This article is sponsored by Ostrum Asset Management
What makes infrastructure debt an attractive asset class right now?
Infrastructure debt is an income driven product, so it is a good fit for insurance companies and pension funds. It also offers long-term and predictable cashflows, which fit with the liability matching requirements of those types of investor.
Debt, of course, offers better protections than equity. And the recovery rate for infrastructure debt is extremely high, at around 76 percent, compared to corporate, unsecured loans, at around 40 percent. Meanwhile, as an illiquid asset class, infrastructure debt provides an illiquidity premium when compared to traditional fixed income products.
Finally, regulators have recognised the specific characteristics of infrastructure debt, which receives a very favourable Solvency II treatment as a result – something that is important for European insurers. Ultimately, this is a stable asset class that offers highly attractive risk-adjusted returns.
How would you describe investor appetite for the space, in light of all these benefits?
Appetite has grown significantly since the first wave of investor interest in 2010. This is not only because of the advantages that I outlined, but also because of the persistent low interest environment that has forced investors to seek higher yielding products.
Initially, a lot of investors began with exposure to infrastructure equity. But many are now hitting a ceiling for that type of product. That means they are now looking to find positive yield but with low regulatory capital requirements. Infrastructure debt is one of the answers.
Other investors, not affected by Solvency II, are interested in infrastructure debt for the purpose of diversification. The borrowers we work with are not the type of borrowers who would go to the public markets, so we offer a new type of exposure.
Given that we offer the whole spectrum of solutions in terms of accessing the asset class, we are certainly seeing increased appetite from a whole range of different investor-types. The largest institutions are starting to invest directly or invest through segregated mandates with asset managers. The smaller and less sophisticated investors are interested in commingled funds.
Which regions are providing the most interesting opportunities for you?
Historically, the market has been driven by Europe and America and there are still lots of opportunities in those regions. Dealflow is strong in core Europe, but also in southern and eastern Europe. We are more opportunistic in the US, especially for euro-denominated funds and mandates for which we have to implement a currency hedge policy.
And what about Asia?
Asia is also booming right now. Traditionally, that region has been driven by Australia, but we are seeing increasing opportunities in Japan, Korea and Indonesia. We believe this to be a growth region and we set up a team in Hong Kong, in 2018, in order to take advantage of it.
In terms of sector, energy transition is clearly one of the big infrastructure themes. How is that manifesting itself in dealflow?
Renewables – ranging from solar, to offshore wind, geothermal, hydro and energy storage – currently represent more than 60 percent of our pipeline. I think this trend will continue. There are a huge number of opportunities around the world. Even in the US, where the federal government may not appear to support renewables, there are myriad initiatives at the state level, including the first offshore wind farm projects in the region.
From a financing perspective, we have seen the cost of technologies come down dramatically over the past decade, which has paved the way for subsidy-free projects. That has changed the shape of the risk profile, bringing more merchant and counterparty risk into the equation. We are well versed in analysing this new type of risk associated with greenfield assets.
We also see plenty of refinancing opportunities with more traditional, regulated tariffs. It is great to be involved in both types of transaction, because it provides diversification of cashflow streams, which we are very attentive to in our portfolio construction.
Finally, from a technical perspective, we think offshore wind will continue to develop, even outside its birthplace in core Europe. We have seen projects in Poland, and Estonia and Latvia have just announced a joint offshore wind project. There are more than 30 live proposals in the US right now, as well as some in Taiwan and Japan.
Meanwhile, the next wave of development will be floating. That applies to both wind and solar. It’s important for solar because it reduces the environmental impact on agricultural land. It will also decrease the cost for offshore wind and increase the potential scope for development by allowing wind farms to go further out, into deeper waters, limiting the environmental impact on the seabed.
“Ultimately, this is a stable asset class that offers highly attractive risk-adjusted returns”
Are you also looking at opportunities around green mobility?
Green mobility will be a key challenge in the coming years because transport is one of the biggest contributors to carbon emissions around the world. And, even though COP25 was not a great success, everyone realises that we must do something to tackle this problem. I think green mobility around rail, electric cars and charging infrastructure will certainly create interesting investment opportunities in the future.
Digitisation is the other major global trend. How is that impacting the infrastructure industry?
There is a huge demand for data in today’s world. Everyone wants to have high-speed connections, wherever they may be. There is also a strong political will to expand connectivity, not only in the cities but in rural areas. Even core Europe is a little behind the curve in this regard, but governments are promoting investment plans to remedy this. The advent of 5G will accelerate this process, because additional fibre will be required to stabilise the 5G network.
What is your approach to origination as a firm? How do you identify and select investment opportunities?
Ostrum AM’s private debt expertise is managed by a team of former bankers with more than 20 years’ experience each, on average. This background provides a vast origination network. It is very important to have your execution capacity understood and recognised in this market. Our execution capacity covers all sectors and geographies. Furthermore, we have the capacity to do direct lending, which gives us access to unique investment opportunities that won’t be seen in the often-crowded syndication market.
Our objective, always, is to select the best opportunities available on the market at any point in time and to build a diversified portfolio in terms of geography and sector, but also in terms of risk. Risk profile is a fundamental pillar of our portfolio construction methodology. All in all, selection is paramount for us and we only invest in around 10 percent of all the deals that we screen.
How would you describe pricing dynamics in the current environment?
We have witnessed spread compression over the past years, but that now seems to have stabilised. And it is important to remember that with infrastructure debt, whatever the conditions, this is still an illiquid product, offering an illiquidity premium and attractive return profile. Considering the strong credit metrics of the asset class, the risk-adjusted returns are even better.
What about the way that deals are being structured? If we are, potentially, on the cusp of a downturn, are transactions being approached appropriately in order to weather the storm?
There are certain financial covenants that we will always want to see in the credit documentation. If we see structuring that looks a bit aggressive, we will steer clear. We operate in the credit space, so for us the best way to earn money is not to lose any. That means discipline is critical. We will only participate in transactions where we can recover our capital.
I think the industry has been pretty disciplined around structuring, in general. Where we are seeing some evolution is regarding interest rates. We are seeing more and more opportunities with zero floor Euribor for short- and medium-term loans. This is quite new to the market and we push hard for this solution.
We are also seeing more mezzanine and junior debt opportunities, which can be interesting, especially if you are working with an investor that is not under a regulatory framework such as Solvency II, because the yields here are higher. This is one of the strategies that we are currently developing in Asia.
Beyond a potential shift in the macroeconomic environment, are there any other challenges facing the infrastructure debt market?
I think the big challenge for investors this year will be reduced rates. But while that will be a challenge for investors, undoubtedly, it will also represent an opportunity for asset managers and for the asset class more broadly.
I think regulation will also play a role for investors, encouraging them to seek out alternative sources of deals. Infrastructure debt will be one of the beneficiaries of that quest. In addition, we will continue to see different types of players entering the infrastructure debt space.
Historically, the market has been driven by banks – and only banks. Then came the asset managers, either raising dedicated infrastructure debt funds or managing segregated mandates. Now, we are starting to see some institutions investing directly.
Competition has certainly increased – although some of the banks will now have to retrench in light of capital constraints such as Basel IV. But nonetheless, this is a big market. Infrastructure debt represents 80 percent of all infrastructure investment – it dwarfs equity. And so, I think there will be a natural place for every type of market participant going forward.
What does the future hold for infrastructure debt?
We will see more and more investors entering the market. Today, it is primarily the large institutions that are involved in this space. It is a relatively new asset class and there is a cost to enter it. However, I think smaller investors will also seek to gain exposure through asset managers. That will be the next major evolution.
What role are environmental, social and governance considerations playing in investor decision-making?
There is strong demand within the asset class for ESG strategies. We have received the Greenfin label from the French government ministry of Ecological and Inclusive Transition for one of our strategies. This demonstrates to investors our approach to sectors, the way in which we integrate ESG into our investment decision making and asset monitoring, and ensures reporting on carbon emissions. There is a real appetite for this type of green product.