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Macquarie on diversifying out of energy

As the infrastructure debt market continues to outperform, US insurers are looking for new options in a maturing market, say Macquarie Asset Management’s Magali Cohen and Tom Danielsen

This article is sponsored by Macquarie Asset Management.

Magali Cohen

How would you describe the appetite for infrastructure debt, and what is driving demand?

Magali Cohen: The market has been incredibly buoyant, not just over the last six months but for a prolonged period after the initial market disruption caused by covid-19. On the supply side, that’s driven by strong political willpower for a transition to a greener energy grid and the mass digitisation of the economy, trends that were accelerated by the pandemic. That has led to a greater requirement for digital infrastructure, which includes data centres and fibre broadband, which has emerged as a new infrastructure subsector over the past few years.

Meanwhile, on the demand side, low public yields and a desire to diversify away from high allocations to mid-market direct lending are pushing insurance companies and other institutional investors to search for alternative fixed income asset classes, including infrastructure debt. Private infrastructure lending has also demonstrated both higher returns and lower credit risk than equivalently rated public debt, with historically lower defaults and higher recovery rates on default. These factors are relatively persistent, so this shift into infrastructure debt is a long-term trend that we expect to continue. Underpinning this backdrop has been the strong credit performance of the asset class over an extended period of time – proving resilient both during the financial crisis and more recently through the pandemic. This stability has in turn supported the demand from institutional investors.

Going into this year, what opportunity set does the asset class offer US insurance companies?

Tom Danielsen

Tom Danielsen: Historically, US insurers have largely accessed infrastructure assets through syndicated private placements and both the tax exempt and taxable municipal bond markets. However, that is where liquidity and competition are highest, and yields are lowest. We see the best opportunities where there is the least competition, and that’s why the platform we’ve built focuses on originating transactions that have a direct sponsor or issuer relationship.

The US market has a rich opportunity set in sub-investment-grade transactions, which tend to suit private issuance over public. In this area of the market, extremely compressed high-yield bond spreads have meant private infrastructure assets are currently delivering large yield premiums and attractive risk-adjusted returns in return for taking more illiquidity or complexity risk.

The other big theme for US insurance companies is a growing appetite to invest outside the US. The US is a big market, so domestic investors have tended to favour opportunities in their home space, but several factors are now causing investors to look further afield.

Historically, a large portion of private infrastructure transactions in the US have been energy driven. Certain subsectors like regulated utilities, or transportation, tend to represent a much bigger market opportunity in Europe. Access to both markets allows investors to build a more diversified exposure across different infrastructure subsectors. Value and opportunity ebbs and flows between different sectors over time, so it’s important to cast as wide a net as possible.

A second driver of that trend is the impact of hedging non-dollar assets back into dollars. There is currently a significant yield pick-up from hedging euro and sterling cashflows back into dollars, which makes these opportunities even more attractive. Moreover, there has also been a slight relaxation of hedge accounting rules which makes it easier for insurance companies to transact those swaps. The result is a more diverse opportunity set with better yields.

Lastly, domestic investment-grade issuance is largely syndicated, resulting in more competitive processes. Venturing to developed markets like Europe with strong regulatory frameworks is an attractive alternative. Here the market is more fragmented and less intermediated, which provides an opportunity to negotiate additional lender protections and achieve attractive yield premiums.

How can investors achieve capital efficiency under the NAIC framework?

TD: The rules set by The National Association of Insurance Commissioners (NAIC), the US insurance regulator, mean that transactions that don’t have external credit ratings face prohibitively high risk-based capital charges. The process to get these transactions rated can be quite onerous, so in general most insurers struggle to invest into unrated assets. Unfortunately, this part of the market tends to be where some of the best opportunities are found.

Assigning an internal credit rating is a fundamental step in our investment process, but that on its own doesn’t satisfy the NAIC’s requirements. It is possible to do a transaction and take it to the regulator for a rating designation, but this is challenging for all but the very largest insurers.

As a result, we are now seeing structures that pool investor commitments and provide efficient risk-based capital treatment. Known as collateralised fund obligations, these vehicles convert fund investments into a rated debt instrument and a residual equity piece so that capital treatment is commensurate to holding the underlying debt instruments directly.

These structures are a big theme in the market currently, given the focus from insurers on capital consumption and efficiency. We have seen something of a breakthrough in demand and expect to see a lot of activity this year.

Where do you expect to see the most activity and what will be the key themes in infrastructure debt going forward?

MC: It would be remiss not to mention the recent Investment and Jobs Act, President Biden’s $1.2 trillion infrastructure bill, which has achieved bipartisan support and is, on paper, a watershed moment with the promise of the largest long-term investment in American infrastructure for over a century.

While a significant step forward, the market impact of this bill remains to be known and we are certainly optimistic. Market studies by companies like McKinsey suggest that the overall numbers fall somewhat short of the overall funding requirement to upgrade old infrastructure and address newer themes like digitisation and the energy transition.

This implies there remains an important role for private finance and in particular debt financing to plug the infrastructure funding gap. Given the stability of infrastructure assets, capital structures tend to be more heavily weighted to debt than equity. In Europe, we are also seeing similar government-led mandates to increase investment, so the backdrop for infrastructure debt is strong and we expect that to continue.

Changing themes, we also expect to see more development in the type of product offerings available to investors. We see a shift towards levered fund structures, a concept which is commonplace in traditional mid-market direct lending. The introduction of leverage takes advantage of the strong credit quality and resilience of infrastructure credit to boost returns.

How do you see investors diversifying away from power and midstream assets moving forward? What is driving that?

MC: There has long been a critique that the US infrastructure debt market is heavily weighted to energy, and it is true that the bulk of activity remains centred on power and midstream assets. However, there is now a demonstrable opportunity in renewables with new sectors like offshore wind emerging in the US for the first time. Other areas of opportunity include distributed solar generation, battery storage to increase the reliability of the grid, and then newer innovations around hydrogen and carbon capture.

We are also seeing interesting opportunities in “infrastructure adjacencies” – sectors that retain some of the core infrastructure qualities, while offering additional yield in return for higher level of risk related to market exposure, shorter contracts or more nascent technologies. Here, we see investors looking at areas like LNG refuelling vessels and barges, recycling facilities, electric vehicle charging, logistics or transportation services.

In these sectors, structure is paramount for risk mitigation – it’s also important that equity-style risks are retained by the sponsors and not passed on to debt holders.