Edmond de Rothschild sees winners and losers emerge

Infrastructure debt is coming of age, says Jean-Francis Dusch of Edmond de Rothschild Asset Management.

This article is sponsored by Edmond de Rothschild Asset Management.

What role has regulation played in supporting the appetite for infrastructure debt?

Jean Francis Dusch
Jean-Francis Dusch

The Solvency II infrastructure definition, which was put together by the EU and the European Insurance and Occupational Pensions Authority, has certainly created a very friendly regulatory framework in terms of the solvency capital requirement levels that investors benefit from. A senior eligible debt portfolio can have SCR levels of less than 10 percent, which compares very favourably with non-eligible debt or equity instruments. That certainly makes the asset class attractive in terms of how we can be accounted for by investors.

What are the other favourable characteristics of a senior infrastructure debt product?
There is a diversified universe of deals available, predictable cashflows and assets are usually regulated. Of course, long-term liability matching is another feature. Senior debt continues, for effective asset managers, to generate attractive spreads relative to the risk profile. Strong asset managers are generating senior debt spreads above 200 basis points. We ourselves are giving investors spreads of around 240-250 bps.

And what about your junior debt offering?
Junior debt can also be attractive, although you are talking about more complex instruments. It is a less commoditised and intermediated space that offers asset managers with structuring skills, like us, the ability to shine. We are even more focused on how effective the covenants and security package that we negotiate are and, on the pricing, what we can achieve relative to the risk taken.

There are players out there with an equity background that can target 6-8 percent-plus for junior debt, but that might typically involve a little less credit discipline than our approach. We target BB internally rated credits, with a shorter duration than senior debt, but still with a great deal of structure, and we manage to generate credit spreads of around 500-plus bps across the portfolio. That is a very attractive risk/return profile, while keeping the key features of infrastructure assets.

How do you select the deals you ultimately choose to pursue?
First of all, you have to act as an asset manager. You have to understand that you work for your institutional clients, to which you are completely accountable. This is very different to working off a balance sheet. You have to be, among other things, highly credit disciplined.

Such discipline involves thorough due diligence, and investment managers need to know and understand what they are looking for. We have investment directors who worked for industrial sponsors. We believe understanding the technical rationale and integrity of an asset is the first level of security that you need. We also have people who have advised extensively in the public sector. This can prove important because it is one of the key parts of the infrastructure play – understanding how the regulators and granting authorities think is critical.

We have very strong structuring capabilities, by which I mean the ability to negotiate a debt instrument so that the final debt structure meets the mandate that you have from investors. That is crucial. As a consequence, we will rarely buy debt in the secondaries market.

We pursue a mix of landmark and proprietary deals. But it is vital for us to be able to structure the debt instrument, whatever the circumstances, and sourcing is therefore a priority. Sourcing means going directly to private equity sponsors, as well as industrial sponsors and operators, to ensure we have access to deals at the earliest stage and are able to influence terms and conditions from the outset.

“Senior debt continues, for effective asset managers, to generate attractive spreads relative to the risk profile”

What changes are you seeing, then, in terms of the way deals are being structured?
You know what? I don’t think I really see that much change if you are disciplined and experienced. For senior debt, in particular, there is a certain framework that needs to be met. I don’t think we are under any more pressure to accept looser covenants and take on more risk. If you are selective and a good negotiator, then very little has changed at all.

What we are applying is an even greater level of due diligence – whether that relates to a specific technical, market, tax or legal consideration, for example – because, for us, risk mitigation is key. We cannot afford a write-off in the portfolio. When we identify risk, we really need to be comfortable with the mitigant in place.

To what extent do you see environmental, social and governance criteria as a risk and what is your approach to mitigating that?
Since 2016, we have had an increased focus on the ESG-related aspects of transactions, both in terms of the investment process – how we assess transactions and undertake due diligence – but also on the monitoring of such aspects. We have made a quantum leap in this area and there is an increased recognition that ESG is incredibly important to investors.

We were one of the first debt funds to obtain an energy transition label – the Greenfin label – in early 2018. That has enabled us to progress significantly in terms of how we demonstrate the effects of good ESG practice.

One of the measures of impact we have chosen to focus on is carbon footprint. We are able, on an asset-by-asset basis, to convey the carbon footprint impact of every investment we make in any sector.

How would you describe competitive dynamics and pricing at the moment?
You could argue there has been a compression of spreads over the past few years across the sector – taking into account liquidity from banks. But I believe we have proved, through our track record of performance, that if you are highly selective, get involved in deals at an early stage and structure transactions without taking on any additional risk, it is possible to keep spreads for senior debt at 240-250 bps at a portfolio level, with spreads for our junior product, which was launched more recently, holding up at above 500 bps. A competitive environment gives you the opportunity to demonstrate your efficiency as an asset manager.

Infrastructure debt remains a nascent asset class for institutions and is unproven in a downturn. What implications could a change in the economic environment have for the industry?
It is difficult to say because, to a certain degree, infrastructure is much less correlated from economic cycles and political shocks than other asset classes. And the beauty of this particular asset class is that governments can seek to boost economic growth through infrastructure programmes, which creates recurrent opportunities for us.

I would point to the technological shift we are seeing and the deployment opportunities it is creating. We see technical advances within the energy transition space – be that battery storage, the production of batteries themselves or renewable technologies such as floating offshore wind. In the telecoms sector, 5G and fibre optic deployment are active. And then there is the interconnectivity of infrastructure, of which ‘smart’ cities are an example.

There is also a need for existing infrastructure to be upgraded or just simply maintained, so, for us, this is a stable asset class offering recurrent investment opportunities. And, at the end of the day, debt represents the lion’s share of the infrastructure assets’ capital structure. I don’t think it is a question of cycles, but of being able to capture the right opportunities and market trends at any point in time.

What challenges does infrastructure debt face in the current market?
I think the industry may face a consolidation process in terms of asset managers. You need scale to be a long-term player. We now have €2.6 billion of assets under management and that enables us to attract even more commitments. It also enables us to have a real impact as a debt provider and to capture the right opportunities in this broad universe.

Infrastructure debt has existed as an institutional asset class for six or seven years now. That means there are data for investors to compare asset managers, even for ESG considerations. So we are now at the stage where there may be winners and losers in the industry, and the winners will probably consolidate. That doesn’t necessarily mean acquiring other platforms, but simply capturing a greater share of the liquidity available in fundraising.

In what other ways do you expect the infrastructure debt industry to evolve?
Appetite for infrastructure debt will continue to grow. In terms of institutional appetite, you might argue that around 75 percent of liquidity is currently targeted at PE funds. But, in terms of infrastructure finance needs, one could argue that around 75 percent of it is debt.

This is now known as an attractive and growing asset class. The rationale for investment is well known to investors and many are now making the decision to carve out infrastructure debt allocations. I would not be surprised to see 2020 and 2021 as bumper fundraising years. That’s when we will find out who the winners are going to be.

Illustration skylineWhere do you see the most attractive sectors in Europe right now?

You have to be able to operate across all sectors. The reality is that trends can change very quickly depending on liquidity. Right now, for example, there is a rally in telecoms, and renewables remain strong. Social infrastructure is a little more competitive and spreads are tighter. However, it is still possible to identify one or two ‘juicy’ opportunities in a portfolio of 10-15 assets without taking additional risk.

For us, it is more about how you can quickly identify a sector or geography where you have an advantage, but then be prepared to move on to the next opportunity when competition becomes too intense. A good example would be Spanish solar. We were a first mover in that space back in 2016, really taking a view on the regulatory framework and how you could structure deals to mitigate any risk. But after six months of doing several interesting transactions, we saw our peers coming to the market. With this, sponsors were able to negotiate looser covenants and be a bit less generous on spreads. We were prepared and invested in other sectors and geographies while still capturing strong renewable assets.

And, as I say, 2019 was the year where telecoms came to represent a much bigger chunk of the infrastructure universe, while renewables are still a strong contender, particularly for asset managers like us that really believe in the energy transition.

Jean-Francis Dusch is global head of infrastructure and CIO of infrastructure debt at Edmond de Rothschild Asset Management