The senior infrastructure debt space had seen “clear pricing compression”, Andrew Jones, at the time AMP Capital’s global head of infrastructure debt, told us in last February’s Debt report.
He added that AMP Capital was targeting the subordinated debt space – specifically mezzanine – partly because there was a less crowded market environment.
That last bit is beginning to change. Infrastructure equity players are entering the credit space with a focus on junior and mezzanine debt at the same time as the more traditional infrastructure debt managers add higher-yielding, junior-debt options to their offering.
Indeed, of the infrastructure debt funds to close in 2020 – excluding separate accounts – approximately half targeted investments in the higher-yield space of subordinated junior and mezzanine debt, according to Infrastructure Investor data.
I Squared Capital is one of the more recent equity blue-chips to join this part of the market, receiving $800 million last September for a dedicated strategy targeting mezzanine investments. It is also thought to be in market with its first mezzanine fund.
When asked why I Squared decided to focus on mezzanine debt, Tom Murray, head of credit investments at the Miami-based GP, expresses similar concerns to Jones about the senior end of the spectrum.
“Equity have found a good use for these products and want more – supply is driving demand”
DIF Capital Partners
“Our strategy fills an important gap between common equity and plain vanilla syndicated credit,” he says, adding that competition in the senior debt space makes many deals unattractive for what I Squared is trying to bring to its LPs. Paul Nash, head of infrastructure debt at DIF Capital Partners, agrees junior debt is a less competitive market. Last year, the Dutch manager launched its maiden €1.1 billion debt strategy, which included a junior debt fund targeting €350 million.
However, he points to a more fundamental reason for the growth of such strategies.
“As the infrastructure sector matures, it is natural that shareholders will look to optimise the capital stack,” he says. “Historically, the products for this did not exist, as the banks, who are still the main lenders to this sector, were reluctant to provide products like junior debt as they really do not fit with their capital model.
“However, in recent years, institutional capital has found its way into the sector and this has changed. Equity have found a good use for these products and want more – supply is driving demand.”
Glenn Fox points to a mismatch in funding as another growth driver. Fox leads infrastructure debt investments at HSBC Global Asset Management, which last year launched its first infrastructure funds, targeting €750 million for senior debt and €750 million for higher-yielding investments. As he rightly points out, the capital raised by equity funds far outweighs that raised by debt vehicles.
A case in point: Infrastructure Investor’s top 15 debt managers raised $74.9 billion over the last five years, according to 2020’s ranking. The top 15 in our II 50 equity ranking have raised $384.3 billion over a similar period.
That creates an opportunity for fundraising growth and different products, especially in an asset class where investments are mostly funded by debt.
“Given the infrastructure debt funding opportunity is larger than for equity, there is ample room for deploying a variety of infrastructure debt strategies,” claims Fox.
Although managers differ on why the subordinated part of the market is growing so significantly, they are all clear on the benefits being reaped by LPs.
“Our infrastructure credit strategy is a natural extension of what we do on the equity side,” says Murray. “If equity is the deeper end of the pool, we are moving a little towards the shallower end where the risk and returns are lower, but equally attractive from a risk-adjusted perspective.”
With that in mind, some are questioning whether higher-yielding debt strategies are offering what core infrastructure equity funds used to be able to.
“Offering a fixed coupon and returns of 7-10 percent, could this space be the new core infrastructure?” asks Anish Butani, senior director of private markets at investment consultancy bfinance. “As core equity is being bid down and down, is the interesting white space higher-returning credit? I think we’re going to see this grow and grow.”
Nash espouses a similar view. DIF was one of the sector’s earliest equity fund managers and Nash remembers when LPs received significant upside from equity.
“The risk-adjusted returns on junior debt can be very good, in some cases better than equity,” he argues. “Some people complain it’s like equity risk without the upside, but in mature infrastructure assets, the upside for equity can be limited. And you can equally say it’s like equity returns without the downside.”
At the same time, junior and mezzanine debt is providing many of the same defensive characteristics displayed by senior infrastructure debt, which has demonstrated a track record of lower default rates and higher recovery rates.
A November report by Schroders on private credit stated: “Although junior infrastructure debt shares characteristics with high-yield bonds rated BB, losses are a fraction of those on high-yield bonds.”
As ever with infrastructure, one of the key drivers of the dynamics in this part of the market is regulation. Solvency II requirements mean that European insurers, for example, are far more likely than other types of investors to be investing in senior-debt strategies.
“This places certain constraints on the types of investments they can pursue,” says Fox. “Some investors can invest both in investment-grade assets as part of a liability-matching portfolio, and higher-yielding assets that can complement an allocation seeking equity-like returns.”
The sub-investment-grade space is receiving a boost as a wealth of Asian investors continue to explore ways to increase allocations to the asset class. “This is a very natural thing for Korean and Taiwanese insurers to do,” adds Butani. “In Korea, the cash-yield profile makes these products very attractive.”
What is not as clear for LPs is whether investments in these strategies represent more of an infrastructure equity play or a private credit investment. And this brings different questions for managers, depending on the LPs they sit in front of.
“If you’re explaining the product to equity investors, it is about what type of covenants and security you get in exchange for the lower returns,” Nash explains. “If you’re talking to fixed-income investors, you need to explain the much higher covenanting and lower expected losses compared with corporate debt.
“But either way, more and more LPs are seeing the benefits of the risk-adjusted returns in this space.”
Under the covid spotlight
The trend of infrastructure equity players broadening their horizons and lenders offering alternatives to senior debt was in place before covid-19 brought an additional layer of chaos to the world. However, much like the growth of renewables and digital infrastructure, while the core dynamics existed beforehand, the safety net of debt is certainly under the spotlight now.
“Covid has demonstrated that there is risk in infrastructure investments,” says Fox. “But almost all of the downside has been absorbed by equity in the form of lower revenues, higher costs and, in some cases, a need to inject additional capital.” That makes debt – and high-yield debt in particular – one to watch in 2021.