RoundtableInfrastructure

Whether it’s a toll road in Ontario or an airport in the UK, Canada’s biggest pension investments are everywhere these days. As they seek to diversify

their portfolios in a low-yield environment, Canadian funds are snapping up high-profile infrastructure assets around the world, from bridges to water treatment plants to utilities. Indeed, The Economist isn’t calling them the “Maple Revolutionaries” for nothing — as key public infrastructure around the world begins to age and fall apart, cash-strapped governments are turning to private investors to foot the bill for repairs and new builds. Canada is leading the pack when it comes to infusing money into the system, but that money is just a drop in the bucket compared to what’s needed: the Organization for Economic

Co-operation and Development (OECD) estimates that US$53 trillion is required to upgrade key global infrastructure to meet future demand. And that opens up a huge area of opportunity for investors looking to diversify into the infrastructure asset class.

But, as Canada’s biggest pension plans lead the way in putting money on the table, what does that mean for other plans? Can they emulate their larger counterparts? And should they even be trying? In this special roundtable discussion, we look at the state of infrastructure investing in Canada today, from the expanding menu of options to the assets and approaches that make the most sense for plans of different sizes. What are the barriers to investing — and what are the key ingredients for success?

ON THE ROAD Canadian plans are everywhere, according to experts at the 2014 Infrastructure Roundtable

2 Sponsored Supplement Infrastructure

Sprott Asset Management LP is a leading alternative asset manager dedicated to providing specialized solutions that can enhance and diversify institutional portfolios. We offer a broad range of innovative products and investment strategies that extend across equity, fixed income and real assets. Our expertise in real assets originates from a well-established reputation and history of investing in this area, dating back to 1981. Our real asset platform consists of equity strategies focused on mining, energy, precious metals, infrastructure, agriculture and timber. We also offer specialty strategies in precious metals and resource-focused private equity and debt. For more information on Sprott, please visit www.sprott.com

Northleaf Capital Partners is an independent global private equity and infrastructure manager and advisor, with more than $5 billion in commitments under management on behalf of public, corporate and multiemployer pension plans, university endowments, foundations, financial institutions and family offices.

Northleaf is a global private markets investor with strong Canadian roots and a long, well-established track record. We are committed to building enduring relationships with our investors, fund managers, business partners and colleagues based on trust, openness, respect and the highest standards of integrity and professionalism.

Northleaf’s 60-person team, located in Toronto, Canada, London, UK, and Menlo Park, USA, is focused exclusively on sourcing, evaluating and managing private markets investments globally. Northleaf currently manages six global private equity funds, a specialist private equity secondary fund, an infrastructure co-investment fund and a series of customized private equity and infrastructure investment mandates tailored to meet the specific needs of institutional investors.

For more information on Northleaf, please visit www.northleafcapital.com

Sponsored by:EXPERT PANEL:

BRYAN DELAURIER Senior Vice-President Sprott Asset Management

JARED WALDRON Vice-President Northleaf Capital Partners

JAMIE STORROW Managing Director Northleaf Capital Partners

JANET RABOVSKY Director, Investment Consulting Towers Watson

MICHAEL UNDERHILL Chief Investment Officer Capital Innovations, LLC

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Infrastructure has had its ups and downs as an asset class over the last decade, particularly during the financial crisis. How has it evolved since?

JAMIE STORROW After decades of underinvestment in public infrastructure, there is now a large and growing need for private capital. At the same time, there is also more public support for private capital, demonstrated in part by the growth in public-private partnership programs across many jurisdictions. For pension plans, this is a positive development as it increases the investment opportunity set, which is particularly desirable in the current low-interest-rate environment. Infrastructure investments are typically categorized as stable, yielding, long-term investments with defensive qualities — all sought-after characteristics post-financial crisis.

JANET RABOVSKY A few important things have happened in the last five to 10 years to make this asset class more acceptable and accessible for plan sponsors. More funds than ever have emerged, and plan sponsors have a lot more choice. Back in 2006, for example, you had 10 funds — now you have over 100. The fund constructs have also changed — it’s no longer just private equity funds. There are open-ended funds and co-investment vehicles, as well. The fee landscape has also shifted: fees are better aligned with outcomes, which is a long way from the 2 and 20 that was the norm before the 2008 financial crisis. Leverage is also being used more responsibly post-2008.

JARED WALDRON Over the last five years, there has been a significant reduction in the yields earned on fixed-income portfolios due to the interest rate environment, and similarly we’ve see a compression in returns in the public equity markets. Investors are now seeing infrastructure as a means of accessing more attractive yields and steady income with total returns comparable to public equity markets but with lower volatility, given the characteristics of the underlying investments.

JANET There’s also a better understanding of the products today. Plan sponsors and advisors are actually working to define the characteristics they are looking for, and to find the types of assets and fund vehicles that will work with what they are trying to achieve.

MICHAEL UNDERHILL We have gone through the dark ages, then the golden age — now, I would say, we are in the period of enlightenment in the infrastructure space. When I first started working in this business, everyone wanted to invest in infrastructure as an asset class, but they had little knowledge of what that meant. When I asked them “What’s your definition of infrastructure?”, they would say, “We want to invest in sewage.” They clearly didn’t understand the characteristics of the asset class or what part of the portfolio to allocate from — real estate, fixed income, equities? There is also now a much better understanding of what role it plays in a pension portfolio. Today, we have more enlightened limited partners (LPs) and general partners (GPs), and I think we’re in a much better place than we were prior to the financial crisis as a lot of the weak players have been weeded out.

Which is more appropriate for pension plans, listed or direct infrastructure?

JAMIE Depending on the investment goals of a particular pension, the listed market, private market, or both, can make sense. There are assets available in the listed market to investors that they can’t otherwise access in the private markets, and vice versa. For plan sponsors, listed products offer liquidity. Private markets can offer pure project finance exposure. Many plan sponsors want a mix of both.

JANET At the moment, we see plan sponsors using listed infrastructure as a parking lot on their way to making allocations to private projects. That may change as the industry matures. Listed infrastructure is certainly more straightforward from

a governance perspective — it’s more transparent, and reporting is much easier. Liquidity is another reason why you might want to go listed — for example, if you’re cash negative and you constantly have to rebalance to come up with cash for pension payments, you might want to control the amount of illiquid assets in the plan. In that case, private infrastructure might not work.

BRYAN DELAURIER It depends on the financial and internal resources of each plan. An allocation to listed infrastructure can be a relatively seamless decision for plan sponsors, compared to direct investments. We’ve seen pension plans taking funds from their public equity allocation and moving to listed infrastructure as a first step.

MICHAEL Given the growing infrastructure financing needs across the world, the money is going to have to come from

Infrastructure investments are typically categorized as stable, yielding, long-term investments with defensive qualities — all sought-after characteristics post-financial crisis.

— Jamie Storrow

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both listed and private. It’s not “either-or” — you need multiple sources of capital to fund this. All the OECD countries are retrofitting their existing infrastructure, while emerging markets countries need to build from scratch. Financing will come from private capital plus publicly traded securities, as both are viable. In the United States alone, US$2.2 trillion worth of infrastructure investment is required. You have to fund all this, and global listed infrastructure is one way to do it — and while the listed infrastructure space is growing and deepening, it’s really just a deck chair on the Queen Mary in terms of solving the problem. Only US$34 billion worth of equity was issued in 2013 in master limited partnerships, so much more investment is needed.

JARED If a plan doesn’t have the flexibility to tie up capital in a private fund, listed funds provide the necessary liquidity — this is increasingly important with defined contribution plans, for instance. But, plans also need to understand that relying only on publicly available information can make it challenging to

determine whether a listed fund is over or undervalued, given the asset level specificity required to determine an appropriate valuation.

MICHAEL More clarity around valuation is another benefit to listed infrastructure. In the days before the financial crisis, for example, you could compare several GPs side by side, each one holding the same assets. One fund would hold the deal at $200 million and another at $270 — that’s a huge discrepancy. Valuation matters and it can be inconsistent in the private fund world— there are at least three different discreet, approved methodologies for valuing deals. In publicly traded infrastructure, it’s a much more level playing field — the value is clear and transparent, and the price is struck on a daily basis.

Canada’s biggest pension plans are considered leaders worldwide in infrastructure space. What can smaller or mid-sized plans learn about the space from them — and is co-investment a good move for smaller plans?

BRYAN I believe the larger plans have demonstrated that alternative assets will, and should, become a larger part in the plan design of all types and sizes of investors over the next few years.

JANET The fact that big plans have been early adopters of infrastructure has been

great — it’s lent credence to the asset class among other institutional investors here. But it’s worrying to think people will look at OMERS or Teachers’ and say, “I can do co-investments.” It’s not that simple. Smaller plans also tend to assume, because they’re given an opportunity to buy a piece of a deal, that the due diligence on asset and portfolio construction has already been done. If you’re going to buy this as an institutional investor, you need to hire your own professionals to do your due diligence — that can be very time-consuming, and it usually has to be done very quickly. People underestimate the amount of time and effort it requires to work your way through the documentation. I know a few plans in Canada in the $5 billion to $15 billion range that have gone through this — it’s been a real learning experience.

JARED Direct investing requires a full investment team with experience in multiple jurisdictions across different types of asset classes, experience in execution and due diligence, and with asset management capabilities and the necessary sourcing relationships. Furthermore, plans’ internal governance processes will likely need to change so they can be nimble enough to participate in bid situations, as opposed to having investment committees convened on a quarterly or semi-annual basis. While many plans are going the co-investment route, the jury is still out on whether those have been successful for plans that have done it. I don’t think any would say it’s been a big success at this point — and in many cases, it’s taken more resources than they anticipated. It’s the human resources element that many underestimate.

While many plans are going the co-investment route, the jury is still out on whether those have been successful for plans that have done it.

— Jared Waldron

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JANET Many plan sponsors consider co-investment a route to lower fees. They don’t understand what is required to go through all the necessary due diligence — the accountants, lawyers and other experts. It’s not as simple as it looks. For mid-sized plans that have succeeded, it worked because they hired the appropriate experts and were able to make decisions quickly.

MICHAEL Small plans trying to emulate what larger plans are doing — it’s not the right model. It’s like heart surgery — it’s not advisable to try it on yourself. You need to hire someone who knows what they’re doing. Smaller funds should hire a consulting firm to look at the asset allocation model, current exposures and their investment framework. After that, they should go back and consider infrastructure from the perspective of what is appropriate for the plan. Smaller plans simply can’t copy the big plans — staffing alone is an issue. Even the big funds struggle with the expertise needed to manage infrastructure internally. CalPERS recently hired 13 people to manage their infrastructure allocations, and they haven’t even deployed half their target capital. You need to hire someone to help you link up with firms to invest your money — funds of funds or co-investment.

JAMIE You can’t go from 0 to 60 miles an hour when building out to become a direct or co-investor. Plans need to take baby steps — it has taken decades for Canada’s big plans to get there. And while smaller plans want to emulate the big players, they have to be realistic about how long it takes and the staffing level it requires.

What types of assets are plans most interested in right now?

MICHAEL Multiple sectors: energy, transportation, water infrastructure across both OECD and non-OECD. Right now, when you look at equity, debt and private markets, we are keeping an eye on Fed monetary policy with a potential for a rising interest rate environment in the coming year. And

when rates do rise, whether you’re in bonds, equities or private markets, there will be refinancing risk. When you look at where the U.S. is trending with interest rates, it’s going to impact currency and bond markets. Investors need to make sure they don’t get caught flat-footed.

BRYAN Any asset that provides inflation pass-through protection and yield enhancement is attracting investor interest. We are in an era of financial repression, with steady doses of quantitative easing and stealth inflation — the search for real yield is a big factor.

Whether it’s listed or private infrastructure, what barriers still exist for more widespread adoption of the asset class among Canadian plan sponsors?

MICHAEL Education is still key; that is why I wrote the Handbook of Infrastructure Investing. There are so many different ways to invest in infrastructure now — you have core funds and sector-specific funds (water, energy, gas, etc.). But it comes back to the risk in the underlying funds and what you’re exposed to. What is the most appropriate way to approach the space? A lot is changing. Since 2011, US$103 billion in institutional investor capital has been raised by unlisted infrastructure fund managers. Roughly US$70 billion remains undeployed by private infrastructure fund managers. You need to map out how and when you want to commit.

JARED Getting the right advice can be difficult. You need a consultant to help you pick the strategy, and the manager and legal counsel to help work through all the documentation. A plan sponsor might have a trusted counsel on the pension side with no experience in infrastructure — they don’t always understand how the asset class works. That can add expense and cost.

JAMIE There is a community emerging around sharing costs and discussing available

resources — plan sponsors are educating each other to a certain extent.

JANET There are certain plans that should not go into private infrastructure. They will never be comfortable with the lag in reporting and the variation in benchmarking. They may also need more liquidity than they can get in the private market. In those cases, publicly listed infrastructure is a better option.

How can plans determine what approach to infrastructure investing is right for them?

BRYAN Assessing their overall need for liquidity, transparency and valuation frequency is a good starting point. With listed infrastructure, plans have tended to either use it for their sole infrastructure allocation

There are certain plans that should not go into private infrastructure. They will never be comfortable with the lag in reporting and the variation in benchmarking.

— Janet Rabovsky

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or as a supplement to direct investment. As a supplement, listed strategies can either be permanent or used as a short-term method of gaining sector exposure until cash is deployed into direct deals.

JANET For plans looking at a private vehicle, size is a determining factor. The minimum investment is often $10 million, so if you’re a plan with only $10 million to $30 million in assets, then private infrastructure isn’t for you. Listed infrastructure makes sense, given the math. At the same time, listed products are appealing for plans in the process of changing their statement of investment policies in order to achieve their allocation. With private vehicles, the drawdowns don’t happen at once, so it can take you some time to build up your exposure. At the same time, listed infrastructure makes sense from a smart beta or thematic investing perspective — you can use it to play growth trends in emerging markets and access certain factors that are tied to the economy.

JAMIE Plan sponsors are now able to access targeted segments of infrastructure with a fund, whether it’s core, core plus or value add across specific geographies. Where previously it was a narrow field of choice, plans can now focus on niches within the asset class.

MICHAEL But you also have to look at the overall asset allocation of the plan to make sure there is no overlap in other areas — for example, private equity or real estate. In Canada, 63% of institutional investors have infrastructure as a separate allocation, 11% of investors have

infrastructure as part of their general alternatives allocation, 10% list it as part of their private equity allocation, 6% have it as part of real assets, 5% under inflation linked allocation, and 5% in a bucket categorized as “other.” In real estate, funds may have industrial properties that look like an infrastructure asset (i.e., a port). The plan needs to work with its consultant to analyze existing assets in their portfolios and make sure they’re not over-allocating or inadvertently overlapping their exposures to a specific sector, like transport or power. That can put their allocations out of whack.

What about public-private partnerships (PPPs)? What are the risks and opportunities for Canadian plans?

JAMIE There are many new entrants in the PPP market, and the sector has been very active in Canada. Over 100 PPPs have been completed in Canada over the past 20 years, and we think this is a very positive development for Canadian plans. Until now, the deals have mainly been hospitals, or civil projects such as roads. There have been some notable privatizations, like the motor vehicle testing centers in Ontario. We believe both public-private partnerships and privatizations will diversify into other areas as well. But the success of a PPP depends very much on where you’re investing. In Ontario, there is an incredibly successful track record of projects being completed. In jurisdictions with less experience or no formal process in place, completion can be more difficult.

At the end of the day, when plan sponsors are looking at procurement processes, they need certainty. The process of putting a deal together is costly and time-consuming. You can get to the final stages and the project could be cancelled — and yet, parties have spent millions getting to that point. You need certainty that a contract will be awarded in the end.

JARED In the Canadian PPP market, it’s rare that a project would be cancelled once it has reached the RFP stage. From a government standpoint, PPPs are capital-intensive projects that require a significant amount of both debt and equity investment. The amount of capital being invested means that governments are well aware of the ramifications of changing the game on private investors after the fact, and the knock-on effects that could have for future investment in their country. I

Since 2011, US$103 billion in institutional investor capital has been raised by unlisted infrastructure fund managers. Roughly US$70 billion remains undeployed by private infrastructure fund managers.

— Michael Underhill

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believe there are other, more significant risks than having governments renege on contracts — for example, inappropriate use of leverage combined with aggressive operating assumptions are far more likely to drive capital impairments. Governments changing the process is fairly low on the list.

JAMIE You really need to pick the right partners, projects and processes. If you look at infrastructure in Ontario, there is an incredibly successful track record of projects being completed. However, if you take jurisdictions with less experience or no formal process, it’s difficult to justify from a time and resources perspective. In Canada, we are in an environment where procurement processes have been highly successful in at least three key provinces: Ontario, B.C. and Alberta.

JANET Most of the risks of PPPs can be mitigated. You really need to understand the jurisdictions you’re investing in. An investor that wants to earn a return of 8% can look at OECD funds. But the more return you seek the more risk you are going to have to assume, and you have to accept there might be things that won’t work out. The process is Canada really works, however — it’s not just the bidding and awarding processes, you have the financing in place from banks and insurance companies.

JARED The processes are also highly de-politicized in provinces like Ontario, where it’s up to procurement authorities such as Infrastructure Ontario, Partnerships BC or Infrastructure Quebec to award concession agreements. You really need to pick your spots — a lot of it has to do with the track record of the jurisdiction.

Is global infrastructure appropriate for Canadian plans?

JANET From the standpoint of traditional asset allocation, Canadian plan sponsors already have Canadian bonds and

Canadian equities, so they are looking to diversify. By staying in Canada for infrastructure, you only have access to social assets like hospitals — you are missing out on energy, water or transportation. Plans must diversify for a meaningful infrastructure allocation. You don’t want to be totally reliant on the Canadian economic cycle.

JARED There’s a world of opportunity outside Canada, and the flexibility to pursue investments across different geographies provides you more opportunities to find relative value. Utilities and transportation here are largely government-owned, so if you want exposure to assets like toll roads or airports, you typically need to go further afield to the U.S., Europe or Australia. If you want regulated utilities, the UK has one of the oldest and most transparent regulated water and wastewater industries. Of course, it means you have to deal with currency risk, but currency overlay programs and strategies can help minimize that risk. At the same time, funds are received periodically over the life of the investment (typically through regular yield), as opposed to in one lump sum at a single point in time.

BRYAN Think of it as being like fixed income — if your fixed income is pegged solely to Canada, you’re far too concentrated in essentially two provinces and one industry sector. The same applies to infrastructure: going global can enhance both risk and return.

JAMIE You also need to look at other jurisdictions for relative value in infrastructure. When you consider supply and demand and the interest rate environment in Canada and the U.S. relative to other jurisdictions like Australia, you can sometimes get a higher return for comparable projects, although there are foreign exchange considerations.

MICHAEL Global infrastructure may be appropriate, but the risks are multifaceted like a diamond: country risk, currency risk, sector risk, investment stage risk like Greenfield risk, are just a few. There are contracted

power deals, utility deals — a host of opportunities. But Canadian investors need to know what is appropriate for their own plans, and they have to be aware of taxes and everything they’re going into.

What about the costs of infrastructure investing — do the benefits outweigh the higher fees?

JAMIE Manager fees have been through an evolution in the infrastructure space. We’re now seeing right-sizing of fees, depending on the type of asset and risk (i.e., lower fees for lower returning assets and vice versa). At the same time, we are seeing some return compression on vanilla assets, such as contracted power, in part due to the interest rate environment and because there are new market entrants. You have to be very patient when investing.

We are in an era of financial repression, with steady doses of quantitative easing and stealth inflation — the search for real yield is a big factor.

— Bryan DeLaurier

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MICHAEL As investors consider the potential for rising rates and trade deficits in emerging markets countries, they need to look at the infrastructure space on a country-by-country basis and to be increasingly selective. After the taper tantrum last year, we know investors need to look at the yield curve in listed infrastructure, and what will perform and how it will perform in a rising rate environment. We are advising clients to be overweight industrial, energy, transportation and industrial assets, but underweight utilities, which may struggle in a rising interest rate environment.

Is infrastructure a good fit for defined contribution (DC) plans?

MICHAEL The U.S. DB marketplace is actually contracting at a rate of roughly 3% a year, as plans de-risk or pass the risk on to participants. In this scenario, global-listed infrastructure can be used in all kinds of ways. DC-plan participants are managing a real liability — their own retirement. Global-listed infrastructure offers inflation protection plus income, plus a low degree of correlation to common stocks and bonds, all of which are key.

JANET DC plan members have been over-reliant on the equity risk premium — they’ve been confined to equities and bonds, with maybe a little real estate. Assets like infrastructure can help them to diversify. There is also pressure to put listed infrastructure in target date funds as well, which is another great way for DC

plan members to access the benefits of infrastructure. It’s not for every member, but within a broader portfolio context it makes sense.

JAMIE Infrastructure can straddle bonds and equities, and can offer inflation protection for plan members, which is important.

What performance benchmarks should plan sponsors be looking for?

JAMIE We invest in OECD assets, and we have a view on what particular assets should be returning. That expectation is our fund return target that we agree on with investors. It’s a range that starts at broadly CPI plus 500 bps, and rises depending on the asset and jurisdiction. Our investors generally have a lower benchmark, but they are executing on multiple strategies with different managers. We do a lot of work with the pension community about what they are trying to achieve — we tend not to look at public indices because, for the most part, they aren’t relevant to what we are doing.

JANET The important point is that there is no one benchmark, and that’s a huge issue. It causes problems for plan sponsors. The most prevalent one is CPI plus something, because it speaks to the role you want the asset class to play. It’s an imperfect situation. I think you’re going to have a mismatch of returns and benchmark no matter which you choose. I still think CPI plus something is the best of the worst — but there is no

perfect benchmark. It’s always a problem and it involves a very long discussion with clients. You’re benchmarking success of allocation but then you’re also benchmarking success of manager. So you really need to have multiple measures.

MICHAEL In global listed infrastructure, it’s easier. There are indices that cover it like the S&P Global Listed Infrastructure Index, which has both developed and emerging and a cross-section of different types of sectors/assets.

What’s next for infrastructure investing in Canada?

MICHAEL Everyone is yield-starved and looking for income. Infrastructure isn’t a silver bullet, but it is a tool. It offers sustainable yields tied to long-dated assets and I see average allocations moving up to 10% to 15% among Canadian plans.

JARED We’ve seen more and more plan sponsors enter the market, including plans we wouldn’t have anticipated. There is a broader range of products and plan sponsors have invested in multiple vintages — it’s really been an evolution. Because the capital base in Canada is so small, I think there is going to be a limit on how much more the Canadian market can grow. I also think there are some pension plans that are never going to invest in these strategies because they don’t have the size and the staffing. But we are still bullish for the medium term.

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