Encouraging infrastructure investment

Overview

One of the biggest changes to Regulation 28 is around infrastructure investment. This article considers the impact of the newly introduced definition of infrastructure, and prudential limits, on retirement fund investment.

Regulation 28 facilitates increased allocation to infrastructure

It is widely recognised that infrastructure provides the structural economic backbone for any economy. As a result, infrastructure investments by retirement funds support all other investments made by a retirement fund, as well as supporting overall economic growth in South Africa. Sound, stable infrastructure is able to provide and support utilities, services or facilities for the economy, business and society.

The availability of transport, communication, electricity, safe water, and sanitation – and other basic facilities – has a tremendous impact on improving the quality of life and wellbeing for any country. Infrastructure facilities and services are essential for efficient production of goods and services, transport and trade – all of which spur economic growth – which in turn helps in reducing poverty.

Conversely, Eskom’s re-introduction of loadshedding in 2022 has resulted in economy-wide, far-reaching negative impacts on business and society. This has highlighted South Africa’s vulnerable energy sector as currently the most critical infrastructure sub-sector. While this presents a serious risk to South Africa’s economic growth, it also offers an opportunity for investment into renewable power projects by retirement funds.

Defining infrastructure

The amended Regulation 28 gazetted by National Treasury on 1 July 2022 introduced an updated definition for infrastructure investing.

Specifically, infrastructure refers to:

any asset that has or operates with a primary objective of developing, constructing and/or maintaining physical assets and technology structures and systems for the provision of utilities, services or facilities for the economy, businesses, or the public.

The social and public aspects of this updated infrastructure definition has accommodated impact investing by retirement funds.

Impact investments are investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return.

Regulation 28 enables a 45% allocation to infrastructure

The infrastructure investment limit applicable across all asset categories is 45% in respect of domestic (South African) exposure and an additional limit of 10% in respect of the rest of Africa.

RSA infrastructure allocation limit: 45%

Rest of Africa infrastructure allocation limit: 10%

Percentages and investment limits applied in Regulation 28 are aimed at protecting retirement fund members against the risk of an excessive concentration of assets in any single asset class and/or individual investment and are not prescribed targets to be met.

Assets held by retirement funds on behalf of their members are considered valuable in any country, because they tend to be sizeable and available for the long term. This means that they can be used to provide the funding needed to build infrastructure capacity in the country, which in turn grows the economy and creates jobs. Investment into the right types of infrastructure projects by retirement funds can have the potential to deliver stable, inflation-beating returns over the long term that align well with members’ needs.

While positive, it is critical to highlight that infrastructure is a highly complex, specialist asset class. The key difference between infrastructure investments and the listed universe of assets is that infrastructure is generally more structured and less liquid compared to publicly traded equities and bonds.

Characteristics of infrastructure investing

Infrastructure investments by retirement funds present both opportunity and risk: they offer stable returns, a longterm investment time horizon, a diversification benefit, and introduce assets uncorrelated to other more traditional asset classes in South Africa and globally. Infrastructure assets produce a real return over time, generally producing inflationlinked cash flows, which enables retirement funds to achieve inflation-beating returns so that retirement benefits can keep pace with inflation. (See graphic below.)

CHARACTERISTICS OF INFRASTRUCTURE INVESTMENTS

• Investment horizon: Infrastructure investments are typically long term in nature.

• Less liquidity: A large portion of these assets are unlisted which, among other factors, can make them less liquid.

• Stable returns and diversification: Investment in infrastructure is less tied to economic cycles, which means they can still provide returns in a downturn. The underlying assets in infrastructure investments are also uncorrelated to more traditional asset classes, such as listed equities, which offers portfolio diversification.

Trustees in the driving seat for infrastructure investing

The opportunity to increasingly allocate to infrastructure investments and projects places an additional duty on retirement fund trustees to pick well-defined infrastructure projects that provide the returns members need on their savings over the long term, without adding excessive levels of risk. Regulation 28 has always placed a duty on retirement fund trustees to educate themselves sufficiently on any investment (including infrastructure) to be able to adequately assess the merits of an investment.

Regulation 28 states that

before making an investment in and while invested in an asset, consider any factor which may materially affect the sustainable long-term performance of the asset, including those of an environmental, social and governance character and those related to infrastructure investment, taking into account the necessary due diligence and risk-adjusted returns, acting in the best interest of the fund and its members and avoiding conflicts of interests.

Trustees need to therefore consider the new 45% infrastructure limit in the context of each retirement fund’s benefit objectives and accompanying investment strategy to support the fund objectives.

Infrastructure investments, by the nature of the projects and asset type, introduce execution risk and liquidity risk. Particularly, investing in greenfield investments requires fund managers and advisers to retirement funds to be able to not only understand the investment thesis of an infrastructure investment or project, but to also be able to assess the execution risk presented by the investment. This calls for the application of skillsets beyond the traditional financial analysis undertaken when valuing, for example, listed equity and bonds. The increased allocation by Regulation 28 to infrastructure and private markets requires a combination of financial analysis, as well as industry specific technical skills.

Understanding the liquidity constraints of infrastructure

Retirement funds generally build a liquidity profile into the fund’s overall investment portfolio. This enables the retirement fund – considering its own liquidity requirements – to allocate a portion of its investment portfolio to longer-term, less liquid assets, such as infrastructure and private equity investments. Infrastructure assets are typically cash flow generating, which results in positive cash flow profile for retirement funds over time.

A retirement fund will therefore need to apply sound due diligence on infrastructure investment projects. Over and above this, trustees need to ensure that the fund manager and intermediaries they appoint to access infrastructure investments and projects have the appropriate team and skillsets in place.

Regulation 28 requires reporting on top 20 infrastructure holdings

Another addition to Regulation 28 is the requirement for retirement funds to report their top 20 infrastructure investments annually. This reporting requirement is a monitoring mechanism for National Treasury and will likely inform any further specific regulatory guidance on infrastructure investing.

REFERENCES

• National Treasury Draft Amendments to Regulation 28. Available online: https://tinyurl.com/2ty8x6ak

• National Treasury, Gazetted Amendments to Regulation 28. Available online: https://tinyurl.com/3fvv8hxy

• FSCA Communication 8 of 2022. Available online: https://tinyurl.com/25kdczwb

• OECD, Infrastructure Financing Instruments and Incentives. Available online: https://tinyurl.com/mrxwuctn

LEARN MORE

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