Most of us generally take roads, bridges, pipelines and airports for granted, but to Ontario Teachers' Pension Plan VP Infrastructure Stephen Dowd, they represent lucrative, stable, long-term investments for plan members, including 170,000 elementary and secondary school teachers, and 108,000 pensioners.

"The members' pensions are indexed to the consumer price index, so in our asset class we are looking for inflation-sensitive investments that will provide returns that help us match the assets and the liabilities of the pension plan," says Dowd. "For example, the utilities we look at have asset bases and formulas that determine their revenue inclusive of inflation over time."

Building a portfolio

OTPP began building an infrastructure portfolio in 2001 and is considered a "first mover" into this sector among pension plans worldwide. As of the end of 2007, infrastructure and timberlands represented 8% and $8.8 billion of the asset mix.

Generally, equity participation is the preferred mode of investment, but in some cases OTPP will provide subordinated debt with some equity characteristics. They also have flexibility to structure specific investment products.

More than 90% of OTPP's infrastructure investments are outside of Canada, but not for lack of trying, says Dowd. "Most of what's available here are roads and bridges under public/private partnerships, or social infrastructure like courthouses, jails and hospitals. These projects have a small equity component. We're a large fund, and we do not have an endless supply of people, so we look to find larger transactions we can concentrate on."

With a broad range of direct ownership interests around the globe, including Northern Star Generation (13 power plants in the United States), three water utilities in Chile, and the Copenhagen, Bristol and Sydney airports, the 20 people on OTPP's infrastructure team spend a great deal of time travelling.

Nevertheless, to conduct proper due diligence and manage these projects, Dowd says having the right local and international advisers is essential. "We spend a lot of time [on location], but it's also a matter of putting the right team together - those who understand the businesses, the countries, the legal regimes and the financing markets."

Because regulatory and political challenges can occur in any market, he says the key is to look for a history of stability. "It doesn't mean we aren't going to be surprised, but it does mean there are rules that regulators work within and abide by, and there is a history of how they will act within these rules."

Benchmarking returns

OTPP's benchmark for infrastructure returns is CPI + 4%, plus a country-risk premium. "This means if we compare infrastructure to real-return bonds, which at that at this point return 1.7% or 1.8% over inflation, the fund is saying to us - go find things that are more attractive than real-return bonds. However, if we go into any country with less than a AA rating, we have to earn a premium above the benchmark," he says.

As of the end of 2007, infrastructure investments returned 0.8%, compared to a benchmark return of   -4.3%, adding $0.5 billion in value to the pension fund. On a four-year basis, these assets generated a 12.6% compound annual return, outperforming this category's four-year benchmark by 9.3%, for $1.7 billion in total value-added.

Dowd is satisfied that his portfolio is meeting its objectives, but cautions that the 2007 benchmark is not a straightforward comparison to previous years. "Prior to 2007, we hedged currency risk internally within the portfolio. In 2007, we switched, so hedging is centralized within the fund as a whole."

Unlike smaller pension plans, which typically make infrastructure investments through third-party sponsored funds that, by their nature, have a limited term, OTPP looks at holding infrastructure investments for the economic life of the asset.

Competing for deals

The 2007 OTPP annual report notes that growing competition for infrastructure assets has made it more difficult to fund and negotiate transactions that meet the pension fund's requirement of reasonable returns and moderate risk

"Our estimate, based on various market studies and what people have shown us, is there is some $150 billion worth of uncommitted capital dedicated to infrastructure in these managed infrastructure funds," says Dowd.

"Add to that other pension funds, like ours, trying to invest directly, plus insurance companies and sovereign wealth funds that have been established in Dubai, Singapore and other Asian countries. There are clearly a lot of groups out there looking for assets with a very nice cash profile like infrastructure."

In spite of the perceived shortages of current infrastructure opportunities, he says, in Europe and North America there is a real need for infrastructure upgrades, and pent-up demand may shake loose potential for investment over time." Nevertheless, he acknowledges it is often a very political and time-consuming process to get these projects off the ground.

Maximizing returns

What kind of returns can smaller pension funds investing in infrastructure funds or other pooled arrangements realize?

That depends on the manager, says Dowd. "Like anything else, I'm sure there are good deals out there, and funds that will perform and funds that will not. There are clearly additional costs as compared to direct investment, and due diligence is important to ensure the goals of the infrastructure fund and the goals of the pension fund are aligned. Manager compensation should also be aligned with fund objectives."

In 2007, assets in the OTPP fund grew to $108.5 billion from $106 billion at the end of the previous year - a return of 4.5%. Yet the fund shows a $12.7 billion shortfall between the plan's assets and liabilities - attributed in part to the growing number of retirees supported by the pension contributions of a shrinking number of active members.

Dowd says it remains to be seen whether refining the plan's investment strategy alone can bridge the funding gap, or if modifications to contribution levels and/or early retirement provisions will be required.

"I'll leave that to the Bob Bertrams and Jim Leeches of the world to decide. I will only say there is always opportunity to improve investment returns," he concludes.