Keep calm and stay disciplined

    Risks are increasing as the late stage of the credit cycle hits and fund managers broaden their horizons. Here are the five main challenges.

    Seen as a resilient, predictable asset, infrastructure debt has grown in popularity among investors. But, as liquidity spreads in the asset class, fund managers are having a harder time capturing the right returns for their investments.

    “There is a disconnect between increased demand for infrastructure debt assets and its supply. The victim of that difference has been price,” John Mayhew, head of infrastructure debt at UK-based asset manager M&G, explains to Infrastructure Investor.

    As a result, the market is being slowly transformed: managers are starting to diversify their portfolios, looking for opportunities in new markets and sectors. At the same time, as more capital becomes available, managers warn about being trapped on the weaker side of negotiations with arrangers and issuers, with contract terms suffering as a result.

    Here are five trends market players should keep an eye on, as infrastructure debt enters a new stage.

    Moving up the risk curve
    As senior-debt returns fall, investors are starting to climb up the risk curve.

    “In some cases, you do see managers engaging in riskier strategies, such as mezzanine strategies, in order to capture higher returns,” says René Kassis, head of private debt at La Banque Postale Asset Management. “Some investors are responding positively to it,” he adds.

    As spreads keep tightening, expect more managers to be attracted to the riskier options available on the debt markets.

    Despite this, Kassis warns this strategy might not have optimal results: “The junior/mezzanine space is quite narrow, especially now that you find a lot of liquidity on both the senior debt and the equity markets. You might end up taking an equity-type risk for a credit-type return.”

    Junior debt is also not right  for every investor. As the UBS Asset Management head of infrastructure, Tommaso Albanese, explains in our keynote interview (see main issue, p. 16): “Subordinated debt has higher capital requirements. If you can structure something that is senior, giving you 4 percent [returns] with a 20 percent capital requirement – instead of 40 percent [for junior debt] – you get quite a nice risk-adjusted return.”

    Lighter covenants and terms
    The walls are starting to cave in, especially in core sectors or safer markets that are flooded with capital.

    “In the last 12 months, people have been trying to take away some credit protections that are fairly standard, such as reserves available for project financing, placing limitations on the amount of liquidity, or contingencies in the financial model during the construction or operation of the asset,” says Mayhew.

    Similarly, Asset Management One  Alternative Investments, a Tokyo-based fund manager raising its second infrastructure debt fund, also warns of a relaxation of standards among some arrangers.

    “Due to the high levels of liquidity, arrangers have been able to structure some so-called ‘covenant-lite’ projects, in which, for example, the threshold of certain ratios is lower,” explains Jack Wang, a fund manager at the firm, stressing that those deals fall out of their investment scope.

    Uncharted sectors
    As more players enter the market, fund managers are increasingly looking to finance emerging infrastructure sectors with little track record. “There are sectors which are still an equity play, because their business model has not stabilised yet, and the predictability of the cashflow is not there yet,” Kassis points out.

    The manager highlights certain areas of energy transition, such as the much-discussed energy storage space, as one of those opportunities that don’t yet feel like a pure infrastructure play.

    ‘Infra-like’ in the spotlight
    The market has also seen a growing number of deals to finance businesses that label themselves as “infrastructure” because they share some of the asset class’s characteristics but that might not offer the same resilience to economic downturns as traditional sectors.

    “We have seen assets financed in the leveraged loan market that then are sold to an infrastructure sponsor, and then return to the infrastructure debt market to try to get financed at a lower price,” explains Mayhew.

    Faced with such situations, the advice is clear: always look at the fundamentals of the asset.

    New (and OLD) geographies
    Fund managers have also been pushed into exploring new markets, as the bulk of liquidity remains in the most developed countries in north and western Europe.

    Without naming specific geographies, Mayhew says that some managers “are going back to countries that haven’t historically behaved well in respect to infrastructure”.

    “As we look at new countries, the question is whether they respect the rule of law, whether we can enforce security if it is needed,” he adds.

    Kassis paints a brighter picture, explaining that some of the rising markets are simply becoming attractive again after recovering from the global financial crisis. “Countries that were big sources of opportunities, such as Portugal and Spain, are back to the market after the crisis,” he says.

    ‘Not all doom and gloom’
    So, is it time to worry? Not yet, as fund managers are staying optimistic about infrastructure debt’s fortitude and good practices.

    “The infrastructure debt market is built to be resilient, and I believe it will stand to its promises,” says Kassis.

    As well as exploring the geographies and sectors where there is less competition, some managers are taking on more complex financial structures that not all investment teams are prepared to tackle. This can reward managers with a much-needed ‘complexity premium’ for their investments.

    “There are still good opportunities out there; it’s just that there are more deals you need to decline,” Mayhew from M&G argues.

    And, as pressure grows on financiers, remaining cool-headed is a must: “It’s not all doom and gloom: the important thing is to maintain investment discipline,” concludes Mayhew.