AXA IM – Real Assets on why it pays to be picky

This article is sponsored by AXA IM – Real Assets

Why is infrastructure an attractive asset class for investors?

Infrastructure investment involves real assets – tangible, concrete projects. Furthermore, we are mobilising funds to finance services that are essential to society. That means we have a heightened ability to forecast cashflows. It also means those services will be needed in good times and bad, supporting the asset class’s resilience. They are highly decorrelated to movements in GDP and therefore provide attractive diversification from a portfolio construction perspective.

A major component of what we do, meanwhile, involves financing ESG-compliant projects. We have the ability to focus on renewables or energy efficiency, or any number of sectors that have an overall positive impact. As an example, when you are financing a new motorway, you are, in fact, taking traffic away from old roads and putting it on bigger and better managed new roads. Even though you may have to cut down some trees to get there, you can achieve a net positive impact.

And why infrastructure debt, in particular?
At AXA IM – Real Assets, we focus specifically on private infrastructure debt. We are not looking at companies that have huge programmes of public debt. Private infrastructure debt involves illiquid instruments. That means we can capture an illiquidity premium when compared to the public markets.

Many investors in infrastructure debt have very long-term investment horizons – pension funds and insurance companies, for example. Infrastructure debt offers maturities of 10, 20 or even 30 years – although we primarily focus on maturities of 10 to 15 years. It is hard to find maturities of those levels in the public markets, outside of government bonds.
In short, then, infrastructure debt delivers diversification, decorrelation to GDP, an illiquidity premium, longer-term stable income-driven returns and the ability to target investments that can have a positive impact on society and on the environment. That is a highly attractive proposition.

Where do you see the most exciting opportunities in terms of geography and sector?
Our focus is on Europe. The reason being that all the sectors that you would define as infrastructure – be that water, transportation, telecoms or renewables – are open to being financed privately. That is very different to the US, for example, where the bulk of the infrastructure market involves energy, because most of the transportation assets are financing themselves through the muni bond market.

We therefore consider Europe to offer a wide breadth of exciting opportunities. That said, you always have to be very careful in terms of selection. You have to look at how transactions are structured, who the sponsors are and what the business model underpinning the credit is. It is very much a bottom up approach.

In terms of which sectors we see as particularly interesting right now, I would point to the telecommunications industry and in particular to financing the rollout of fibre optic networks. There are some very compelling business models emerging there.

In terms of geography, we are open to investment opportunities everywhere. It is really a matter of relative value. Of course, we like France, the Netherlands and the Nordics. We are also looking at the UK, albeit with some caution. Hopefully the political backdrop will stabilise and more clarity will emerge about how things are going to evolve.

“It isn’t a feeding frenzy where pricing has tightened so much that you can’t execute. You just need to be careful”

What is your approach to origination and deal selection?
We believe that, thanks to our track record and our ability to mobilise significant amounts of liquidity, people are very interested in working with us. That means we are approached on a regular basis by advisers, borrowers and banks to see how we can work together. But once again, the key here is asset selection. We carefully analyse every opportunity. Sometimes it doesn’t take long to realise something is not going to work. Sometimes you need to spend a little more time. Sometimes you need to spend an awful lot of time if the situation is complex.

We review many opportunities every year, but only bring between 10 and 15 deals to our investment committee per annum. It is a very thorough selection process and transactions have to meet highly stringent criteria in terms of relative value, structuring, sectors and ESG before they pass the threshold to be brought forward for investment committee review.

Where in the capital structure do you focus?
Our focus is on senior secured debt at both an opco and holdco level. We don’t do mezzanine or junior debt. We don’t mind being structurally subordinated, but we want to be senior secured at the level of the borrower.

How would you describe competitive dynamics and pricing, and the subsequent impact on returns?
I have always operated in a competitive environment. Yes, you have pressure on spreads. But Solvency II’s recognition of the specific characteristics of infrastructure debt means investors can generate savings in terms of regulatory capital. That means transactions that are deemed Solvency II-compliant are all structured in the same way. For this reason, we haven’t really seen transactions that are covenant-lite or too aggressive, and so pricing as the variable of adjustment has tightened. That said, even though margins are coming inwards, there are still opportunities for quality transactions.

Relative value still exists, but it is important to exercise caution. There are many transactions that we have declined because pricing went away from us. So yes, there is healthy competition, but although the institutional investor base is gaining market share at the expense of the banks, the overall market is getting bigger. It isn’t a feeding frenzy where pricing has tightened so much that you can’t execute. You just need to be careful.

What other changes are you seeing in terms of the way deals are being structured?
The good thing about our platform is that we are not in the position of having to deploy capital at any cost. Sometimes you need to hang back because the market conditions aren’t right, or pricing is too aggressive. We can afford to sit it out and wait for things to improve. We maintain very high underwriting standards and therefore will not compromise on terms.

What is important, in terms of transaction structures, is understanding why things are structured in a particular way. There has to be a strong rationale behind it. That could be regulatory changes or capex programmes, for example, but there must be objective justification for why a repayment profile has been sculpted in a particular way. What we don’t like is being presented with a case and when we ask the question “why”, the answer is, “because we can”.

What role do environmental, social and governance issues play in infrastructure debt and what is your approach?
It is important to look at every environmental aspect relating to a project, and to that end we have developed an internal methodology. When it comes to the social and governance elements of ESG, it can be more difficult to establish a clear set of criteria for infrastructure debt, but we certainly look very closely at sponsors’ policies, as well as the overall sector and whether or not it has a positive impact.

When it comes to governance, we look at sponsors’ governance policies which are generated at a group or fund level. We also look at the geopolitical environment. Some countries are more proactive than others when it comes to ESG and climate change.

Finally, we look at how many of the 17 UN Sustainable Development Goals a project will meet. An investment in a water project, for example, is likely to contribute towards sanitation and health objectives.

How is infrastructure debt positioned if and when the economic cycle turns?
Top of the market behaviour is more of an issue for infrastructure equity. It is fair to say, if you look at mergers and acquisitions transactions, that the multiples being talked about are pretty high. We, however, focus on senior secured debt, and primarily investment grade senior secured debt. Only so much debt on any given asset can be investment grade, based on underlying cashflows.

In that sense, it doesn’t matter if the asset trades at 20 or even 30 times EBITDA – the investment-grade senior secured debt may be capped at five times EBITDA. The underwriting standards for senior secured investment-grade debt have continued to be strong – unlike in the leveraged finance market, for example, where we are increasingly seeing covenant-lite structures, and leverage going up. We just haven’t experienced that in the infrastructure debt space.

What does the future hold for infrastructure debt?
It is a market that will experience a great deal more growth. It has established its place as a credible and dependable source of liquidity, which means that more money will continue to be committed to the asset class. Meanwhile, structures will increasingly evolve to meet the precise needs of the different subsectors within infrastructure. It remains to be seen whether pricing will widen or tighten, but I am confident about the ability of the infrastructure debt market to grow.

Meeting borrower needs
How would you describe investor appetite for infrastructure debt and is it changing?

We see significantly more interest coming from traditional institutional investors – so, insurance companies and pension funds that are looking for new ways to meet their distribution liabilities in the current depressed interest rate environment. Other types of investors – sovereign wealth funds, for example – may be less inclined towards senior debt because the returns can be relatively tight. In terms of geography, there has been an increase in interest from Japanese investors in European infrastructure. US investors are also looking at this market carefully because of the favourable exchange rate.

Indeed, institutional investor participation in infrastructure debt has increased dramatically, altogether. If you look back 10 or 15 years, there was very little involvement, but the relative share of institutional financing has grown significantly and continues to grow. Banks have retreated to a large extent and that gap has been filled by institutions. We believe there is no turning back to a bank-led market. Over the past six or seven years, the institutional investor base has demonstrated an ability to meet borrowers’ criteria and has proven to be a highly dependable and trusted source of liquidity.