Where now for infrastructure debt?

This article is sponsored by AMP Capital, Asset Management One Alternative Investments, Aviva Investors, Credit Agricole CIB, HSBC Global Asset Management and Ostrum Asset Management.

The “high point” for the debt market came with the $2.5 billion close of AMP Capital’s third fund in August 2017, and we were still revelling in it at last year’s roundtable. The fourth largest fund that year, we described it as “further proof of the substantial progress made by infrastructure debt”.

Indeed, 2017 was the highest ever year for infrastructure debt fundraising, with $8.5 billion raised across 16 funds, according to Infrastructure Investor data. But, to put it lightly, in 2018 that plummeted, falling 61 percent to $3.31 billion raised across four funds.

With six industry experts gathering at Aviva Investors’ offices for our roundtable, it’s plain to see that interest in the sector hasn’t just fallen off a cliff. But their explanations of what LPs want are differing and wide-ranging.

“The issue we find is there’s a lot of appetite for long-term, boring infrastructure debt, but not at the yields the market offers at the moment, certainly not from a European perspective,” begins Darryl Murphy, head of infrastructure debt at Aviva. “Therefore, you’re left with investors who are perhaps more attracted to strategies which have a little bit more risk and return. The challenge is people badging what are effectively high-risk products to investors who actually want very low risk, and there’s a mismatch there.”

As a representative of the aforementioned “high point” of infrastructure debt, AMP Capital’s Emma Haight-Cheng offers a different perspective.

“We are seeing a good amount of appetite for our product as a mezzanine debt fund,” says the group’s director. “For investors with upwards of about $500 million, they may want more control and so would look to bespoke managers to provide bespoke solutions.”

Celine Tercier, head of infrastructure finance at Ostrum Asset Management, agrees with Haight-Cheng. “We’re seeing very large investors that want to have a bespoke mandate and smaller ones who are keen to have a co-mingled fund with a quite small ticket,” she explains. “It really depends on their size, their allocation to the asset class and where they are on their investments.”

“Investors want core and very secured infrastructure, but they want a yield that no longer exists in Europe” –  Tercier

This divergence of priorities presents difficulties for fund managers to put together products that will work for everyone.

“Our experience has been that the bigger investors are able to commit significantly more capital to a segregated mandate than they are to a fund,” says Glenn Fox, head of infrastructure debt at HSBC Global Asset Management. “The challenge for us is to find a strategy for a fund that has sufficient appeal to a wide enough base of investors to be scalable. I think a lot of people have found that difficult in the infrastructure debt market.”

Those challenges in the infrastructure market can, of course, lead to a stretching of the boundaries of the asset class. This is a worry for Crédit Agricole CIB’s global head of infrastructure Matthew Norman.

“Certainly, for the last 12 to 24 months, I would say the growth in the pipeline is largely driven off the core-plus, hybrid sector, with an expanding sector definition. I think there’s an interesting approach here for the LPs because on the one hand, this gives the industry exciting avenues to grow, such as tech-related infrastructure, but on the other, raises questions on whether this is providing them the risk-return profile they signed up for?”

It’s this thought process that is driving the mandate for Asset Management One Alternative Investments and its debt fund series, according to chief investment officer Hironobu Nakamura.

“With the definition of infrastructure debt becoming a bit broader, we want to define what precisely it is. Our fund is defined as a project finance fund. We see a lot of infrastructure debt in the market but it is a little bit of a different story. Project finance senior debt has quite a lower default rate and higher recovery rate.”

DEFINE AND CONQUER
Fox offers a different perspective, preferring not to focus too much on definitions.

“We don’t define core infrastructure, we simply have a set of credit characteristics that we’re looking for and my investment committee understand,” he says. “The question is where one goes either on the country risk scale or credit risk scale, in order to achieve the minimum returns investors are looking for.”

“[Asia-Pacific] has the potential to be a very interesting market and the land of opportunity” – Fox

The question certainly highlights the spread of viewpoints around the table, as well as the challenges infrastructure debt faces. To borrow Murphy’s earlier comments, “long-term, boring infrastructure debt” means different things to different managers and investors.

“We’re quite cautious when it comes to investing in developing markets,” says Norman. “Probably the closest area we’ll see around developing markets would be Latin America, that’s where we do see quite a lot of demand from clients. That to me is the area where you can play the country aspect to drive return.”

That, of course, depends on who you’re in conversation with, according to Murphy.

“We talk to European investors and if you’re not comfortable with Italy, then Latin America sounds like a pretty scary place,” he responds. “Latin America has better investment-grade structures than a lot of deals elsewhere, but a lot of institutions are struggling with southern Europe, so the idea of going to other jurisdictions is a long way off.”
Tercier believes managers may need to diversify to deliver for investors. Echoing Murphy earlier on, she says:

“I think investors want core and very secured infrastructure, but they want a yield that no longer exists in Europe. That’s why it’s interesting to be flexible in order to be able to select the transactions that bring diversification to your portfolio and also the best relative value.”

Even as one of the participants who is more willing to diversify, Nakamura remains cautious about developing countries and says Asset Management One would require risk assurances.

“We want to diversify as much as possible, but we have to be careful about developing countries,” he says. “We need some credit enhancement to cover those kinds of countries. But otherwise, we are happy to diversify as much as possible, country by country, sector by sector. As long as there is a mitigant for the country risk, we’re happy to take it.”

However, as Haight-Cheng views it, country risk doesn’t just apply to developing countries, but can also be a factor in more developed countries, when it comes to pricing.

“We see a higher pricing in North America consistently,” she explains. “I would have to put that down to the slightly less mature market than we enjoy in Europe.”

“I think there’s very different perspectives depending on where investors are coming from,” Fox summarises. “All of the money that we raised is in Asia-Pacific and from some very big institutions. They are used to the idea that they have to invest in US dollars because there isn’t sufficient local currency liquidity. There are some investors out there who, if they get local currency, will accept a BB-rated investments as the best they’re going to achieve.”

CREEPING LEVERAGE
At last year’s roundtable, we were told “the market has been very good at keeping control of leverage creep”. However, we were warned looking ahead that it “is the next big thing”.

A little over 12 months later, it’s clear that for some, this forecast has borne fruit.
“Asset pricing right now in the infrastructure sector is reaching elevated levels in some areas compared to the previous cyclical high point,” Norman asserts. “From a lending perspective, we have been less concerned this time around because what has driven this is more equity than debt. But certainly, we’re seeing, over the last 12 months, greater use of leverage in transactions and leverage creeping up across the board. I think that may become a real concern, particularly when you combine that with very weak structures, compressed pricing and a future cycle re-adjustment. I believe it is key to be patient and maintain discipline.”

Murphy responds that while things have changed over the past year, the sector would not face the same financing challenges it faced during the global financial crisis if there were another one tomorrow.

“A lot of institutions are struggling with southern Europe, so the idea of going to other jurisdictions is a long way off” – Murphy

“You’re getting a fair price and covenant packages are not overly aggressive,” he says. “I think we’re in a world right now where sponsors choose to push all of these.”
Nakamura remains flexible on the amount of leverage, as long as it meets Asset Management One’s typical deal requirements.

“We are looking for a triangular approach. The project will have stable cashflows, a good capital structure for the leverage and a covenant or strong protection,” he says. “If a project is stable we can afford a higher leverage. If a project is not so strong, we have to be more cautious on the leverage.”

Haight-Cheng, though, agrees with Norman. “There are a number of new entrants to the infrastructure debt sector who are not used to looking at pure infrastructure projects,” she explains. “As a result, on certain projects we have seen more aggressive leverage than we would be comfortable with and we’ve found that we’ve had to step away from a couple of processes because of that.”

Norman wonders whether actors inexperienced in the infrastructure market are prepared for a potential downturn.

“I think that’s a really interesting challenge for managers and the investors,” he says. “As a bank, we’ve been through that, and we’ve been through many dips in terms of cycles, so we’re prepared for it. The question for those new entrants is: are they?”

“We’re buying and selling the same assets in certain sectors we’ve done for the last 10 to 15 years – that does not create a sustainable market” – Norman

But Tercier sees new entrants backing a wealth of managers as a positive for the asset class.

“There are new investors coming to this asset class in Europe and from other geographies and from an investor perspective, I think that they like to diversify their asset managers.

They don’t want to put all their money with the same provider. They need diversification in terms of asset managers and in terms of strategies. I think it’s a good thing to have new entrants.”

“With the definition of infrastructure debt becoming a bit broader, we want to define what precisely it is” Nakamura

For Fox, a combination of leverage and issues with rating agencies is a bigger issue.

“One of the interesting things I observe in the market today, which is very reminiscent of 2007, is rating agency arbitrage,” he says. “In the North American market, everything gets structured to BBB minus by one agency. It’s very clear that experienced sponsors are shopping to see who will give them the required rating at the highest leverage level. I look at other markets such as Canada where I simply don’t believe the ratings that come out of the market. I saw one transaction recently where the degree of operational leverage is absurd for a transaction rated in the A category.”

SEEING THINGS DIFFERENTLY
Fox’s reference to 2007 is a timely reminder of the warnings of another impending economic downturn. With the warnings already issued by our participants, is the sector ready for another financial slump?

“The only good thing from the crisis is if you are doing due diligence on a toll road, or a GDP-related asset like a toll road or an airport or port, you do have the data now to say whether the structure can withstand that type of shock,” argues Murphy. “That’s a much better position than previously, at least we have some empirical evidence.”

Murphy’s statement brings a nod of agreement across the table from Norman, who highlights the sector’s strengths in the previous crisis.

“It’s a good thing, rather than just theoretically coming up with numbers, you’ve actually experienced a live crash test,” he says. “The asset class did do generally very well. It came out the other side and is actually stronger for it. The market has shown resilience through the cycle, combined with long-term fundamentals of the sector.

“One of the biggest challenges the industry faces is ever-expanding capital allocations to the sector. We’re buying and selling the same assets in certain sectors we’ve done for the last 10 to 15 years – that does not create a sustainable market. You need new primary infrastructure investment, that’s what Europe really lacks right now. There’s a very limited tangible pipeline there currently. However, we do see a very positive outlook for M&A in 2019.”

“We’ve found we’ve had to step away from a couple of processes because of [aggressive leverage]” – Haight-Cheng

Since Fox’s playground is not Europe, he brings a more bullish perspective to the market.

“We’re developing Asia-Pacific focused mandates and there is a degree of uncertainty going into that market about deployment and speed of deployment,” he says.

“One can see the economic development and the growth of the middle class so we see the expansion of insurance company balance sheets and the pressing need to invest in infrastructure. From our perspective, that looks like it has the potential to be a very interesting market and the land of opportunity.”

Elsewhere, “the ability to compete in an increasingly ESG-conscious market is more and more at the forefront of our concentration”, says Haight-Cheng.

Back in Europe, all is not lost, according to Tercier and Nakamura, who foresee an interesting secondary market on the horizon for debt investors. Both identify Basel regulations as the reason for “a quite dynamic secondary market in the project manager space”, Nakamura says, while Tercier sees this as “the next step for the banking market”.
European greenfield worries aside, there is still much to work with in infrastructure debt.

AROUND THE TABLE

Darryl Murphy, head of infrastructure debt, Aviva Investors
Murphy is responsible for origination, structuring and execution of new infrastructure debt transactions. He joined the group in 2017 after nearly eight years as partner at KPMG’s infrastructure advisory business. Murphy was also head of infrastructure at HSBC and has over 22 years’ experience in infrastructure finance.

Matthew Norman, global head of infrastructure, Crédit Agricole CIB
Norman has over 20 years of infrastructure and energy industry experience. Before joining Crédit Agricole CIB, he worked in the investment banking and wealth management divisions at Indosuez. He was appointed global head of infrastructure in 2016.

Emma Haight-Cheng, partner, infrastructure debt, AMP Capital
Haight-Cheng is primarily responsible for sourcing, arranging and managing infrastructure debt investments in Europe and has over 10 years of infrastructure and energy finance and private equity experience. She joined AMP Capital in 2014 from NIBC.

Glenn Fox, head of infrastructure debt investments, HSBC Global Asset Management
Fox joined HSBC’s asset management arm in 2015 after three years managing social housing PFIs on behalf of two debt investors. He spent the previous year at Bishopsfield Capital Partners and before that, he was chief investment officer at Hadrian’s Wall Capital.

Hironobu Nakamura, chief investment officer and head of infrastructure debt, Asset Management One Alternative Investments
Nakamura is responsible for investment origination, fund management and operations. He manages two infrastructure-related debt funds targeting a range of investments from senior project finance to core infrastructure projects globally. He has 20 years of experience in infrastructure-related businesses, fund management and project finance.

Celine Tercier, head of infrastructure finance, Ostrum Asset Management
Tercier became the manager of infrastructure at the Natixis asset management group when it was created in 2016. She had previously been at the French bank for nearly eight years, in various roles in the bank’s infrastructure business. Prior to that, she was vice-president of structured finance at credit rating agency DBRS.