funds, including two from Canada.

The Thames Water debacle raises questions of the suitability of this kind of private-market investment for pension funds. In principle, as an asset securing future pension payment obligations, infrastructure should make for an ideal pension fund investment. But the case of Thames Water shows that is not always the case in practice.

What is the actual exposure of pension funds to infrastructure investments, and to other private-market investments such as real estate and private equity? (Unlike publicly traded assets such as company shares and bonds available to retail investors, private market investments are subject to considerably less regulation.)

Toronto-based CEM Benchmarking collects asset-allocation information from more than 400 pension organizations worldwide. Most recently, of a total asset base of $15.9-trillion, private-market investments account for a material 16.6 per cent of total pension assets, and that proportion has been growing steadily in recent years.

Private-market assets have performed well for the Canadian funds in the CEM database. The three classes of infrastructure, real estate and private equity produced median 10-year returns of 9.5 per cent, 8 per cent and 17.1 per cent, respectively. That compares with returns of 9.8 per cent and 3.7 per cent, respectively, for publicly traded Canadian equities and bonds (all net of expenses). Further, the infrastructure and real estate asset classes have historically exhibited lower return volatility and, in inflationary times, stronger inflation protection.

All this suggests private-markets investments have generally been highly suitable for pension funds in the past, and it is no wonder pension funds have been increasing their exposure to them.

In that context, what are we to make of the Thames Water story? It is a predictable consequence of the convergence of two forces that have been affecting pension-fund investing for some time now.

One force relates to a culture transition over the past 30 years in how pension investment decisions are made, with funds increasingly gravitating toward ownership-style investments. The other force is the growing importance of assessing the sustainability of future cashflows (e.g., corporate profits) in a world of rising geopolitical and climate-related risks.

The ownership style of investing and the increasing focus on corporate sustainability both require expertise in understanding the governance structures, business models, and balance sheets of public and private corporations and other business structures designed for the production and distribution of goods and services.

More specifically, this kind of investing requires expertise in assessing business model credibility, organization design and governance quality, the financial impact of possible geopolitical events, as well as the ability to keep up with new developments in physics, engineering and information technology.

On the whole, CEM’s private-market results suggest pension funds have been successfully moving in these two directions. But will these efforts always be successful? The case of Thames Water provides a firm “no” to that question. Undoubtedly, the lessons learned there will be put to good use in future transactions.

Keith Ambachtsheer is director emeritus of the International Centre for Pension Management, senior fellow of the National Institute on Ageing, executive-in-residence at the Rotman School of Management and co-founder of CEM Benchmarking and KPA Advisory Services.

Alright, let me cut to the chase, Keith is so diplomatic, so nice, so Dutch that he writes well but doesn't say very much here except at the end when he says investing in Thames proved to be a failure.

I have already covered the Thames Water debacle and its impact on OMERS and BCI here.

Thames Water is an utter disaster and it highlights a lot of risks of investing in foreign infrastructure.

The biggest issue is when you invest in an asset like this, you have to think and act long term.

Let me be more specific.

Prior to 2006, when Germany’s RWE AG owned and operated Thames Water, it was a cash cow, the Germans invested a lot of money in the infrastructure to maintain it properly.

In 2006, the Kemble Water Ltd. consortium led by Macquarie which BCI was part of acquired Thames Water, and it all went downhill from there.

Macquarie operates its infrastructure assets in the opposite way the Germans do, meaning it's always looking to strip an asset, extract maximum equity and pile on debt, which is exactly what it did with Thames Water.

BCI and OMERS knew this but maybe they didn't see how bad things really were because if they did, there's no way they would have kept their stake in this company.

When you own an asset like this, you need to think and act like the Germans, not like Macquarie.

That goes for all infrastructure assets, they're like buildings, they need massive investments to maintain them and make sure they're  keeping up with demand and also make sure they are reducing their carbon footprint.

In other words, if you want to own an asset long term, treat it better than you treat your own house.

A friend of mine who recently returned from Greece was appalled with Terminal C at Athens Airport which PSP owns through its airport platform company, AviAlliance, which is the old Hochtief group. 

He is an infrastructure expert and told me: "They cut so many corners to save money and didn't think long term," adding "I wonder if anyone from Hochtief's original group is still part of AviAlliance because the Germans don't build infra assets for tomorrow, they build them for next ten years."

His point was if Canada's pension giants are going to buy foreign infrastructure assets, they better maintain and operate them properly over the long run or else they risk huge reputational hits.

"You can't have financial engineering types operating these assets, that's what Macquarie did with Thames Water and the results were predictably disastrous."

And guess what? UK citizens and ministers now know who OMERS and BCI are and that too doesn't bode well for them and other large Canadian pension investment managers looking to do more business there.

The myopic focus on performance to beat a benchmark doesn't mesh well with infrastructure assets which by nature are long term assets. The same goes for real estate but to a lesser extent.

All this to say, piling into private markets, especially heavily regulated ones like Thames Water requires a different approach and it requires a special skill set, one heavily focused on maintaining and operating an asset over the very long run.

Below, an amazing clip where Barry Gardiner of Alastair Cochran, Joint interim CEO of Thames Water; Sir Adrian Montague CBE and Chair of Thames Water and Cathryn Ross, Joint interim CEO of Thames Water, all get roasted.

Also, a 25km-long ‘super sewer’ is near completion in London after years of building work. The Thames Tideway Tunnel will divert water from drains which used to flood into the River Thames during heavy rainfall, making the waterway much cleaner for wildlife and river users. The infrastructure is being broadly welcomed by environmental groups, but sewage outflow is a nationwide problem which is going largely unchecked outside the capital.