Unlevered infrastructure: challenging convention

Pension schemes looking for low risk inflation-linked cashflows offering the potential to generate significantly higher yields than index-linked gilts should take a closer look at unlevered infrastructure strategies.

3 minute read

The UK’s decision to leave the European Union and recent easing measures by the Bank of England has left gilt yields in unchartered territory. Given the uncertain macro-economic environment, with gilt yields expected to remain low for longer, and returns in traditional asset classes exposed to heightened volatility, there is an obvious rationale for pension schemes to consider alternative income assets to help meet their long-term liabilities.

Infrastructure is one option; either through a stand alone allocation or as part of a wider multi-asset alternative strategy. Infrastructure assets have certain characteristics that should appeal to pension funds, namely they are long-term investments and are designed to withstand periods of volatility and economic uncertainty.

Challenging conventional approaches to investing

The conventional way to invest in infrastructure is through debt or equity; participating in the financial returns of an underlying infrastructure project and getting exposure to the market. An alternative approach is to invest on an ‘unlevered’ basis, where the investor buys the whole infrastructure project capital structure and gains full control of the assets. This can reduce financial volatility and provide low risk inflation-linked cashflows at significantly higher yields than index-linked gilts. In other words, it offers the chance to generate ‘equity-like returns whilst taking debt-like risks’.

Until recently, this approach was predominantly the domain of pension schemes with significant governance budgets or in-house expertise, but now there is a range of products available to suit the needs of pension schemes of all shapes and sizes.

What infrastructure projects could form part of the strategy?

Infrastructure investments can be sourced from lower-risk sectors, such as utilities, renewable energy and social infrastructure, to higher-risk sectors, such as ports and mobile telecoms. Where the objective is to generate low risk inflation-linked cashflows, the focus needs to be on lower-risk infrastructure projects.

There is a diverse range of opportunities that fulfil these criteria whilst aiming for attractive - high single digit - returns; in particular ‘low carbon’ infrastructure assets such as renewable energy or energy efficiency projects. Revenues from these types of projects tend to be contractual or from regulated mechanisms rather than based on economic usage, making them especially attractive from return and diversification perspectives. The stable, long-term income streams they can provide make them a good fit for pension schemes with liabilities to match.

Energy centres for hospitals offer one such opportunity. An energy centre is a mini power station, providing both electricity and localised heat distribution to the hospital at a lower cost than taking energy from the grid. Energy efficiency is increasingly important to the UK’s National Health Service (NHS), which has an estimated annual energy bill of around £750 million1. Powering lifesaving equipment and large hospital buildings is a growing strain on public finances, so it is not surprising that energy efficiency facilities have been gaining favour.

In Dundee, a £15.4 million2 project is underway that will include the construction of a new energy centre for Ninewells Hospital and Medical School. The energy centre will supply 100% of the hospitals’ heat requirements and c.90% of power requirements. The project is forecast to reduce energy costs by c.25% and CO2 emissions by c.13%3.

As well as providing savings for the NHS, it should also provide stable and low-risk cashflows to investors that funded the project. All cashflows for this project are contracted with NHS Tayside.

Renewable infrastructure assets such as solar panels and wind turbines qualify for regulatory support through Feed-in-Tariffs or Renewable Obligation Certificates. These provide payments for the electricity generated as an incentive to invest in the sector and also offer predictable returns.

Equity-like returns with debt-like risks

Investing on an unlevered basis gives investors the opportunity to capture all of the returns on the whole project. An unlevered asset will be subject to exactly the same project risks as debt on that asset - including operational, revenue and counterparty risks - but have a different return profile.

The traditional model of structuring an asset using debt and equity tranches introduces financial risk that is not present in the unlevered approach. The chart below illustrates how the return forecasts, defined as Internal Rate of Return (IRR), from a typical windfarm project, assuming different levels of leverage, are affected by a fall in wind speeds and hence energy generation.

Illustrative example of the IRR impact from a 20% drop in wind speed
Source: Aviva Investors. All information is based on the internal forecasts and estimates of Aviva Investors and should not be relied upon as indicating any guarantee of return.

The green line on the chart represents the central forecast return for different levels of leverage, and the red line the impact on returns should wind speed fall by up to 20 per cent. The return dispersion is illustrated by the blue boxes. For an unlevered investor, the forecast base return may be eight per cent with downside volatility limited to approximately three per cent – equivalent to an IRR of around five per cent – if the electricity generation drops by 20 per cent over the 20-year life of the project as a consequence of the fall in wind speed4. For a levered investor, the same drop in wind speed could result in significant losses or even default. The downside risk increases with the level of leverage employed.

Investing on an unlevered basis in ‘low risk’ infrastructure projects can significantly reduce the volatility of returns associated with equity investing. Volatility can be further reduced by investing in a diversified portfolio of unlevered infrastructure assets, which could form part of pension schemes’ matching strategies with significantly higher yields than comparable index-linked gilts.

Opportunity knocks

As with any innovation, it often takes time for the market to catch up. To date, a small number of pension schemes have invested in low risk infrastructure on an unlevered basis, but there is growing interest in this type of strategy. There is certainly enough capacity for pension schemes, large and small, to benefit. Those that have invested have received stable high single digit, inflation-linked income from their investments.


1 Green Investment Bank. A healthy saving: energy efficiency and the NHS. April 2014

2 Aviva Investors 31 August 2016

Vital Energi, July 2015 (Date of Assessment)

Aviva Investors

Important information

This document is for professional clients and institutional/qualified investors only. It is not to be distributed to or relied on by retail clients.

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 21 September 2016. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

Issued by Aviva Investors Global Services Limited, the Investment Manager to the Fund registered in England No. 1151805. Registered Office: St. Helen’s, 1 Undershaft, London EC3P 3DQ. Authorised and regulated by the Financial Conduct Authority (Firm Reference No. 1191780).