Nigeria Strategy Report H1 2017 (9) - Pension Reforms Set Sights On Infrastructure Investing

Thursday, January 19, 2017 03:48 PM / ARM Research 

Key Developments in Domestic Economic and Policy Environment  

In today’s cut-out from our core strategy document – the  Nigeria Strategy Report, we focus on developments in domestic pensions industry over H2 16 as well as delineate potential impact of new initiatives on the market over 2017.  

Despite prevailing economic headwinds which drove unemployment rate higher (+4pps to 13.8% in Q3 16) and delayed payments of RSA contributions to appropriate PFAs at the Federal and State levels, total pensions asset rose 17% YoY (2015: +11% YoY) to N6 trillion over 9M 2016. Specifically, the rise in the number of unemployed had stoked concerns over outflows from RSA accounts given the PENCOM provision which allows individuals who are out of work for a period of at least 4 months, to access 25% of their RSA contributions. The concerns notwithstanding, optimism was bolstered by subsisting increases in the number of compliance certificates issued by PENCOM which could cascade into new offsetting RSA inflows. 

Elsewhere, possibly reflecting concerns over the sustainability of currently elevated interest rates environment—in view of the recession-hit domestic economy—and recent clamour for a redirection of Nigeria’s pension resources to infrastructure upgrade, PENCOM released draft regulation on investment of pension funds in infrastructure in November 2016. Under the guidelines, PFAs can now invest up to 20% of accumulated pension assets in infrastructure (vs. 5% previously) split into investments in infrastructure bonds (75%) and infrastructure funds (25%). However, PENCOM noted that both instruments (infrastructure bonds and infrastructure funds) must demonstrably meet the conditions for investing pension funds in infrastructure before PFAs would be allowed to take advantage of the outlets. 

Our review of experiences across other markets suggest inherent problems with attaining the 20% target. First, in terms of deal flow, after a brisk pace in early 2000s, privatization of public enterprises has slowed on the back of strong resistance by labour unions and political interest groups which shrinks the amount of brownfield assets available for infrastructure investing. Secondly, the average lifespan for PPP projects is north of 20 years and given the lack of a deep and liquid non-sovereign naira yield curve, funding for such projects acts as a constraint. Added to all these, given the usual long gestation periods for infrastructure projects which is often characterized by constant litigations in environments where contractual agreements are often breached, Nigeria’s weak regulatory and legal institutions look set to remain a key setback to the new initiative. 

PFAs maintain FI “love story” as equities journey south

Despite prevailing economic headwinds which drove unemployment rate higher (+4pps to 13.8% in Q3 16) and delayed payments of RSA contributions to appropriate PFAs at the Federal and State levels, total pensions asset rose 17% YoY (2015: +11% YoY) to N6 trillion over 9M 2016. Specifically, the rise in number of unemployed (+21% to 16 million people by Q3 16) had stoked concerns over outflows from RSA accounts given the PENCOM provision which allows individuals who are out of work for a period of at least 4 months, to access 25% of their RSA contributions. The concerns notwithstanding, optimism was bolstered by subsisting increases in the number of compliance certificates issued by PENCOM (9M 16: +31% YoY to 3,619 vs. +27% YoY to 2,762 in 2015) which could cascade into new offsetting RSA inflows.   

Looking at the breakdowns of overall asset holdings, gains mirrored strong expansion in value of Fixed Income (FI) securities (+20% YoY N5.1 trillion) as well as tamer growth in Variable Income investments (3% YoY to N870 billion). Notably, PFAs stepped up their chase for higher yields (average fixed income yields over Q3 16: +127bps YoY to 15.98%) which boosted FGN (+26% YoY to N3.5 trillion) and corporate bonds assets (+99% YoY to N294 billion). 

Accordingly, FI share of pension assets climbed 202bps YoY to 85%. At the variable income end, gains across investments in real estates (+3% YoY), private equity (+73% YoY), and infrastructure funds (+67% YoY) more than offset weaknesses from declines in domestic equities (-3% YoY). Overall, given the scale of the inflationary spiral in 2016, gains in pension assets looked less promising in real terms.

Figure 1: PFA Asset Allocation

 

PENCOM unfurls guidelines for infrastructure investing

Possibly reflecting concerns over the sustainability of currently elevated interest rates environment—in view of the recession-hit domestic economy—and recent clamour for a redirection of Nigeria’s pension resources to infrastructure upgrade, PENCOM released draft regulation on investment of pension funds in infrastructure in November 2016. Under the guidelines, PFAs can now invest up to 20% of accumulated pension assets in infrastructure (vs. 5% previously) split into investments in infrastructure bonds (75%) and infrastructure funds (25%). However, PENCOM noted that both instruments (infrastructure bonds and infrastructure funds) must demonstrably meet the conditions for investing pension funds in infrastructure before PFAs would be allowed to take advantage of the outlets. 

Specifically, for infrastructure bonds, the underlying (single) infrastructure project must be worth at least N5 billion with the contract awarded to a concessionaire with strong record of accomplishment via a transparent bidding process. Beyond this, the target projects must be viewed as feasible as well as financially rewarding for interested PFAs with the bond also having clear credit enhancements in forms of FGN or bank/DFI guarantees and a maturity date that is before the termination of the concession.  

To protect investing PFAs against project suspensions, cancellations, and changes in policy decisions that could alter prior financial forecasts, PENCOM also recommended that the said infrastructure bonds have practicable redemption procedures. For infrastructure funds, the guidelines require that qualifying funds are expected to have clear exit windows via IPOs, sale to other PE Funds, trade sale, or sale to strategic investors. Furthermore, the requirements mandate PFAs only to invest in infrastructure funds managed by SEC registered fund managers. As with the underlying projects for infrastructure bonds, these funds are required to have a value of at least N5 billion, 60% of which must be invested in projects within Nigeria, with the pricing of its underlying assets available for disclosure alongside its carefully audited annual financial statements. In addition, in the event that the fund does not have development finance institutions or MDFOs as co-investors, it would be required to possess a minimum of BBB ratings from a SEC recognized rating agency as well as a minimum of 3% ownership stake in the business. 

Review of global trends throws up interesting insights

Globally, the idea of pension fund investment in infrastructure has gained grounds in recent years, as pension fund managers seek to expand their investment frontier beyond the traditional asset classes in a bid to diversify risk and return. Infrastructure investments meet this need for underlying cashflows stem from hard assets and display lower correlation with traditional asset classes which are increasingly interlinked across countries in today’s financial markets. In evaluating the feasibility of PENCOM’s claims, we examine trends across other regions starting with Australia and Canada, whose pension funds are pioneers in the deployment of pension assets into financing infrastructure projects. In Australia, where defined contribution schemes are prevalent1 as in Nigeria, average pension funds allocation to infrastructure has risen 

from 2% of AUM in the 1990s to 5-6% in 2013 and infrastructure funds are the dominant vehicle for pension fund exposure to infrastructure given lack of depth and liquidity of Australia’s corporate bond markets. On the supply side, limited influence of the central government in the provision of infrastructure assets has resulted in the broad adoption of the PPP approach towards provision of infrastructure. Furthermore, limited political opposition to privatization has ensured a steady flow of pipeline brownfield assets for infrastructure investments. Worthy of note is that Australian pension funds display a marked preference towards brownfield assets to limit risks from construction cost overruns and lower than forecast project cashflows in the future. In terms of fund performance, empirical research finds that pension funds with high exposure to alternative assets, comprising unlisted property, infrastructure, PE and hedge funds, outperformed those with lower exposure. 

On the other hand, pension funds in Canada, where defined benefit type schemes are dominant2, gain exposures to infrastructure largely via direct infrastructure equity (51%) and infrastructure bonds as Canada’s deeper debt markets allows these investment vehicles issue bonds (vs bank financing in Australia) to finance the construction of infrastructure projects. That said, in contrast to Australia, political opposition to privatization in Canada ensures that the deal flow pipeline for PPP type schemes in Canada is limited resulting in more participation in offshore infrastructure schemes than in Canada. Outside of these two countries, pension fund allocations to infrastructure hover between 2-3% across other developed climes. Across Africa, infrastructure investing remains in its infancy and, as with its developed market counterparts, is largely conducted via specialized funds. 

Figure 2: Pension fund allocation to infrastructure across countries (%) 

But familiar bottlenecks temper optimism

Our review of experiences across other markets suggest inherent problems with

attaining the 20% target. First, in terms of deal flow, after a brisk pace in early 2000s, privatization of public enterprises has slowed on the back of strong resistance by labour unions and political interest groups which shrinks the amount of brownfield assets3 available for infrastructure investing. For greenfield projects, fears of political backlash to tolling of public projects has resulted in FG and State Government’s adoption of multilateral funding arrangements in the provision of such projects. Though recent collapse in oil revenues and the scale of infrastructure needs render these approaches piecemeal, government remain unwilling in electing to gear national balance sheets as against adopting PPP vehicles towards providing infrastructure. 

Secondly, the average lifespan for PPP projects is north of 20 years and given the lack of a deep and liquid non-sovereign naira yield curve, funding for such projects acts as a constraint. In contrast to Australia, where infrastructure funds can raise bank financing or tap overseas bond markets, given relative currency stability, these options are unavailable for Nigerian infrastructure funds. Added to all these, given the usual long gestation periods for infrastructure projects which is often characterized by constant litigations in environments where contractual agreements are often breached, Nigeria’s weak regulatory and legal institutions look set to remain a key setback to the new initiative. 

Putting all of this together therefore, though laudable, PENCOM’s quest to achieve 20% asset allocation to infrastructure (40% by 2019) could pass as inordinately overambitious if the aforementioned concerns persist. In any case, even optimistically assuming that PENCOM manages to reach its lofty ambition which we feel could also have the potential to broaden investment frontiers beyond generic stocks and bonds investing as well as provide outlet into characteristically high inflation-hedged instruments, the scale of Nigeria’s infrastructure requirement ($100 billion/N30.5 trillion annually according to National Integrated Infrastructure Masterplan) renders the potential N1.2 trillion and FG’s planned 2017 capex of N2.3 trillion, cumulatively, at a sizable discount to actual needs.  

Culled from proshare