Infrastructure Debt: five years on

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07 Dec 2017

This article is an opinion piece written by Kit Hamilton a Managing Director for Macquarie Infrastructure Debt Investment Solutions (MIDIS). It was first published in Private Debt Investor (PDI) Magazine.

In 2012, Europe was entering an unprecedentedly low interest rate environment and a prolonged era of loose monetary policy, where over-supply in the corporate bond market soon suppressed returns and made the search for yield among fixed income investors even harder.

The changing regulatory environment also created an opportunity for institutional investors. For example, Basel III regulation required banks to hold significantly more capital against both their longer term and lower rated assets, meaning that opportunities opened up for more flexible institutional investors - who were able to lend to borrowers who were previously well served by banks.

Simultaneously, the demand from governments in developed geographies to spur economic growth through increased infrastructure spending – sourced from both public and private capital – created a timely supply-demand dynamic: pension funds and insurers sought to match long-term liabilities that often extend beyond the term of the majority of fixed income assets, whilst infrastructure borrowers required a flexible debt financing solution to rollout new projects and refinance existing ones. 

Fast-forward to 2017, infrastructure debt has cemented itself as an alternative private debt strategy in its own right. It has proven its ability to consistently generate superior credit spreads of around 100bps over comparable corporate bonds, thanks to a complexity premium which arises due to the length of time it takes to structure an infrastructure debt transaction and the specialist knowledge it needs to undertake the credit analysis of the borrower.

It is now a staple tool for portfolio diversification that provides superior risk-adjusted returns over the long-term, but how has institutional appetite for the asset class evolved?

In a similar way to the commoditisation of the real estate debt market, there is a temptation to bucket infrastructure as one homogenous term. But not all infrastructure projects have similar risks, and investing across a range of infrastructure subsectors (e.g. transport, economic and renewables sectors) has provided an opportunity for enhanced diversification within the asset class.

Institutions are now increasingly comfortable investing across the risk-return spectrum, incorporating non-investment grade infrastructure debt assets into their portfolios. Whilst these assets were traditionally the preserve of short-term bank lenders, more flexible institutional investors are recognising that these higher returning assets have a substantially lower expected loss on default1 compared to corporate bonds of a similar credit rating. This is due to the fact that (in common with investment grade infrastructure debt) they tend to have lender protections built into the loan documentation such as cashflow covenants, restrictions on business activities and security over the underlying asset(s).

Consistent with five years ago, infrastructure borrowers tend to favour a more transparent and consultative relationship, whereby they have a bilateral relationship with the lender. This comes about because, often, the only way to deliver the tailored solution required by the borrower is to have a bilateral relationship with the lender. Additionally, should there be a need to renegotiate any terms of the loan, the borrower is able to propose amendments with an infrastructure expert who understand their business and is there for the long term.

The divergence from where we were in 2012 is that this bilateral relationship tends to be with an asset manager rather than a bank. This raises an interesting question as to why institutional investors don’t just lend direct to infrastructure projects?

Whilst some of the larger investors do invest directly, many have experienced difficulty in deploying capital into high quality transactions, due to the fact that they don’t have large teams of infrastructure specialists with longstanding relationships in the market.

Infrastructure debt’s first five years has been a period of rapid evolution, where it now occupies a significant percentage of portfolio allocation amongst most European institutions. Institutions are now set up to invest through the credit cycle, as the supply of investible infrastructure projects opens up to match the institutional demand for long-term, low-risk, diversified and competitive yield.

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