Thames Water's sludge incinerator,used to generate electricity, is pictured at the company's Crossness Sewage Treatment Works, in south east London on July 3. The UK government has expressed serious concern about the financial plight of the country's biggest privatized water company.BEN STANSALL/AFP/Getty Images
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.
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.