The emergence of infrastructure debt

This article was sponsored by Schroders

How has institutional appetite for infrastructure debt developed over time?

Appetite from the life insurance companies has always been very high. They were attracted by the liability matching investments. But the asset class offers other benefits as well, from credit diversification to superior returns, and while insurance companies remain very active, the range of investors taking part has evolved.

How has infrastructure debt evolved as a distinct asset class over the past decade?
The rise of infrastructure debt is part of a wider financial disintermediation that began in the US 10 years ago. Infrastructure debt in Europe, meanwhile, was really born in 2012 from a combination of low interest rates, changes in banking regulations and the political will to revive the European economy through a major works programme. It was first and foremost insurers, and in particular life insurers, which – encouraged by the political establishment – set up investment teams as alternative financing solutions to the banks.

These financings were primarily long-dated and linked to greenfield project financings, typically PPPs. They were offered at a fixed rate with protection mechanisms in the event of early repayment, frequently with an external rating. Today, however, infrastructure financing is not just about projects. Infrastructure debt has diversified into more traditional private debt investments – shorter-dated and unrated. The market is expanding rapidly and even if bank financing still dominates globally, direct lending now accounts for nearly 20 percent of infrastructure financing.

How have competitive dynamics in this space changed over the course of the past decade?

Infrastructure debt is really three separate asset classes in one. First, we have long-dated infrastructure debt. Capital inflows there have been massive, particularly following regulatory changes. The introduction of Solvency II and the reduced capital charge on infrastructure financing had a significant effect and, as a result, the attractions of these long-term financings have become more questionable.

Then you have shorter-term financings. Here, returns on infrastructure private debt remain very stable at 200-250bps above base rate. This is primarily due to the fact that banks are still dominant, while they have left the long-term market. Banks have remained disciplined in pricing assets according to underlying risks.

This shorter end of the credit curve offers higher relative value as a result, but also more diversity in portfolio construction. In this space, we see a combination of a small number of insurance companies investing directly, the banks and also infrastructure debt funds. But competition is still relatively low because the market is huge. There is room for everyone. The third distinct component of the infrastructure debt market involves junior debt. There are almost no banks and no insurance companies operating in this space. It is only the debt funds and, again, competition remains limited.

Speaking of junior debt, how has the arrival of this newer product impacted the market?

Junior debt is not that new. We made our first subordinated loan in 2014. But this segment has developed rapidly over the past two years in conjunction with the abundance of capital we have seen targeting long-term maturities, and also the abundance of capital available for equity investment.

In the first instance, borrowers leverage the regulatory bias associated with long-term financing by ‘tranching’ existing debt and refinancing it with two instruments: a long-dated, fixed rate, externally rated product that is priced aggressively, and on top of that, a shorter subordinated instrument that is more juicy. All-in, the cost of capital is optimised.

In the second instance, competition between equity providers forces them to be more creative in the way they structure acquisitions, and junior debt is frequently used to extract the value that will make the bid a winning offer. We also qualify senior debt related to value-add investment as junior because the underlying risk is materially different to traditional infrastructure debt.

These drivers that were behind the emergence of junior debt are not going to disappear. In fact, we believe that this product will become mainstream. This is a form of private debt that yields more than other debt, without being mezzanine, and with low underlying risk.

What other innovations have you seen?

The infrastructure debt market is still maturing and we will see many more innovative propositions in the future. We recently observed global offerings with infrastructure debt denominated in different currencies. This is a very different value proposition as infrastructure risk is not yet the same in the US, in the UK or in continental Europe, and currency risk is difficult to hedge.

We are also looking at emerging market infrastructure debt as investments in these markets involve essential infrastructure assets, such as water or electricity, which will have a strong social impact and the sources of financing are highly limited.

In what way has the asset class evolved differently in different geographies?

Infrastructure debt in the US is a more mature market where direct financing from institutional investors through ‘US PP’ is becoming the norm. The market is dominated by energy assets, exposed directly or indirectly to merchant risks, however. Most of these assets would not qualify as infrastructure in Europe and, for us, the market is less attractive because there is less diversity.

We are living through a period of political upheaval. What impact are phenomena such as Brexit likely to have on infrastructure debt?

Political risk is the most important risk to which infrastructure investors are exposed. There are those that have claimed that infrastructure is a no-risk asset class. We have always said this is untrue and current market conditions reveal that we were right.

Risk can be mitigated through a disciplined credit analysis, investment selection and portfolio construction to avoid any correlation between assets.

Fund structuring is also essential. We have designed euro-denominated funds with euro-denominated assets, and sterling-denominated funds with sterling-denominated assets. This reduces the risk of fallout from FX movement, as well as any potential regulatory impact.

As we near the top of another cycle, what does the future hold for infrastructure debt?

As we near the top of the cycle, any reasonable investor will be looking at a more defensive approach. That will mean looking at core infrastructure and shifting to debt as opposed to equity.

Infrastructure debt also offers more protection to investors compared to any other private debt investments. The underlying assets are essential to the population and strict financial covenants help identify any problem before a default event occurs. The extensive security package also improves recovery in the event of default.

I would add that lenders have remained far more disciplined than in previous market peaks. The future of infrastructure debt is bright.

Charles Dupont joined Schroders in 2015 as head of infrastructure finance to build a specialised investment platform in Paris that has raised and invested €2.3 billion from institutional investors in Europe and Asia