Just changing Regulation 28 isn’t enough

Last week, National Treasury proposed amendments to Regulation 28 that would allow greater allocations to infrastructure in pension funds.

This has been largely welcomed, yet very few funds are near the current limits as they stand. Investing in private markets is often seen as risky, and highly specialised.

“This is still fairly unfamiliar territory for many institutional investors,” says Yoza Jekwa, joint MD at Mergence Investment Managers. “There’s still a lot of work we need to do in developing the understanding of what unlisted credit and unlisted equity look like, and what the performance track record has been.”

There is, however, clearly a growing interest in this space.

Risk-return

“That is firstly because these are asset classes that provide attractive risk-return profiles,” Jekwa says. “But it’s also because of the ESG impact associated with the types of assets we have in these portfolios, such as clean energy projects, affordable housing, water and sanitation, and agriculture. All of these can deliver significant socio-economic impact.”

The returns available in the unlisted space are evidenced by Mergence’s own recent performance.

Over the five years to the end of December, the Mergence Infrastructure and Development debt fund returned 10.6% per annum. The Mergence Infrastructure and Development equity fund gained 17.9% per annum over the same period.

These returns have also tended to be reasonably stable. Last year, the debt fund was up 8.6%, and the equity fund 15.6%.

Underlying investments

This is one of the most attractive features of private market funds that aren’t subject to the daily pricing of listed markets. It also illustrates the resilient cash flows from the assets in these portfolios.

“With credit, you are typically coming in at a point where there is clear visibility with regards to cash flows,” says Jekwa. “So in the debt fund, we typically aren’t likely to be taking development risk. We are coming in where we have a clear line of sight in terms of the commissioning of a project. There may be a period where there is a capital moratorium on the debt, but thereafter you start to see interest and the capital being paid down.”

In some instances, these debt investments may also be secondary refinancing for projects that have already been operational for some time.

“On the equity side, there are instances where we would be coming in at the developmental stage of the project, but at the same time we have other assets at more mature phases,” Jekwa says. “Some equity exposure is also equity financing for the BEE component of the shareholder structure – in other words an instrument that allows the BEE entity to fund its stake within the business. There we would be getting a high-yielding return even though we are not an ordinary shareholder.”

Liquidity

However, Jekwa acknowledges that while institutional investors may find the stable cash flows of these long-term assets attractive, the lack of liquidity often poses a problem for them.

“The burning question for a lot of institutional investors looking for exposure is the liquidity issue in private markets,” Jekwa says. “These are not assets that can be readily liquidated at short notice.”

Mergence has tried to address this by creating a composite bond fund. This portfolio is split evenly between unlisted infrastructure debt and more liquid instruments.

“The product gives investors an exposure to both listed fixed income as well as private market infrastructure debt,” says Brad Preston, joint MD at Mergence. “We then use derivatives to maintain the overall portfolio positioning that we would like.

“This allows us to manage the liquidity at the portfolio level. If a client wanted to redeem 10% of that portfolio, for example, we would service that liquidity from the bond portion of the portfolio. That would result in the private markets portion being upweighted, but we would then adjust the hedging appropriately.”

Listed vehicles

While this does not solve the problem of needing to liquidate the entire portfolio at short notice, it does offer some measure of a solution.

“A client with a certain liquidity requirement – say 10% or 20% – is achievable,” says Preston. “We’ve also done this in a balanced portfolio where we take exposure to private markets through debt but then used listed equity that provides liquidity.”

This does offer a measure of comfort for institutional investors who require liquidity, particularly in defined contribution funds.

Pension funds have been asking for this kind of innovation to make the asset class more accessible.

Another option is to create a listed equity for the private market holdings, although this also has its limitations.

“The listed vehicle is then effectively a holding company exposed to a number of infrastructure assets,” says Jekwa. “That provides indirect exposure to these assets. But then you start coming back to being a exposed to some of the risks typically associated with the listed equity market that perhaps you were trying to migrate away from.”

Patrick Cairns is South Africa Editor at Citywire, which provides insight and information for professional investors globally.
This article was first published on Citywire South Africa here, and republished with permission.

LISTEN: Malusi Ndlovu of Old Mutual on how the proposed amendments to Regulation 28 will affect your retirement