Alberta Investment Management Corporation, AIMCo, the $160 billion asset manager for pensions, endowments and insurance groups in Canada’s western province, is developing a total portfolio approach in private assets.

Unlike other Maple Eight investors, AIMCo’s client funds decide their own asset allocation and most of them have reached their target in private markets. Rather than continuing to plough in capital, the investment team are now thinking more about comparing opportunities across assets and anticipating future trends.

“The investment horizon for these assets is long and the ability to rebalance in the future is hampered,” warns Marlene Puffer, who joined AIMCo as CIO in 2023 from Canada’s railway pension fund CN Investment Division.

This approach ensures AIMCo taps sufficient risk but also protects against embedding too much connected risk. Puffer says cross-functional conversations and analysis from the risk team supports intelligent decision-making and avoids unintended consequences.

The team is exploring how different themes cut across different asset classes, she says. The best example is AI which manifests in every corner of the portfolio, but in private markets is encapsulated in red-hot investor demand for data centres. These buildings touch infrastructure and real estate; they hold private equity elements in the construction and development phase; and that are also a renewable energy play.

“We are having more sophisticated conversations around where we want to play in this [AI] value chain and why,” Puffer says.

“It is about making sure we don’t miss part of the value chain because of our definition of what constitutes a real estate or infrastructure investment, or the geographical focus of the portfolio.”

AI is just one example. The total fund approach will touch every point of AIMCO’s strategic direction defined by global diversification, a focus on Asia, integrating climate and new energy opportunities, and garnering more strategic input from partners so that fund investments lead to co investments and direct investment.

“Global diversification, energy and climate opportunities and strategic partnerships all sit in total portfolio management,” Puffer says.

“It is about collaboration and breaking down silos.”

A new approach to risk

The new approach is supported by AIMCO’s rebooted risk culture following losses during COVID-induced market volatility when the investor shed $2.1 billion on a strategy meant to profit from low volatility in equity markets, known as VOLTS. A review found that escalation of the risk of the strategy to senior management and the board was “incomplete” and did not come soon enough.

Now the breadth and depth of risk governance and collaboration has been overhauled, fanning a new risk culture. The investment process involves a two-step approach to analysis whereby anything new coming into the portfolio (a manager or strategy, for example) is discussed first at the investment committee level, before further scrutiny by the investment, risk, legal and sustainable investing teams.

Governance has been reviewed and refreshed. The board has oversight of the risk parameters of every underlying product, and review and set the appetite for risk tolerance and the total fund risk budget. Escalation policies are also now embedded.

New high profile hires include Kevin Bong, senior managing director, chief investment strategist and head of Singapore; and chief risk officer Suzanne Akers who joined in 2022. Puffer says the pair represents a new level of talent and leadership that is now embedded into investment teams, weighing in on due diligence.

“Deals have not been done, or we’ve added more due diligence, as a result of these people,” she says.

There is an independent risk assessment for every transaction and Akers is a voting member of the investment committee.

New C-suite hires have helped build a new culture that encourages psychological safety in all interactions, and open and challenging conversations. Team building and in-person, regular offsites despite the teams being spread around the globe is fostering strong relationships and ensuring everyone pulls towards the same strategic goals. Puffer says gatherings may thrash out strategies, or just focus on building trust and understanding of each member of the team, she says.

“We all know where we are going,” she says.

Private credit is the star of the show

AIMCo’s $7 billion private credit portfolio is another a key area of Puffer’s focus. The investor is expanding its already significant private credit talent base in London and Toronto, with new hires in New York. Maintaining the portfolio’s size, and growing it further, requires stepping up from the small-cap investments made at the beginning and developing large-cap partnerships and deal flow out of New York.

It’s difficult to scale in small cap, she explains. The typical four- to five-year tenor of a private debt deal means around 20 per cent of the portfolio is in perpetual motion.

“You have to feed the portfolio,” Puffer says.

“We are a small team, and feeding it with large-cap deals is more effective. Although it’s possible to scale through small deals, they take up as much time as a big deal and require the same level of talent and staffing.”

AIMCo is one of many investors piling into the asset class which now accounts for some $2 trillion of assets under management. The IMF recently sounded the alarm at so much debt being traded out of the public eye in its latest Global Financial Stability report.

Puffer acknowledges the risk of scaling the allocation in an environment where interest rates are more likely to fall than rise, but she is reassured by an enduring return profile that adds value and provides an alternative exposure to liability matching fixed income.

“Private credit is the star of the show,” she says.

“The sensitivity to interest rates and duration is not the only reason we are in private credit. We are also in it for the credit spread, and for a little extra because of today’s base rate. Even as rates come down, it still has value because it will be down less than our other investments in fixed income.”

Moreover, she says AIMCo has an edge because of the team’s ability to execute. Private credit is shaped around fund investments, yet with each partner the team expects significant co-investment deal flow opportunities. Cue a sophisticated internal team not only with the ability to turn deals around quickly but also a familiarity with its partners and the way they work, and knowledge of the underlying companies.

Puffer will also spend the coming months sizing opportunities in Asia via AIMCo’s new Singapore office, opened late last year. She says fund mangers are increasingly setting up shop in Singapore, enabling new partnerships out of the city state that will lead onto co-investment opportunities, particularly in renewables and diversified infrastructure.

Pioneering responsible investor Brunel Pension Partnership is using AI to improve stewardship evaluation and has spent much of the last year improving the misalignment of interests between asset owners and managers in relation to climate stewardship.

The team uses an AI-driven tool called a generative pre-trained transformer (GPT) to analyse and compare the voting guidelines of approximately 20 asset managers and owners, according to the fund’s recently published Responsible Investment and Stewardship Outcomes Report 2024.

The £30.8 billion ($38.9 billion) Brunel uses the insights to update its own voting guidelines, ensuring they are ahead of current practices and expectations.

“It’s about understanding the broader shifts in stewardship standards and ensuring our guidelines reflect these,” says Oliver Wright, responsible investment officer.

Brunel has also developed a quarterly report reconciliation tool which uses AI to assess implementation of its voting guidelines. It then uses the reports generated as a tool to engage with its service provider where it sees discrepancies.

“Given the importance of voting implementation, the ability to automatically verify this information has been invaluable,” Wright says.

“It ensures the reliability of our reports and significantly reduces the time and effort previously required for manual checks. This means that we can devote more resources to engaging with investee companies and other core stewardship activities.”

Brunel believes AI’s role in stewardship is only set to grow. As the technology advances, Wright says he expects new tools for more effective engagement with companies, improved monitoring of sustainability factors, and even predictive analytics for identifying potential governance risks to appear.

The future of stewardship will likely involve a greater integration of AI to not only streamline operational tasks but also to enhance the strategic aspects of work like focusing engagements to ensure meaningful outcomes.

“GPT has already proven to be an asset, and its ongoing development will undoubtedly open up further possibilities for enhancing our stewardship practices,” Wright says.

However, whilst AI brings substantial benefits, Wright warns of its risks. Like the potential for social bias in AI algorithms. Given that AI systems are trained on large datasets that may contain societally biased historical data, there’s a concern that these systems could replicate and even amplify existing societal biases.

Alongside this, there’s the challenge of ensuring that the fund’s reliance on AI doesn’t diminish the value of human judgement, and that data privacy and security are rigorously maintained. To mitigate these risks, the team regularly audits AI tools for bias, ensures transparency in operations, and maintains a balanced approach that combines the efficiency of AI with the nuanced understanding of experienced professionals.

Addressing misalignment

In another noteworthy trend, Brunel has spent the last year working with other asset owners to address the misalignment of interests between asset owners and managers in relation to climate stewardship.

The 2023 proxy season provided signs that some asset managers had failed to unequivocally challenge oil and gas companies that were backtracking on their climate commitments, the report says. This contrasted with the positions of large asset owners that shared the view that if climate related risks are not addressed through stewardship activities, this can translate into investment risks for their portfolios, affecting long-term beneficiary interests.

To address the discrepancy, Brunel entered “robust and constructive dialogue” with its managers, identifying how fund managers can be better supported in delivering asset owners’ climate stewardship strategies.

Brunel’s analysis of the misalignment, and conversations with other asset owners, was framed by research findings presented by independent academic, Professor Andreas Hoepner. Using the energy transition in the oil and gas industry as a test case, Professor Hoepner and his team have evaluated the voting records of select managers on oil and gas majors.

This research provided evidence of a misalignment. The full research which was released in November 2023 provided insights on misalignment trends and voting rationales. For example, only a select few asset managers publicly align their reasoning with asset owners.

Some asset managers perceive voting and ESG engagement as mutually exclusive, raising concerns about potential access loss to management if misaligned.

The review also found distinct engagement process types ranging from persistent, long-term engagement with considerable progress to “quick fix” and “jumping the bandwagon” styles, pointing to issues around consistency and a long-term approach to engagement.

The research also put forward a number of rationales for the gap, highlighting that further research is needed to explore these issues in greater detail.

These include cultural misalignment – namely the differences between UK based asset owners and non-UK based asset managers – and resource allocation misunderstanding – aka the potential misunderstanding of the importance of stewardship and voting, leading to insufficient resource allocation.

Other reasons include a misunderstanding fiduciary duty, particularly in terms of risk management related to climate change and financial conflicts of interest.

In the next phase of the project, asset owner participants will initiate one-to-one bilateral conversations with their managers on the basis of the research findings. The next phase will also look into how asset owners can articulate their views on climate stewardship.

For Marcus Frampton, CIO of the $81.8 billion Alaska Permanent Fund Corporation (APFC), a handful of issues are front of mind in the current investment climate.

Tight spreads for corporate bonds, despite the likelihood of a default cycle in fixed income, have been driven by the fall in corporate issuance as companies wait on the sidelines for rates to fall.

Fixed income accounts for 20 per cent of the fund, and Frampton’s current focus is on quality investments only, avoiding more risk in the asset class.

In public equity, APFC is hunting opportunities in areas like value over growth, an overweight to gold miners and in a more contrarian allocation, China. None of the plays are huge bets (there is a 2 per cent tracking error in equity) but he is looking for pockets that run counter to wider market sentiment.

Alaska is approximately 1 per cent overweight the MSCI World allocation to China A Shares via KraneShares and iShares ETFs using dedicated managers that can trade a mix of A and H shares. The allocation sits in a sleeve of the portfolio called tactical tilts where the fund leans into opportunities.

“Lots of people are shying away from China but our overweight has done well in recent weeks.”

Hedge Funds continue to deliver

Hedge funds aren’t transparent; they are expensive, rarely put on high returns in a bull market and can be a tough sell with trustees and stakeholders. But Frampton describes APFC’s 7  per cent allocation as one of the most exciting and valuable corners of the entire portfolio, delivering 8.13 per cent and 5.74 per cent over 3 and 5 years respectively.

The allocation has come into its own in an environment where stocks are expensive and corporate bond spreads tight, and in the last quarter the APFC has redeemed several funds to lock in profits and bring managers to the desired allocation. It has around 20 mangers on its books including names like Elliot and Millennium, invested in equity market neutral, growth and multi-strategy funds; commodities and  CTA trend following strategies.

“If you are backing high quality macro, equity market neutral and zero beta managers it’s possible to outperform a 60:40 portfolio with no correlation.”

Real estate shows the cracks

In contrast, APFC’s slightly above target 11.5 per cent allocation to commercial real estate is showing some cracks. It makes the portfolio a natural place to source funds for recent asset allocation tweaks – namely increasing the allocation to private equity.

Alaska’s proactive build-up of real estate in recent years has focused on life sciences developments; apartments and industrial. Billion-dollar deployments also include active lending to construction projects via two separate accounts.

“If they don’t pay off at maturity, they are properties we don’t mind owning,” he says.

Still, the portfolio has experienced some lumpy patches. Like stakes in downtown office buildings, often only 20 per cent let, which remain an enduring drag on performance. The challenge lies in the fact these buildings are not easy to reconfigure into apartments. There are no balconies, and turning the existing space into apartment blocks would leave some like “the worst cabin on a cruise ship,” he says.

Frampton suggests the costs of converting offices into apartments may require subsidies from cities and reflects that many downtown office investments – often in the best locations – have now shifted to become a land play.

“Someone, at some point, will demolish the building and build apartments, but right now interest rates and construction costs are putting investors off.”

Turning up the heat in Private equity

APFC has just turned up the heat on private equity, increasing its target exposure by 3 per cent to 18 per cent, a tweak that brings the portfolio in line with the current overweight of 18.3 per cent.

With the S&P 500 up, the relative case for private equity is stronger than it was a year ago and Frampton is reaping the rewards of cutting programme pacing in 2021. Hitting the breaks back then meant allocations fell from $2 billion a year to $1.6 billion in 2021 and 2022, and  $1 billion in 2023 and forecast for this year too.

“It caused us to pass on somethings which was hard, but at the time everyone felt it was important.”

More so now given that investors that hit the accelerator coming out of the pandemic are now struggling. Witness Kaiser Permanente, and LPs USS and Washington State, reportedly selling in the secondaries market at a discount.

“We are in a luxurious position because we didn’t deploy,” he says. “I think 2021 and 2022 will go down as the worst vintages for private equity and I think we are coming out of it, this is an attractive market now,” he says.

He says AFPC is finding opportunities in industrials and the old economy. And with a typical cheque-size of $30-$50 million the investor can be nimble, unlike larger funds with ticket sizes of $100 million.

The venture allocation, sitting within private equity, has also been reset. APFC has a mix of fund investments and directs, and Frampton is currently figuring out whether to re-up with existing managers or explore new allocations given venture with a bias to software and biotech, has been hit hard in recent years.

“If you look at the private equity performance this year versus other state pensions, we’ve had a tougher time as venture has taken heavier market downs that buyout.”

He thinks the fund will reup with some venture managers but will also add new relationships in the more traditional buyout space.

Still, the team are quick to act when they see an investment they like. AFPC recently concluded a venture co-investment with a new manager for the first time.

“We know the manager well and we didn’t go into the first fund. But we looked at it and respect the team and made an exception.”

The £26 billion ($33 billion) People’s Pension, one of the largest master trust workplace pensions in the UK and forecast to reach £50 billion assets under management in the next five years, is modelling itself on Australia’s superannuation funds.

Dan Mikulskis, CIO of the People’s Partnership which oversees the pension fund, would like to set up an industry-owned asset manager modelled on Australia’s IFM Investors. He also likes the way Australia’s superfunds benchmark each other, and how they have built their own internal investment teams.

“We look outside the UK for our benchmark and the Australian superfunds are our closest cousins,” says Mikulskis who adds that the fund’s huge inflows will put it on a par with university scheme USS and NEST to become one of the biggest in the UK.

Since joining as CIO in September 2023, Mikulskis has spent most of his time developing the systems and processes behind the pension fund which was founded in 2012 off the back of auto-enrollment legislation. This has included building the team which now counts 900 staff working across the value chain in everything from customer service to administration.

Recently settled in new City of London offices close to the asset management community, he’s now turning his hand to investment strategy.

Most of the assets are invested in off the shelf index tracking funds, but Mikulskis has started to explore different products in a departure from a typical master trust. Around $15 billion (of the equity portfolio) was recently moved into climate indices, and now he is looking at how to move beyond index tracking to add value in fixed income and emerging markets.

“The huge choice of indexes means deciding which indexes to track is a strategic role. There are lots of choices we can make.”

Fixed income accounts for anything between 20-60 per cent of the (eight) different funds on offer and is focused on sovereign and investment grade global corporate bonds. He wants to push beyond standard products and approaches to include structuring bespoke mandates and leveraging the fund’s growing size and scale to shape a more adventurous approach to duration and credit, targeting parts of the market with more value for money.

“In fixed income, many of the products we use are higher quality and there isn’t much of a risk of defaults, but the returns are less.”

He says the delineation between active and passive has softened allowing a more creative approach. Strategies like buy and hold that involve more active decision making are now just part of a spectrum that includes custom indices and quant approaches.

He is also exploring different ways to access emerging markets which currently account for around 10 per cent of the equity allocation. Not only does he think emerging markets are cheap – “they were cheap a decade ago and have just got cheaper and cheaper” – he wants to carve out China where he says SOEs dominate. This could allow for increasing exposure to under-represented regions like the Middle East, South America and Africa.

“The term emerging markets is an early 80s label that doesn’t fit anymore. I’d like us to get more bullish on emerging markets and find a way of allocating that lets us unleash this. It’s difficult to get conviction in vanilla indices.”

The People’s Pension is still some way from developing an allocation to private markets, and one reason for Mikulskis’s caution is high investment management fees. The pension fund caps management fees at 50 basis points, and he doesn’t want to have to introduce a basket of investments with a higher fee. What he wants is a better split with alternative managers between economics and terms.

“In private markets, you can identify a good opportunity but end up paying a whole lot to the manager and it shouldn’t be the case. The end investors should benefit.”

Witness his decision not to join the Mansion House Compact. Names like Aviva, Scottish Widows, L&G, Nest, and Smart Pension have signed up to the endeavour by the UK government to get pension funds to invest at least 5 per cent of their assets under management in unlisted UK equities by 2030, but Mikulskis wasn’t keen.

“It is our choice where we invest, and we want to do it right. We want to dictate the terms and will allocate when the terms suit us and when the market is right,” he says.

He thinks the fund’s first foray into private markets will be in infrastructure, or possibly real estate, because these two asset classes are the most aligned around collaboration on fees, external co-investments and fund structures. “Open ever green structures are more prevalent in infrastructure than closed end funds which I don’t like.”

But for now he is prepared to wait it out. As the People’s Pension grows in scale, it will grow easier to swing fees in the fund’s favour and leave more of the return in the hands of members. He is also using the time to explore the possibility of setting up an industry-owned asset manager modelled on Australia’s IFM Investors, owned by a collective of 17 pension funds.

“This is one way to access private markets. We are talking to people about this, and trying to start the conversation.”

Despite the sizeable staff, there are only 20 people in the investment team. He says this will grow alongside AUM.

“We will get to 25 by the end of the year. It’s rule of thumb that you have one person per one-billion AUM, getting towards that.”

Once again, he is turning to Australia to see how to build internal teams and when to bring allocation inhouse. He also likes the Aussie comparison model that promotes competition in the sector via league tables, and has lead to underperforming funds merging with the most successful.

“The superfunds have a well-known and mature approach to compare performance.”

As he approaches his first year in the job, Mikulskis says his leadership will focus on cutting through short term noise and focusing on what the pension fund can realistically achieve. For example, introducing climate tracker funds will meaningfully reduce emissions in the portfolio and also chime with the fund’s competitive advantage, expertise and low cost priorities.

He wants to avoid being distracted by talk of uncertainty and risk, both of which are inherent to investment.  “We could walk in tomorrow, and our assets could be down by £2 billion. This will happen at some point and it is part and parcel of what we do.”

His approach is to shift his gaze upwards and draw on evidence of the past to see how asset classes will behave and have faith in the fact that in the long run stock markets go up.

“I like to start with the last five years, and focus on that number. Drop off those columns and rows that are short term and diving in too deep.”

 

 

The investment committee at the $94 billion State Teachers Retirement System of Ohio (STRS Ohio) has narrowly voted to block bonuses to investment staff.

The decision to stop at least $8.5 million earmarked for performance-based bonuses marks the latest turmoil at the pension fund. The 11-member main board has a 6-5 majority in favour of reform-minded trustees who have publicly supported moving the fund to index strategies and downsizing the 108-member investment team.

They also have the backing of a noisy beneficiary group, Ohio Retirement Teachers Association, ORTA, which has used the board election process (7 members are elected) to push reform-minded candidates onto the board.

In-house investment and costly alternative allocations have become a lightning rod for anger amongst ORTA members who never received an adequate annual cost-of-living allowance (COLA) given to retired teachers.

The previous board cut the standard 3 per cent COLA and then eliminated it for five years to help stabilise the system’s finances. Retirees got a 3 per cent adjustment in 2023 and 1 per cent in 2024, not nearly what they wanted.

Meanwhile, other forces are trying to pull Ohio STRS in the opposite direction. The state’s Republican attorney general is suing to remove two board members, claiming they have breached their fiduciary duties following an anonymous memo – reportedly from the investment team – flagging board misconduct. The board, the memo said, was lobbying to mandate 70 per cent of the fund’s assets to an investment firm touting an untested AI-driven trading strategy.

This hotchpotch of grievances made for a fraught June investment committee meeting where discussion included the annual review of performance compensation for the investment team. The testy back and forth, peppered with applause from current and retired teachers assembled in the audience, shows what happens when the investment team are drawn into politics and face public participation.

One board member argued that recent returns showed the fund was doing well without needing to pay higher compensation. “If we can get top performance and not pay as much, what’s wrong with this?” the board member asked. STRS’s net total fund performance is in the top 10 per cent of  sponsor peer group analysis over the long term.

A reference to the disconnect between asset performance and the COLA was greeted with angry shouts. Elsewhere, concerns from one board member that not paying the investment team performance compensation risked staff leaving, met with calls from the gallery to “let them walk.”

It fell to Lynn Hoover, acting executive director, to lay out the risks of not rewarding investment performance. Sixty-nine members of Ohio STRS 108 investment staff are eligible for incentive pay and current levels sit below peer funds, she warned. Competitive pay is crucial to the fund’s ability to attract and retain staff  at a time an increasing number of staff members are approaching retirement.

Over the last five years, 200 staff have retired or left the organisation, and between 90 and 95 current employees who have been at Ohio STRS for the past 25 years will also retire soon.

“Ninety four billion dollars in assets – that does not manage itself,” Hoover said.

Hoover added that investment performance is a key source of funding for benefits. She said internal management is a strategic advantage at the pension fund and provides low-cost access to both active and passive strategies. Outsourcing internal management would increase costs by an estimated $130 million annually.

“It is important for eligible associates to understand performance goals and expectations before the fiscal year begins,” Hoover said. The bonuses would be applicable for July 1 to June 30, 2025. Although the board agreed to explore alternative plans for employee performance incentives at a meeting in July, they did not set an exact date.

The meeting also exposed the challenge for pension funds when members of the board lack investment expertise. Witness one board member’s rapprochement of the investment team during presentations on asset class performance for using investment terms like tranches, credit and pre-payment risk. Calling for better explanations and clarity, and more information presented in a simple way, he said:  “It’s not helpful making decisions if you don’t have a good grasp of the information.”

Others countered it was incumbent on board members to take an active role by asking questions, and suggested focusing board scrutiny on the competency of investment staff in managing the fund and making investment decisions. Members of the investment team responded that they seek to find a balance between clear explanations and not dumbing down or patronizing the intelligence of the board.

Such discussions will surely grow more heated as the year progresses. Decision-making will now focus on a new asset liability study requiring board decisions on implementation and the asset liability mix.

The $127 billion Ontario Municipal Employees Retirement System (OMERS) has just written off its entire 31.7 per cent stake in troubled UK water utility Thames Water. Valued at £990m at the end of 2021, that fell to £321m by the end of last year, until trickling away altogether.

OMERS losses mirror write downs at other investors in the utility which are split over four continents. Like £75 billion British Universities Superannuation Scheme (USS) which wrote down its 20 per stake. According to financial statements published at the end of last year, USS valued its investment at £364.4 million. A 62 per cent write down from £955.8 million the year before.

Other investors include British Columbia Investment Management Corporation and  PGGM the Dutch asset manager for €237.8 billion PFZW, the healthcare pension fund.

Write downs and write offs won’t have much of a financial impact on the pension funds. But Tim Whittaker, research director at the EDHEC Infrastructure Institute in Singapore where he is also head of data collection, argues the losses illustrate that managing infrastructure assets is complex and has brought reputational damage to the investors.

“Not every organization has the skills to be able to do it well,” he tells Top1000funds.com.

What went wrong?

Whittaker says that Thames Water epitomised the stable and predictable cash flows that investors are attracted to in infrastructure. Yet the company’s previous owners (Australia’s Macquarie Group which owned the utility until 2017) took cash out of the business and increased the leverage “and the new owners failed to see this before it was too late.”

Despite abrupt and unexpected losses revealed at the end of 2022, just nine months earlier, some investors were still increasing the valuations of their stakes.

“For a large water utility to lose so much value so fast, the investment must in fact have been mispriced for several years leading up to the impairment,” writes Whittaker in an EDHEC paper “Low Tide” co-authored with Frédéric Blanc-Brude and Abhishek Gupta.

Now, faced with a choice between putting more money into the utility and recapitalising, or cutting their losses, investors have baulked. A key issue, says Whittaker, has been demands from Britain’s regulatory authority, OfWat, that investors cut their returns below the cost of capital.

“After more than a year of negotiations with the regulator, Ofwat has not been prepared to provide the necessary regulatory support for a business plan which ultimately addresses the issues that Thames Water faces. As a result, shareholders are not in a position to provide further funding to Thames Water,” wrote the shareholders in a statement published in March.

Lessons Learnt

Whittaker argues it is possible to learn important lessons from recent events. Firstly he says  “OfWat should recognize that not all water companies are the same and recalibrate the allowed return calculations to properly take into account the risk associated with these companies.”

This would require a change in the methodology for estimating the allowed returns (WACC) for water utilities, as the current method does not work.  “OfWat employs a long-discredited methodology to set returns. If market returns were employed, then investors would more likely to be willing to provide the funds needed to both invest in the network and reduce debt.”

He also warns that balance sheet arbitrage which allows companies to borrow more debt to pay more equity returns should not be allowed.

“A significant number of water utilities have done and are still doing this. It is only recently with the ban on dividends that OfWat brought in last year that we’re seeing these businesses recapitalize and reduce debt,” he says.

It leads him to reflect that previous owners of the water utility had short investment horizons and acted more like private equity investors than infrastructure investors. Having better scrutiny of the investors and incentivizing long-term asset management over short-term profit taking “should be the focus if the assets are to remain in private hands.”

The importance of a comparative view in infrastructure investment

Worrying, Whittaker believes there is every chance of it happening again. The report flags the authors concerns that infrastructure investors often see their investment in the context of one asset, not the wider market or peer investments.

“This narrow vision can obscure the big picture and the role played by market dynamics. When compared with its peers, Thames/Kemble Water showed some significant risks that were not accounted for when viewing the utility in isolation – as its investors apparently did when assessing the asset.”

Instead of concentrating their attention on just the one asset in isolation, investors would have done better to take a comparative view of Thames/Kemble Water with other assets in the UK and around the world, states the report. This would have helped to identify the red flags sooner and allowed for a better assessment of the risks involved in investing.