Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
‘Red ink pouring on the page’: Nation-building, Black Swans and the ‘Texan mentality’
Renewable infrastructure manager Quinbrook is fresh from the $1.55 billion sale of wind power company Scout to Brookfield, which it bought for $6 million in 2017 and deployed another $470 million of funding into. It’s a big win by any measure – but even bigger for Quinbrook having weathered the Texas deep freeze of early 2021 to deliver it.
“It was probably the single biggest challenge,” says Quinbrook co-founder and managing director David Scaysbrook. “For those that had windfarms in Texas, navigating that and coming out the other side of that was not a small challenge. We were possibly the only fund manager with wind farms in Texas that came out unscathed.”
The Lone Star State – the only state, a popular myth holds, that still has the right to secede – is also an island from a power regulation perspective, a deliberate effort to limit cross-border trade. The off-take arrangements in Texas take the form of financial derivatives – contracts for difference rather than physical power purchase agreements, similar to Australia.
As temperatures dropped, turbines and gas pipes froze to the point where half of the Texas power system was inoperable for five days. Wind projects that couldn’t operate couldn’t satisfy their delivery obligations under their contracts for difference, meaning they were unable to generate revenue while being exposed to the Electric Reliability Council of Texas (ERCOT) price rising as high as $9000 a megawatt hour – an “obscene multiple” of the traded value, which is normally $40. It didn’t take long to lose $100 million. Within that five days, most wind projects lost all the equity invested in them.
Quinbrook didn’t, owing to “a pretty smart legal strategy and a pretty smart commercial strategy”; it had elements in its derivatives that were different to norm, with components of weather insurance. There was a legal defence open to them that they exploited aggressively to bring the counter-party to the table for a mutual resolution that enabled it to restructure its contracts.
“That took us about four months. We did nothing else. We had 120 people working the problem for four months, 24/7. We managed to get out the other side with our investors’ value intact,” Scaysbrook says.
“As I was sitting there watching the millions tick over and the red ink just pouring all over the page, it didn’t seem like the resolution we achieved was remotely possible. But at the end of the day, that’s why you get paid your management fees. Not just for when things are going well – that’s easy – but how you dig yourself out of a hole when some of these existential events happen that you can’t predict.”
If institutional investors learn anything from the Texas deep freeze, it’s that the inconceivable is now conceivable; the extreme outcomes from weather events are more frequent and more severe.
“Generally speaking, the context in which we operate our assets is becoming riskier: oil, geopolitical embargo, war, extreme weather,” Scaysbrook says. “There has to be some risk compensation in all of that. From an equity sponsor point of view, it’s a pretty topical point when you’ve got a lot of new money rushing into a sector which is now becoming undercompensated from a risk point of view.
“They want to treat Texas as an isolated, black swan event that’s never going to happen again. Well, look what’s going on in the UK with gas prices and the upcoming winter; the strategic shut-off essential services; the potential sabotage of international gas pipelines. All of these unthinkable events need to be brough into the paradigm of your risk/reward equation when you’re investing at scale.”
Nation-building and other dreams
For a long time, super funds have “talked a really good game” on nation-building infrastructure projects; but on any analysis, Scaysbrook says, super funds are under-allocated to renewables compared to their global peers and too fee sensitive to pay for top managers (though not for no reason; fees are a key component of APRA’s peer comparisons and the Your Future Your Super test, where cutting them is one of the fool-proof methods for passing).
“There’s an opportunity in Australia, for the first time in a long time with the Albanese government coming to power, where you can genuinely turn your allocation guns on the local market,” Scaysbrook says. “There wasn’t really a lot to do in Australia for quite some time. You’ve now got no excuse, because the local market is going to open up. You’ve got funds coming to Australia from offshore. They’re going to compete aggressively against the local super funds for projects and for deals.”
“Australia has now gone onto the radar of the world’s biggest infrastructure fund managers… This next couple of years will be the real test of whether our super funds do change and become proactive in allocating capital to climate focused infrastructure. The money will come regardless and the investments will be made. There’s no question about that. The question will be how much of that gets taken up by our local institutions and how much of it gets invested by offshore institutions.”
Still, YFYS is a “healthy reform” that has exposed superannuation rent-seekers who were previously getting away with subpar performance, Scaysbrook says. But like all things, the devil is in the detail. The non-discriminatory nature of benchmarking means that higher returning strategies with higher fee structures than passive equities are penalised, and it’s difficult for a trustee board to make a decision that makes them look expensive.
But on other fronts, trustee boards are ahead of the curve. They’re no longer “buying the greenwashing bullshit in their equities allocations” and looking for positive impact in unlisted infrastructure instead.
“We are seeing that the genuine, increasingly authentic commitment to impact and positive additionality in ESG metrics attached to the allocation of capital for unlisted infrastructure strategies,” Scaysbrook says. “That’s so critical to driving capital to areas where we can build new stuff. That’s really what we need if we’re going to do anything towards the ambition of the resolution of climate change and the reduction of carbon emissions.”
