BNP Paribas on the evolving role of infrastructure debt

As the asset class matures, investors are seeking greater customisation, says Karen Azoulay, head of infrastructure debt at BNP Paribas Asset Management

This article is sponsored by BNP Paribas Asset Management

Karen Azoulay

Private debt seems to be gaining momentum in the market and moving more into the mainstream in terms of allocation – have you experience or recent evidence of this?

Infrastructure funds are raising much more capital, still driven partly by the low interest rate environment. For example, capital raised for European infrastructure funds in 2021 totalled about $70 billion, up from about $42 billion in 2020 and from around $45 billion in 2019, according to Preqin. As the infrastructure debt asset class matures, we’re now seeing second and third generations of funds in the space.

We’re also seeing some large investors now looking for customised solutions to deploy their increasing allocation into private debt. So, they are looking, for example, for dedicated mandates or separate accounts where they can define specific return targets or objectives, and certain sectors or geographies. We are also witnessing a rise in co-investment alongside investment in flagship funds. Meanwhile, smaller investors tend to seek diversification by investing in commingled funds.

How do you evaluate private debt investment opportunities? What key elements do you look for?

For private debt investments, we are selling relative value to our investors, so the objective is really to target the best risk-return profile while offering an illiquidity premium on top of diversification. We choose transactions offering an attractive relative value with an acceptable credit risk profile, and the illiquidity premium.

Infrastructure debt is characterised by stable and predictable cashflow, which enables us to offer regular distributions to our investors, and that’s the case for both senior and junior debt. Usually, our investors who are investing in junior debt want to diversify from equities in their alternative investment buckets. So having no J-curve is a plus.

We also have ESG impacts fully embedded in our investment process, because ESG factors may impact long-term performance.

Being part of the Private Debt and Real Asset platform in which we have professionals coming in from leveraged finance, SME lending, real estate and of course infrastructure debt, we can share our ideas when structuring transactions, incorporating features from other asset classes we see currently on the market.

It’s also quite important to access industry knowledge to keep strong fundamentals in place when investing in new emerging sectors. It’s a great advantage to be part of BNP Paribas Group and to leverage our internal resources for ESG, but also because we can discuss those new sectors – a new theme such as hydrogen or green mobility within the group, for example.

What do you think is driving interest in junior debt?

Investors find junior infrastructure debt attractive as it provides higher absolute yields than senior debt, while generating more regular cash income and being less risky than infrastructure equity. Investors in the junior debt space can have access to regular coupons and other benefits of an infrastructure debt investment. Infrastructure assets are essential assets, with a high-barrier-to-entry, and they produce predictable cashflows.

The sharp expansion of the investment universe from infrastructure equity players and the increasing price paid for infrastructure assets is creating growing opportunities for junior debt, with issuers keen to add an additional layer on top of traditional senior debt to finance their acquisition or to raise HoldCo subordinated debt to support their portfolio expansion in renewables.

We are also observing a convergence between corporate debt, and infra debt, with assets bearing corporate and infra features, sometimes with a financing structure for both types of ratios. This trend definitely drives new opportunities for high yield infra financing.

We have been active in the junior debt market for three years, and at the end of 2021, we launched our first commingled fund in junior debt. During that period, we have seen the exponential demand for junior debt, and it allows us to position our junior debt strategy in the BB rated area where we see the greatest market depth.

What infrastructure financing opportunities do you see in the expanding energy transition sector?

We are seeing new opportunities emerging from the energy transition, it has been a very strong focus in our market in particular after the pandemic. The European Union goals of decarbonisation and to be climate neutral by 2050 are driving investment decisions. Also, the EU’s Sustainable Finance Disclosure Regulation (SFDR) enacted in 2021 requires investment funds to disclose their sustainability characteristics, which will help steer capital into the transition to renewable energy.

Along with the decarbonisation of utilities indicating large investments to phase-out from conventional energy, we will see a lot of renewable energy infrastructure constructed in the next few years. For example, in the EU, renewable energy is to increase to the very ambitious target of representing 40 percent of energy consumption by 2030, compared with 20 percent today. So, we will continue to see a lot of investment in traditional solar and wind farms across Europe, as well as the development of biogas and clean hydrogen electrolysers.

As part of the decarbonisation, transportation will also play a big role with electrification, mobility as a service and with hydrogen as a fuel to replace traditional vehicles. Electric vehicle charging stations, hydrogen fueling stations and battery factories may present opportunities for financing. What is also important is that we need to incorporate sustainability features into the design of new infrastructure and not only decarbonise existing assets. That’s really the key going forward.

What about social investing?

Social infrastructure is at the forefront of impact investing as it provides essential services to the benefit of the communities. There are massive investment needs in social infrastructure, as the sector faces many transformation and modernisation challenges. Coupled with limited public resources, this creates opportunities for the private sector in essential services infrastructure, such as healthcare or education assets, which offer key infrastructure characteristics such as resilient demand, supportive regulation and long-term predictable cashflows.

As a consequence, on the financing side, we observe a movement from pure public PPPs or fully private corporate financing to transactions sitting at the crossroads and fitting the long-term business view of infra equity owners, offering the possibility to capture early-mover premium.

A great testimony of our willingness to be a pioneer in the movement is our mandated lead arranger role in the acquisition financing of Finnish company Parmaco: it builds and leases high quality wood modular buildings for schools and daycare centres, providing highly flexible and ESG-friendly solutions for local municipalities. We expect to do more of this and see more opportunities in the coming months in the social infrastructure sector.

Can you expand on the growing opportunities in new technology, such as the 5G rollout?

We see an acceleration of opportunities in new technology and the multiplication of jumbo deals driven by the huge rollout of fibre across Europe. We also observe the multiplication of data centre infrastructure and the densification of telecom towers to cope with explosion of data usage and to serve the new 5G technology. There is also the emergence of new infrastructure linked to smart cities, electric vehicles or self-driving cars.

All are interesting investment opportunities, but they require dedicated people with a strong industry knowledge to understand the technology risk and the market trends. As part of the BNP Paribas group, we have access to a large number of industry professionals throughout the bank who can help select the best investments in new technology.

An increasing emphasis is put on ESG factors for digital infrastructure assets because digitalisation will play a key role in decarbonisation. For instance, you can use data analysis to make your infrastructure more efficient, or you can use smart meters to gain energy efficiency.

Market players put attention to the consumption of these digital assets with a growing number of large data centres powered by renewable energy. That is very important, as new data centres have more efficient energy consumption and cooling systems, limiting the environmental impact due to the greater connectivity and the huge increase in data use.

Finally, infrastructure debt showed impressive resilience during the pandemic; how can investors mitigate future risks in this asset class?

Some of the current market trends are definitely a consequence of the pandemic; there is a strong focus on social infrastructure such as healthcare. And other trends were already in transition before the pandemic, such as the decrease of the conventional transportation sector and the increase in transactions for infrastructure like electric vehicle charging platforms. At the same time, we’re seeing the telecom growth for the high-speed internet and related technology advances, expedited by the pandemic, so it’s quite diversified. The asset class is resilient as well because these are essential services.

The main consequence of the covid-19 crisis was that it confirmed the need to be very cautious on the financing structure. Even for transportation assets during the pandemic, we have seen resilience because the right financing structures were in place. It’s essential to ensure good financing ratios and build liquidity buffers in order to face downward cycles. For investors, it’s important to work with an asset manager that has the capability to really analyse the transaction and to set up an adequate financing structure.

What can infrastructure debt offer investors who demand more attention to ESG and socially responsible investing criteria?

We think infrastructure debt has a big role to play in promoting sustainable investing and ESG. Investors are also keener to see ESG criteria embedded into the investment process – it’s part and parcel of the selection process. For us, ESG is in the DNA of the BNP Paribas banking group, and as such, we have implemented very detailed ESG reporting. Within BNP Paribas Asset Management, ESG scoring is provided by our own in-house sustainability centre.

In addition, we use an external provider that provides quantitative analysis on every asset in terms of carbon footprint and alignment with a two-degree trajectory. That consultant scores the net environmental contribution of the asset and benchmarks it against its peers.

It’s really an ongoing discussion as we’re always trying to be on the forefront of ESG. We are discussing with our sustainability centre and with the bank how we can go a step beyond what we have implemented so far. So, we are now thinking about the next generation of funds both on the environmental and social side.