Tapping the illiquidity premium in water

Posted on August 15, 2011


The age of austerity has inadvertently created countless win-win opportunities for UK pension schemes as managers of infrastructure seek to tap into sources of long-term funding. With long-term liabilities, pension schemes have always been the ideal owners of infrastructure assets. They can take advantage of the ‘illiquidity premium’ that comes with being prepared to tie money up for a long period. But this will only work if they avoid the leveraged, private-equity approach to buying infrastructure, common before the 2008 crisis, where assets are purchased with up to 10% equity and 90% debt. This model led to high internal rates of return in the good times but underperformance in the credit crunch.

Instead, by using un-geared equity investments, pension funds can hope to partner with the underlying infrastructure entity, such as a water company or a power utility, providing long-term capital in return for long-dated secure inflation linked cash flows. As financial markets continue to deleverage, UK pension schemes have the potential to fund the full spectrum of UK infrastructure needs – from social infrastructure, like care, education, health and housing, through to economic infrastructure such as roads, railways, ports, and utilities. The classic example would be Cambridge Water, which has just been sold by Cheung Kong Infrastructure Holdings Limited to HSBC Bank for £74m. The sale was a regulatory requirement, allowing Cheung Kong to buy Northumbrian Water. HSBC are simply warehousing the asset until a buyer is found. This presents a unique opportunity for a UK pension fund to acquire one of the UK’s most efficient water companies. Cambridge Water provides essential fresh water services to over 300,000 people in Cambridgeshire. Its activities are regulated by Ofwat and its prices may be increased in line with the agreed price review, based on a formula related to the retail price index, plus or minus a sum relating to its level of efficiency. Cambridge Water is permitted to earn a secure inflation linked return on its regulatory capital value of £64.64m. At its March 2011 year-end, revenue was approximately £20m, with £7m in profits before tax. In sum, this is an ideal asset for a pension scheme looking for secure, long-dated inflation-linked cash flows, but with a significant real return above long-dated inflation-linked gilts. The attractiveness of Cambridge Water is that its small size of £74m makes it a palatable acquisition for one of the top 25 UK pension schemes by assets, as it will represent a capital investment of less than 1%. It’s well run and has no external debt apart from its revolving credit facility to cover working capital.

 This is the time for pension schemes to step out into the limelight and be the 21st century social capitalists. With investments in existing and new infrastructure developments under long-term partnerships, they can combine profit to pay their scheme members with general welfare for our society, which has never been in greater need of infrastructure funding.

Posted in: Pensions