Infrastructure debt appears to be defying a brutal fundraising environment, with 30 percent of respondents to Infrastructure Investor’s LP Perspectives Study 2023 planning to increase allocations over the course of the next year, more than any other infrastructure strategy.
“Infrastructure debt, as an asset class, provides exposure to investments that are deemed to provide an essential service, combined with high barriers to entry and a hard to replicate asset base resulting in long-term stable cashflows,” explains Hadley Peer Marshall, managing partner and co-head of Brookfield’s infrastructure debt and structured solutions business.
“This combination of ingredients leads to highly predictable and defensive cashflows that should be relatively immune to macro conditions, and which serves as the foundation for low default rates and high recovery rates. In addition, infrastructure debt provides portfolio diversification and highly attractive risk adjusted returns.”
While demand for infrastructure debt is buoyant, the appeal of the asset class is changing in the current macro context, with its risk profile taking centre stage. “In a low interest rate environment, appetite for infrastructure debt was mainly driven by diversification and a pricing premium over corporate bonds,” explains Augustin Segard, co-head of infrastructure debt investments at Schroders Capital. “However, with the interest rate repricing, the infrastructure debt asset class is now attractive on an absolute return basis, particularly when you take the safer risk profile into account.”
Viktor Kozel, head of infrastructure debt, EMEA, at UBS Asset Management, Real Estate and Private Markets, agrees that appetite for infrastructure debt is being driven by its attractive risk characteristics. “According to Moody’s, infrastructure debt borrowers demonstrate lower historical losses versus equivalently rated corporates. This is particularly beneficial in the current macro environment, where inflation remains very high and interest rates are rising.”
In fact, in some instances, equity allocations are being redirected towards debt because of the risk/return premiums on offer. “Some infrastructure equity managers have not yet fully adjusted their return targets, particularly in the core space,” says Tommaso Albanese, head of infrastructure at UBS Asset Management, Real Estate and Private Markets. “This is eroding the premium between high yield debt and equity due to increasing interest rates.”
“Infrastructure debt is in fashion right now,” adds Gordon Bajnai, partner and co-head of global infrastructure at Campbell Lutyens. “Increased interest rates have made returns more lucrative, coupled with undersupply. There are far fewer players in infrastructure credit when compared to infrastructure equity and we are seeing a growing number of equity players trying to raise parallel debt strategies, as well as generalist private credit managers looking to enter the space.”
This arrival of new entrants in the infrastructure debt space is creating an interesting fundraising dynamic. Infrastructure debt acting as a fixed income surrogate has never been a primary focus for funds, as the returns are too low for fund fee structures to make sense. Managed accounts are more typical.
“That part of the market is challenged right now, because it is possible to get a materially better return from government bonds. A number of insurance companies are sitting on books of senior debt in the infrastructure space and feeling quite sore about it, although they are taking a long-term view,” explains Bruce Chapman, co-founder of Threadmark.
The other piece of the market involves junior debt, or blended senior and junior debt, with typical return expectations of 5 to 7 percent. That market tends to invest in much shorter dated structures and the returns being generated by capital deployed in the last cycle are looking anaemic compared to what is possible today.
“In some cases, inflation correlation has been built into portfolios, in which case performance is better, but generally speaking investors in the last cycle traded inflation correlation for a higher absolute return,” Chapman explains.
“All of this is making for an interesting fundraising market. Experienced managers are potentially sitting on track records that in today’s environment don’t look particularly exciting. Investors must therefore decide whether they wish to back an incumbent with a track record that looks lacklustre or a newer manager that doesn’t have a large legacy portfolio that may be facing some challenges.”
Meanwhile, infrastructure secondaries is another segment of the infrastructure universe that appears poised to benefit from macroeconomic turmoil. Just over a quarter of respondents to the LP Perspectives Study plan to commit to a secondaries fund in 2023, the highest figure to date.
According to Andrea Echberg, partner and head of global infrastructure and real assets at Pantheon, it is precisely the dynamics that have made fundraising difficult that are making secondaries so appealing. “We are seeing a large number of sellers coming into the market, not only for portfolio construction reasons, but also due to the denominator effect and liquidity challenges,” she says. “This unprecedented dealflow is increasing investor appetite, coupled with the fact that discounts are now typically in the 10 to 20 percent range, outside of the most hotly contested auctions.”
Brent Burnett, managing director and head of real assets at Hamilton Lane, agrees that pricing dynamics in the LP secondaries market are improving. “This is partly driven by increased volume of dealflow. It is also being driven by changes in the fund financing market,” he says. “A year to 18 months ago, when volume was lower, there was a lot of aggressive buying, fuelled by access to cheap and long-dated credit facilities. As that credit has become more expensive, it is becoming more challenging to pay those full prices.”
The momentum building behind the infrastructure secondaries market is clear. Ardian closed its debut fund at $525 million nine years ago, before raising its third generation at 10 times that sum seven years later. “Overall dry powder in the market has followed a similar trajectory,” says Ardian senior managing director and member of the ASF Management Committee, Daryl Li.
“Six years ago, there was around $2 billion and now there is roughly $10 billion. Investors are drawn to the opportunity to get all the benefits of secondaries investing in terms of J-curve mitigation, accelerated cash back and diversification, as well as the benefits of the infrastructure asset class.”