USS targets steady returns with KCom investment

KCom, previously one of the highest-valued UK companies during the dotcom bubble, remains a near-monopoly provider of internet services in Hull and East Yorkshire, a region not covered by BT’s network.

USS will pay 97p-a-share to take the company private, representing a 33.8 per cent premium on its share price prior to announcement. The company’s two largest shareholders, representing a quarter of the shares, agreed to back the deal.

In the background, the joint expert panel appointed to scrutinise USS’s 2017 valuation continues to investigate its underpinning methodology. The 2017 valuation initially recommended a radical derisking strategy after finding a £7.5bn funding deficit, but this was identified as “fundamentally flawed” and revised down to £3.6bn.

The first part of the report, released in September 2018, “highlighted a number of issues arising out of the methodology” of valuations. The second part of the report could be released as early as the end of May, according to the JEP.

The KCom investment is unlikely to provoke unrest among the University and College Union. It falls in line with USS’s longer-term strategy, showing no signs of shifting to a radical derisking approach that saw the plan’s members – among them Oxbridge dons and university professors – join picket lines in protest.

But the investment does raise other questions relating to governance, risk and returns.

You need a hefty investment to get the benefits of infrastructure investments of this sort

Steve Balmont, Bestrustees

Schemes move to cut out middle men

Becoming a direct investor can deliver greater returns, lower fees and more hands-on control for pension schemes.

Over the past decade, USS has increased its private markets allocation to 26 per cent from 8 per cent, of which 59 per cent is directly managed by an internal team of 38 people.

“We look for investments slightly different from what the bulk of our competitors are looking at,” says Roger Gray, chief investment officer at USS Investment Management.

Despite offering less liquidity, private market assets “provide access to industries and return streams that are difficult to access via public markets”, he says.

USS manages a 60 per cent stake in motorway services operator Moto (2015), a 10.9 per cent stake in Thames Water (2017), and an 8.7 per cent stake in Heathrow Airport (2013).

These hybrid infrastructure investments are attractive for a number of reasons. “They all fit in the regulated asset [area]. They are UK-based, inflation-linked, long-term equity investments,” says Mr Gray.

KCom, with elements of infrastructure, consumer and business-services, largely fits into USS’s long-term strategy. That is, as Mr Gray puts it, “gradually derisking” while achieving steady returns.

Governing risk effectively

But becoming a direct investor of an infrastructure company like KCom presents USS with unique governance challenges.

Whereas institutional investors that invest through funds are typically once removed from the assets, here they are directly in the line of fire

Unlike schemes that invest in pooled funds, direct investors have nowhere to hide. Anish Butani, director in the private markets practice at bfinance, says: “I think the big issue is around governance and oversight. Whereas institutional investors that invest through funds are typically once removed from the assets, here they are directly in the line of fire.”

As a direct investor, USS will ultimately be held accountable for everything – the quality of service KCom provides, liaising with stakeholders and local communities, staffing and management considerations.

Shouldering this greater responsibility brings the potential for value creation, but also means greater risk. “There is potential for headline risk. This is where the rubber hits the road as far as managing the assets is concerned,” says Mr Butani.

Moto, for instance, has elements of retail, property and infrastructure. Being a direct investor is “certainly a learning curve”, says Mr Gray.

Tight and effective governing structures will be necessary to ensure KCom is operated with as little risk as possible. In particular, dealing with consumers will present challenges. “Not to belittle USS, who are clearly a very sophisticated investor and know what they’re doing, but you are taking consumer risk as well with this kind of business,” says Mr Butani.

What remedies are available to pension schemes that invest directly? USS must be prepared to be an active investor to effectively manage risk.

Steve Balmont, trustee executive at Bestrustees, says: “If you look at other organisations that have made similar investments – such as the Ontario Teachers’ Pension Plan – you’ll find they are very active managers when it comes to governance.”

Whatever direction they take with KCom, USS will have a lot more work on their plate.

The KCom takeover remains largely consistent with USS’s long-term strategy, from its £330m private rental sector investment in Places for People in 2018, to upping its stake to 33.3 per cent in Spanish gas distributor Redixis Gas.

Prospects for growth and returns are potentially high, but USS must be prepared to inject capital into the struggling telecoms business to chase returns.

“You need a hefty investment to get the benefits of infrastructure investments of this sort,” says Mr Balmont.

But KCom stands atop a strong foundation for future expansion. A near monopoly player providing internet services to 140,000 consumers and businesses in Hull and East Yorkshire, and boasting large public sector contracts for technology solutions, USS is in a good position to explore growth.

“If we look at the infrastructure characteristics of this business, it’s got a sticky customer base, it’s got effectively a monopoly position, it serves large enterprise and public sector organisations,” says Mr Butani.,“An investment such as KCom could be very interesting.”