What is a sustainable fixed income strategy? How does it differ from ESG analysis in equities? How can ESG criteria be incorporated into fixed income portfolios? Asset owners and fund managers are increasingly facing these questions, and things have finally started to move in this traditionally more conservative field.

The main focus of ESG investing has been on equities but it is now spreading more widely. Bonds constitute a substantial percentage of institutional investors’ assets. Pension funds in the seven largest markets own about $11 trillion in fixed income, which accounts for about 27 per cent of their assets. Insurance companies’ bond allocations tend to be even higher.

The world’s largest pension fund, Japan’s Government Pension Investment Fund started to incorporate ESG elements into its equity portfolio in 2017. It is now also looking at ESG in other asset classes. GPIF recently announced its partnership with the World Bank Group to identify leading ESG approaches used by international investors and service/data providers in fixed income. Due to the size of GPIF’s assets, $1.4 trillion, a main purpose of the project is to help investors deploy capital at scale in a more sustainable way.

Key differences
Applying ESG to various asset classes requires adaptation; for example, fixed income investing is very much a quantitative process. Managers find it difficult to include ESG criteria in their conventional financial models and are, therefore, often ESG-resistant. To highlight how some key elements of fixed income strategies are different from those in equities:

• The main focus is on risk analysis, i.e. the downside capital and default risk vs equities’ capital appreciation.
• Bondholder rights as opposed to shareholder rights
• The importance of sovereign and supranational issuers
• Dealing with securities of finite maturity
• Emphasis on cashflow stability and the use of bonds in liability-driven strategies.

Our research report, “Incorporating Environmental, Social and Governance (ESG) Factors into Fixed Income Investment” for the GPIF/WBG project, which involved an extensive literature analysis and structured interviews with leading players, found that ESG investing has finally gained momentum in these asset classes, especially in corporate bonds. Other fixed income asset classes, such as sovereign bonds, high yield, asset-backed securities or private debt have further to go.

Academic and industry research have been growing over the last few years to link ESG with financial performance in fixed income. It is now more widely accepted that ESG factors can constitute material credit risk and incorporating them in the investment process does not mean having to sacrifice returns. In practice, investors are trying to understand the link between ESG issues and traditional credit ratings; the ratings agencies need to enhance guidance.

Implementation strategies for ESG in fixed income vary widely. They range from purchasing thematic investments (such as green, social, sustainable bonds/funds) to following indices, hiring active managers and embedding ESG across the whole investment process. This can be done by following the methodology of specific service providers or by customising strategies with one’s own philosophy. Leading investors tend to have a full organisational approach (starting at board level) with clear ESG and climate-change objectives; however, smaller investors often find their options curtailed in practice.

From process to impact
One trend surprised us both in terms of the attention it is attracting and the pace of change. There is increasing attention to environmental and social outcomes (such as carbon emissions, environmental footprints and social indicators), going well beyond the traditional emphasis on ESG inputs and investment process.

More investors are seeking to extend ESG into impact investing or even merge the two. This is broadening from establishing dedicated impact projects/funds (typically of small size, such as social impact bonds) to attempts to measure the impact of portfolios on targeted environmental and social outcomes, including the UN’s Sustainable Development Goals (SDGs). How to do this is still a work in progress.

There are a number of general issues with ESG that apply to all asset classes being debated in the industry and academia. There are varying definitions, methodologies and ‘standards’, and a lack of transparency and comparability across providers. This is causing questions around who regulates sustainability. How is one to distinguish between material analysis and ‘green-washing’? ESG and climate change regulation are changing but remaining issues around fiduciary duty and ESG incorporation are still very much live. Finally, differing beliefs, especially in social and ethical matters, are not to be underestimated.

Fixed income’s unique obstacles
In addition, there a number of challenges specific to fixed income, including:

• What are material factors in terms of E, S and G for credit risk, and how do they change over different maturities?
• The relationship of ESG to other risks/opportunities, such as market risk, inflation risk and liquidity risk.
• How to organise engagement with corporate issuers for bondholders?
• Political sensitivities of, for example, exclusion of countries from sovereign indices/portfolios.
• Does it make sense for ESG to force an even higher portfolio concentration on the most developed markets? Some analysts now emphasise improvements in ESG in order to get exposure to higher yield, developing markets.
• Data for many fixed income instruments is still limited – in both quantity and quality – notably for smaller issuers and those in emerging markets.
• There has been a dearth of ESG index products and other ESG investment tools, compared with what’s in equities. This is changing and the two market leaders, MSCI and Sustainalytics, are complemented by new providers; for example, J.P. Morgan launched a new suite of ESG fixed income indices in 2018.
• There are also challenges in the green/climate/social/SDG bond markets, with demand outstripping supply.

Advancing ESG incorporation into fixed income portfolios will take more work. Progress in four main areas is recommended:

1. Governments and international organisations, but also corporations, should improve the provision of timely underlying environmental and social data. They can then be tested for robustness and materiality in ESG analysis.
2. Further rigorous conceptual work on ESG and fixed income is required and it needs to go beyond credit risk.
3. A refining of standard principles and metrics for applying ESG and impact investing is much called for. This will allow investors to customise their approach from a robust basis, to reflect their own beliefs and goals.
4. Finally, more innovative products could be rolled out to accommodate the growing demand for fixed income sustainable investments. They should be scalable and more diverse in order to become meaningful benchmarks and portions of asset allocation.

Georg Inderst is an independent adviser to pension funds, institutional investors and international organisations. Fiona Stewart is a lead finance sector specialist in the finance, competitiveness and innovation global practice of the World Bank.

Asset owners are too important to fail in their mission – producing wealth and wellbeing for all of us who can afford to save. Their collective assets are worth about $55 trillion, under a narrow definition, amounting to more than $10,000 for every adult on the planet.

Yet the term asset owner, which first emerged a generation ago, is still misunderstood.

It applies to institutions that are the economic owners of investment portfolios and also have investment management responsibility for those portfolios. This contrasts with asset managers, who are agents executing the mandates given to them by asset owners and are not economic owners.

The most significant categories of asset owners – pension funds, sovereign wealth funds, endowments and foundations – manage assets to meet the needs of savers or investors. There is another category: outsourced CIOs and master trusts that manage funds like asset owners but are, strictly speaking, agents.

The distinctive feature of all these entities is their discretion to put capital into any country and any asset class that suits them. Their decisions regarding asset allocation and stewardship shape capital markets and are a key element in the functioning of the global economy. Through their size and role, they represent the most influential capital on the planet.

Survey of the biggest

In a Thinking Ahead Institute study, Asset Owner 100 (AO100), we surveyed the 100 largest asset owners, responsible for $19 trillion between them (at year end 2017). The largest of the AO100 is the Government Pension Investment Fund (GPIF) – the Japanese public-sector pension fund responsible for managing $1.5 trillion. The AO100 is made up of 67 pension funds, 21 SWFs and 12 outsourced CIOs; 44 are located in North America, 30 are in Europe, the Middle East and Africa, and 26 are in the Asia-Pacific region.

These are complex organisations that are having to adapt to tougher terrain. Many are building their internal teams while looking for deeper collaborations and strategic partnerships with peers and asset managers. This move to streamline intellectual capital is assisted by the increasing use of technology, an area in which asset owners have previously been out-spent by asset managers. The AO100 group’s future success hinges on how well they can marshal technology and data, and also how effectively they can harness their talent by creating the right cultures. ‘Smart, motivated people allied with smart, integrated technology’ is becoming a mantra within these organisations and also in their partner organisations.

The strength of AO100 leadership is increasing markedly as they leverage their scale. It will have to increase further amid greater need to function transparently, better meet their members’ financial expectations, become more sustainable and achieve a social licence to operate.

This social licence to operate is a new part of the asset owner proposition. It is a tacit social contract whereby asset owners gain legitimacy according to their actions and impacts. We, as individuals, may or may not have our money managed by them, but we certainly feel the effects of their investment footprint – for better or worse.
Asset owners cannot award themselves a social licence to operate, it requires external trust and legitimacy, along with the implied consent of those affected. Investment has economic, environmental and social impacts, and stakeholders will grant legitimacy based on their view of these impacts. In other fields, social licence has been lost; the AO100 will have to be vigilant to avoid this fate.

A complex agenda

The AO100 asset owners take their financial and social responsibilities seriously, but they will need an infusion of board talent to cope well with the complex agendas that confront them. And they will need to be more strategic, particularly on sustainability.
The institutions in the AO100 all own a large slice of the markets and the economies underlying them. The returns they need can come only from a financial system that works. They may need to help change the system in some areas, particularly where governance is weak and where portfolio assets may be impaired or stranded by fast-changing circumstances.
GPIF, for one, is leading the way. The Japanese fund sees its main vulnerability as systemic failure so it pursues a sustainability strategy based on managing ESG exposures and being active stewards of long-term holdings. Like a number of the AO100, GPIF is a large, long-term and leadership-minded asset owner – a ‘universal owner’. Such funds are the most influential asset owners because of their systemic positioning.
The opportunities for the AO100 to step up and deliver better outcomes for more people are clear. Public policy should align these asset owners by influencing their governance and transparency where more needs to be done.

This should not be to the detriment of innovation. The investment industry, suitably configured and aligned, is an immense force for promoting the wellbeing and fulfilment of the good society. And in the ranks of the AO100, there is the technical know-how to get big things done well.

All we need now is for strong leadership to have the courage of its convictions.

Roger Urwin is global head of investment content at Willis Towers Watson.

The sheer weight of money behind the world’s largest 100 asset owners represents a huge opportunity for them to step up and show leadership in where, and how, capital is allocated.
Discretionary assets of the world’s largest 100 asset owners at the end of 2017 totalled $18.69 trillion, a new report by Willis Towers Watson’s Thinking Ahead Institute (TAI) states.
Roger Urwin, global head of content at WTW, says the total capital controlled by asset owners (including insurance companies and mutual funds) is $125 trillion, with third-party fund manager assets totalling $80 trillion.
“Big isn’t everything but it does describe a fair amount of influence,” Urwin says.
The influence of the largest asset owners in the latest Willis Towers Watson Asset Owner 100 is top heavy, with the top 20 (listed below) representing more than 50 per cent of the assets; however, while the amount of capital in these large asset owners is big, and growing, WTW identifies only about five of the top 20 funds as universal owners.
The TAI report states that most large asset owners find reasons not to manage their funds in line with universal ownership principles. They see themselves as not large enough, lacking a long-term orientation, or not having the leadership buy-in to operate that way.
Universal ownership means integrating financial and extra-financial exposures through actions both within the system or designed to change the system, recognising inter-dependence across the portfolio.
“This capital has the potential to be game changing. But there is opportunity for this capital to be doing more work in stewardship and universal ownership area,” Urwin says. “This is early days but the returns we need can come only from a system that works. If people take that approach, naturally they will work on the system more.”
Urwin has called for asset owners to be responsible for the footprints they carry, which are associated with some “nasty externalities”, such as carrying around carbon.
“In 20 years, we will be challenged on why they didn’t do more about it,” he said. “These are reputational and returns issues. We need to be more leadership minded.”
The top five universal owners, by size, are Japan’s Government Pension Investment Fund, the Government Pension Fund of Norway, APG in the Netherlands, the California Public Employees’ Retirement System in the US, and the Netherlands’ PGGM.
“[Universal owners] are the funds that are making a difference in the world. I’m trying to get asset owners to step up,” Urwin said. “The top-five asset owners are clearly trying to be universal owners, they are hyper-integrated with regard to stakeholder relationships and are being long term about it.”
The WTW report points out that foundations and endowments represent an important category of asset owner, however the largest of these – which is the Bill and Melinda Gates Foundation with $50 billion – does not make the list of the largest 100 asset owners.
Within the asset owner 100, the Asia-Pacific region is the area that accounts for the most assets under management, representing 36 per cent of the list’s total. Both China and Singapore have three asset owners in the top 20.
The US has the most asset owners in the top 100, with 39, followed by Australia with nine.

Outsourced CIOs and master trusts

Pension funds make up the majority of assets, with 60.8 per cent, followed by sovereign wealth funds (32 per cent).
Outsourced CIOs (OCIO) and master trusts, a new category to be measured by the TAI, accounted for 7.2 per cent. Mercer is the largest OCIO/master trust in the survey, with $211 billion in AUM, ranking it 23.
The largest sovereign wealth fund is China Investment Corporation, with $900 billion (ranked 3 overall), while the largest pension fund is Japan’s GPIF with $1.4 trillion, making it the biggest asset owner overall.
Willis Towers Watson’s own OCIO offering ranks 43 with $110 billion.
Urwin says OCIOs and master trusts fit in the asset owner survey because they have the freedom to invest capital on a fully discretionary basis.
“If an OCIO is doing a good job, they have the most progressive portfolios because of their total-portfolio approach, they are more flexible,” he explains.
Urwin says total portfolio management can add 50-100 basis points relative to good strategic asset allocation, which he describes as a set of compromises.
“A total portfolio approach is a very big edge,” he says. “New Zealand Super, the Future Fund, Canada Pension Plan Investment Board and Railpen couldn’t do what they are doing without the flexibility in allocating capital that allows. It’s quite persuasive.”
He describes some of the defining elements of an asset owner as: fiduciary capacity; social licence to operate; a sponsor; and mission-specific outcomes.
“What this is saying about the world’s influential capital is important – it is free to go wherever it needs to go,” Urwin says. “Asset owners are very interested in how they exercise their responsibilities. Managers need to be more reticent of that.”

Thinking Ahead Institute AO 100 top 20

1. Government Pension Investment Fund (Japan) $1.443 trillion
2. Government Pension Fund (Norway) $1.063 trillion
3. China Investment Corporation (China) $900 billion
4. Abu Dhabi Investment Authority (Abu Dhabi) $828 billion
5. National Pension Fund (South Korea) $582 billion
6. APG (Netherlands) $564 billion
7. Federal Retirement Thrift (US) $531 billion
8. Kuwait Investment Authority (Kuwait) $524 billion
9. SAMA (Saudi Arabia) $514 billion
10. HK Monetary Authority (Hong Kong) $456 billion
11. SAFE (China) $441 billion
12. GIC (Singapore) $359 billion
13. National Social Security (China) $341 billion
14. CalPERS (US) $336 billion
15. Qatar Investment Authority (Qatar) $335 billion
16. Canada Pension Plan Investment Board (Canada) $283 billion
17. Central Provident Fund (Singapore) $269 billion
18. PGGM (Netherlands) $262 billion
19. Temasek (Singapore) $230 billion
20. Public Investment Fund (Saudi Arabia) $230 billion

A year and a half ago, Denmark’s DKK 114 billion ($17.4 billion) MP Pension, the scheme for the country’s academics in universities and secondary schools, decided to allocate 5 per cent of assets under management to climate-related investments. Since then, the pension fund has crafted a careful, diversified strategy in which the risk in the new portfolio is kept in line with the broader risk in the fund.
Half the new portfolio will be invested in bonds and listed equity and half will go into illiquid assets such as clean energy infrastructure. The fund has just made its first investment in a Danish climate-focused infrastructure fund. Other early-stage investments include an allocation to emerging-market green bonds with Amundi, and two new mandates with listed equity managers focusing on companies developing green technology.
The challenge in the crowded green tech space is today’s rich valuations, MP Pension CIO Anders Schelde says.
“High valuations in these kinds of technologies are a concern in the short- to medium-term, but it will play out over decades,” Schelde says. “In the mid-’90s, no one knew the winners of the tech revolution. It is a question of following and learning.”
He joined the fund a year ago from Denmark’s Nordea Life and Pension, where he was CIO for nine years and oversaw a DKK165 billion ($25 billion) portfolio comparable to MP Pension’s 50:50 split between bonds and equity. MP Pension’s vibrant member-owned organisation and stakeholder relationships have brought a new element to the CIO role that Schelde finds particularly fulfilling. It is also driving what he calls the fund’s “revolutionary” climate strategy.
The pension fund embarked on a carbon-divestment program after members at the 2016 AGM requested investment strategy comply with the Paris Agreement to limit global temperature increases to well below 2 degrees.
The program involves MP Pension committing to sell all its shares in fossil-fuel companies and excluding more than 1000 companies from its investment universe. Companies operating in the coal and tar sands industries will be sold this year; oil shares will be sold by the end of 2020 in a divestment program that will free up more than DKK1 billion ($150 million) to invest elsewhere. Fossil fuel companies can re-enter the portfolio if they convert their production and business model into one that is more climate-friendly, Schelde says.
“Our analysis doesn’t see major oil producers or upstream companies performing relative to the rest of the market, so from an investment perspective, it makes sense to divest,” he explains. “We have worried that if we are not owners we lose our influence but it is possible to be a responsible investor without being an owner, applying more change from the outside.”
Indeed, MP Pension has a growing reputation for a vocal presence and sharpened profile in Denmark’s ESG space. This is visible in Schelde’s lobbying for more gender diversity on corporate boards, which was influential in convincing shipping giant Maersk to change course and appoint the first female chief financial officer in its 114-year history earlier this year. “Whenever we have the chance, we speak up,” Schelde says.
In another development, the fund is also working on a quant-based sustainable product inhouse. It already runs two global quant portfolios internally and is now adapting this strategy and product to integrate sustainability themes from ESG data.
“It involves a lot of number crunching and it is early days,” Schelde says. “It is also broader than just climate, since the theme is sustainability.”

Evolution not revolution
Schelde plans to increase MP Pension’s exposure to unlisted assets in the next three years. The fund’s existing 19 per cent exposure to illiquids is spread across a diverse portfolio of triple-A structured products, direct lending, infrastructure and private equity. The boosted allocation to about 29 per cent of assets, added in increments over the next three to four years, will focus particularly on private equity and infrastructure, he explains.
The fund will invest as a limited partner with managers but Schelde is also looking for co-investment opportunities, which he says MP Pension has “done for a while and would like to do more of”.
He would also like to do more direct deals but only in club structures alongside other investors. The new allocation will not be made via funds of funds. Although MP Pension already has some fund-of-fund exposure, Schelde doesn’t want to increase it.
“In fund of funds you buy expertise…and we cannot spare this cost,” he says.
MP Pension’s manager cohort comprises mostly established relationships, although new managers are added “from time to time”.
In a “conservative approach”, he tends to avoid managers raising their first fund, prefers buyout funds to venture, and exposure to Europe and the US over emerging markets. The fund has about 25 managers in listed assets. The internally managed allocations comprise Danish government and mortgage bonds, Danish equities and the two global quant portfolios.
MP Pension doesn’t have a targeted rate of return because guarantees in the portfolio on the liability side are contingent on the interest-rate level in markets.
“We don’t need to meet a specific return to stay solvent,” Schelde says. “We are unconstrained and can invest as we like; our targeted rate of return is our expected return.” The fund has returned 9.6 per cent, on average, over the last nine years.”
Schelde is also planning to reduce the fund’s equity exposure. MP Pension has 47 per cent of its portfolio benchmarked against equity indices and 53 per cent benchmarked against various bond indices; Schelde plans to lower the share of the portfolio that is mapped against the equity benchmark to 44 per cent. But he is also weighing up a counter strategy that would use derivatives and not change the cash allocation.
“We may just short derivatives on top of the portfolio to get the right risk exposure and keep the mandates in cash equity,” he says.

A decision on whether to use derivatives isn’t imminent, however, and is more likely to come next year.
“It will be quite a while before we do this,” Schelde says.

The C$60 billion ($48 billion) Investment Management Corporation of Ontario, Canada’s newest pension investment manager, is assessing its inherited asset allocations and making plans to revitalise.
The fund, which was created in July 2016 and launched a year later, will look to increase its allocation to private markets and make more direct investments. It will also introduce a global credit portfolio, consolidating the global credit allocations that are now scattered across the asset-class buckets.
“The new structure will have all credit within one diversified portfolio, and we would expect the credit exposure of clients to increase because of that,” IMCO CIO Jean Michel says. “It’s a great way to diversify.”
IMCO’s current asset allocation is public equities (39 per cent), fixed income and money market (23 per cent), real estate (14 per cent), diversified markets (7 per cent), infrastructure (7 per cent), absolute return (6 per cent), private equity (3 per cent) and private debt (1 per cent).
Compare this with Ontario Teachers’ Pension Plan, one of IMCO’s contemporaries, which has an allocation to private equity of about 17 per cent.
Two specific aims of IMCO’s strategy evolution are to increase its amount of private assets and to increase the amount of assets managed inhouse.
When IMCO’s two inaugural clients, the Ontario Pension Board and the Workplace Safety and Insurance Board, came into the fold, the fund inherited their existing strategic asset allocations.
One of IMCO’s core offerings is to provide asset allocation and portfolio construction advice; it is now going through that process with clients. IMCO clients will retain asset allocation decision-making, with input from the IMCO team, which will offer 15 strategies for clients. It offers only eight now.
Key to its approach is the belief that asset allocation is among the most important determinants of investment returns and risk. Another core belief is that understanding and managing risk is at the core of investing.
One of IMCO’s key initiatives, and one of the purposes of the pooled asset management concept, is to provide better access to investments than clients can get on their own; in particular, minimising the use of expensive structures and maximising scale and experience to pick strong strategic partners.
“We inherited asset allocations that were fully invested and were 75 per cent externally managed,” Michel says. “We also inherited a cost structure we think we can improve on, as the existing investments include lots of active management as well as fund of funds and manager of managers.
“We are working with clients to look at the type of portfolio we are offering and working with them on asset allocation 2.0.”

Internal management, manager relationships and fees

Michel was appointed CIO in June, coming from Caisse de dépôt et placement du Québec, where he was executive vice-president, depositors and total portfolio. Prior to that, he was the president of Air Canada Pension Investments. He says the plan is for IMCO to manage the majority of assets inhouse within five years.
“We will be cheaper than our clients [for] the same asset mix,” he says. “The savings we make by managing assets internally we are using to build out our risk and portfolio construction function. Then, overall, we will get a better asset management function.”
As with many pension fund managers, one of IMCO’s core beliefs is that costs matter. That’s something it lives day to day.
“When we look at results, we look at them on a fully net basis, not every asset management firm does that,” Michel says. “We make sure all our portfolio managers understand the full costs of what it takes to invest and know all the external management fees they have, explicitly and implicitly, even those that are not fully transparent, so they can make the best decisions on whether to invest.”
IMCO will internalise investment management where it makes sense and where costs work. About 40 of the firm’s 100 staff are in the investment team. The expectation is that, five years from now, the organisation will employ between 250 and 300 people.
Direct investments are expected to provide a big portion of this growth. But Michel is quick to point out that the evolving investment structure will include a total-portfolio team to look at the fund as a whole.
“The probability of achieving long-term value creation is increased by looking at the total portfolio view. This is critical for us,” he says.
IMCO has many external managers, with an average of 10-15 partners per asset class. This will be reduced and the number per asset class is expected to be closer to five or six.
“Using strategic partners will be very important to us and we will focus on a limited number of great partners,” Michel says.
As the investment decision-making process becomes internalised, with IMCO taking more direct investments, there will also be a shift in the way the firm uses managers.
“We will be making more direct, but also more complex, transactions,” Michel explains. “So we will still use partners but use them differently. The goal is to be closer and create true partnerships. We will also look to co-invest but on more equal footing.”
IMCO chief executive Bert Clark, who was formerly chief executive of Infrastructure Ontario and the recipient of the 2017 Champion Award from the Canadian Council for Public Private Partnerships, says good partners offer something the firm can’t provide itself.
“We think what makes a good partner is origination capability and asset management expertise we don’t think we can replicate,” Clark says. “One clue to what that might look like is the fact IMCO has a global portfolio but just one office, in Toronto. Private assets are becoming more difficult and complicated, as there is more demand and also expertise has risen. We need to be important to external managers, and I think we can, as we can move quickly but still look at complicated transactions.”

IMCO was created following extensive review by the Ontario Government into the best model for managing pension assets, resulting in a report by the pension investment adviser, William Morneau. The report outlines the key attributes of best practice – including appropriate scale and an approach to governance – that could be a guide for all organisations managing pension assets.
Morneau’s report shows the advantages of a pooled pension management organisation, including reduced duplication and costs, greater access to additional asset classes and enhanced risk-management practices. It also outlines potential cost savings between $75 million and $100 million a year, once fully implemented.
Clark says the organisation offers strong risk management and reporting, which also requires scale.
There are two key advantages to such a new investment organisation, Clark says.
“On the IT side, many organisations struggle with legacy systems and it is hard to move off those. Starting at this point means we don’t have those legacy problems and, for example, we can buy software as a service [not a product].
“We also get to step back and see what’s worked for other big public funds globally. Everyone is aware of the success of the Canadian model, but that is not the only successful model and we’ve looked to the Northern European pension funds and the US endowments,” he says. “Starting with C$60 billion means we have the critical mass to build right.”
Specifically, the fund has looked to the specialties of various players and can borrow from each of them. US endowments are good at strategic partnerships with managers and focusing on the origination of investments. Northern European funds are good at total portfolio management. The Canadians are good at internal investment management.
IMCO has now built up its risk and investment functions and is ready for action.
“We are very close to being ready to engage with potential clients and will look to do that in Q1 next year,” Clark says. “We have our CIO, CRO [chief risk officer], a risk system and a way of reporting to clients. We have a set of investment strategies for each asset class and can advise on portfolio construction.”

When investors hear about opportunities in Africa, their initial reaction may be to dismiss them as too risky. Stories of political upheaval, natural disasters, famine and corruption often populate international news headlines about the continent.
Beyond the headlines, however, lie stories of innovation, improving governance and unprecedented growth in many of the 54 diverse countries that make up Africa. The time is ripe for Organisation for Economic Co-operation and Development (OECD) investors to begin exploring potential opportunities on the continent.

The investment opportunity
Mobilizing Institutional Investors to Develop Africa’s Infrastructure (MiDA), a partnership between the United States Agency for International Development (USAID) and the National Association of Securities Professionals, commissioned Mercer to develop a report, for which seven OECD asset owners were interviewed about their perceptions of the risks and opportunities in African infrastructure, along with four asset managers who are investing in infrastructure on the continent. The findings were surprising in a number of cases and support the argument that investors should learn more about related opportunities.

Low default rates…
A Moody’s report on global project finance default rates found that African projects defaulted at a rate of 5.3 per cent between 1990 and 2016, less than half the default rate in Latin America, which exceeded 12 per cent, and far lower than in Asia, where defaults occurred 8 per cent of the time. In fact, the average across all global regions was 5.4 per cent, meaning African projects were statistically less likely to default than the average global project. Only Western Europe and the Middle East had a lower default rate.
A paucity of data and Africa’s relatively low number of projects overall may indicate that only highly structured and risk-mitigated projects are seeking financing there in the first place; this would be a reflection of the key role development finance institutions (DFIs) and some private infrastructure investors continue to play in the region by helping local governments develop enabling policy frameworks and investable project pipelines

Paired with strong credit spreads
Investec Asset Management interviewed industry experts across global regions to assess potential credit spreads and found there is, indeed, a premium in Africa. For example, senior project finance debt in Africa (with a spread between 400 and 600 basis points) was priced in line with OECD market mezzanine debt (about 550-600 bps). African subordinated project finance debt ranged between 600 and 1000 bps, in spite of the low default rate Moody’s identified.

Research by South Africa-based asset management firm African Infrastructure Investment Managers shows that investments made in African infrastructure projects from construction through maturity (i.e., greenfield) are able to target dollar returns on the order of 20 per cent. Investments made once projects are operating (i.e., brownfield) offer dollar returns in the low-to-mid teens. It seems clear that with appropriately structured deals and adequate due diligence, investors can achieve strong risk-adjusted returns.

The impact imperative
The United Nations adopted the Sustainable Development Goals (SDGs) in 2015, which collectively seek to eradicate all forms of poverty by 2030. The SDGs commit all signatories to achieving sustainable development across economic, social and environmental dimensions; therefore, they are quite comprehensive in scope. Meeting them will be a global challenge requiring public, private and civil sector co-ordination. This is particularly true in southern Africa which, as a region, ranks lowest or near the bottom on most SDG indicators.

Poverty by region
Region % of population below international poverty line
Central Asia 10
Eastern Asia 1.8
Eastern Europe 0.1
Latin America and the Caribbean 4.5
Northern Africa 2.7
Northern America 0.9
Northern Europe 0.3
Oceania 9.4
South-East Asia 7.9
Southern Asia 14
Southern Europe 1.2
Sub-Saharan Africa 43.7
Western Asia 3.5
Western Europe 0
Source: https://unstats.un.org/sdgs/indicators/database/
Latest data available: 2013 (2012 for Oceania)

Using data from the G20’s Global Infrastructure Hub (GI Hub) database, we were able to quantify the infrastructure investment gap between current trends and what would be needed to achieve the SDGs for universal water, sanitation and electricity access. Through 2040, GI Hub figures indicated that $18 trillion above current baseline global investment figures would be needed to achieve the SDGs – or more than $700 billion a year. For the African continent, the gap was $3.3 trillion through 2040, or more than $132 billion a year. As public-sector spending on infrastructure has largely stalled since the GFC, and is unlikely to meaningfully increase, private-sector infrastructure investment will be essential for closing this investment gap.

Historically, private investment in African infrastructure has fallen far short of meeting needs in developing and frontier markets. Since 1995, private investment in core power and transportation infrastructure in Brazil and Turkey exceeded $300 billion and $115 billion, respectively. Compare that with $51 billion across the entire African continent over the last 25 years. Both the Brazilian and Turkish governments implemented legal and regulatory reforms reducing uncertainty and enhancing transparency for investors, to facilitate public-private partnerships. This shows what is possible for other emerging and frontier markets with appropriate political and institutional support.

Risk mitigation and blended finance

Infrastructure investment demands in Africa can best be met via direct project debt or equity stakes in greenfield, private markets opportunities, given the historical underinvestment in the continent and its fewer mature capital market structures overall. Such opportunities present unique risks and also may not fit neatly into an investor’s asset allocation structure. Most asset owners treat infrastructure as an inflation hedge prized for its stable yield profile – for example, revenue-generating brownfield assets – but African infrastructure tends to have a risk/return profile more aligned with growth-oriented opportunistic allocations, which typically make up small portions of asset owners’ infrastructure portfolios.

Recognising these challenges for institutional investors, DFIs such as the World Bank Group, African Development Bank and others offer risk-mitigation tools at both the project and fund levels. These include political risk insurance, guarantees, foreign exchange hedges and other instruments. The DFIs will also frequently offer long-term project financing to complement greenfield equity investors. Such blending of public and private capital can make otherwise unpalatable projects investable or enhance long-term, risk-adjusted returns. In addition, a number of Africa’s 54 countries have been actively developing the regulatory and legal frameworks necessary to facilitate increased private investment in infrastructure. South Africa’s Renewable Energy Independent Power Producer Programme (REIPP programme) stands as an example of an effective market intervention to advance the development of renewable energy projects in a country.

Opportunities for action

What can interested investors do to gain further exposure to – and comfort with – the risks and opportunities African infrastructure presents? Mercer’s report offers ideas for consideration and a few key recommendations for asset owners to investigate follow:

Collaborative investing: ‘Club’ deals are used successfully by Danish asset owners. They establish syndication protocols in which one investor leads underwriting of a fund or co-investment for a group of typically smaller investors, which make voluntary investments of their own. Such an approach can streamline due diligence and lower costs that one institution would otherwise have to bear alone.

Engaging local investors: One American asset owner Mercer interviewed indicated that the best form of risk mitigation was co-investing alongside a local institution, due to the inherent alignment of interests with local governments and stakeholders this afforded. Organisations such as MiDA aim to facilitate such interconnections among investors.

DFI investment partnerships: DFIs have great expertise at investing in Africa and other emerging and frontier markets. They can partner with private investors in a number of ways: as the anchor limited partner in a fund, as the GP for a fund or as the lead in a project co-investment platform. DFIs are often seen as ‘honest brokers’ driven to advance development impacts first and foremost, rather than to realise commercial gains, and often have other outstanding financial arrangements with countries; thus they can influence local stakeholders to protect investors’ interests in case of disputes.

While investing in Africa is not a decision to be taken lightly nor one investors can simply jump into without adequate research and due diligence, Mercer believes the positive development effects and potential risk-adjusted returns present compelling reasons for investors to devote resources to investigating opportunities on the African continent.

Max Messervy is senior responsible investment consultant at Mercer.