The global financial crisis continues to haunt financial markets. Old paradigms are being constantly challenged as investors adjust to a new environment in which returns have been compressed without a commensurate reduction in risk.
While governments seek to stimulate their economies on one hand, they are imposing stricter regulation on financial markets on the other. This seems counter-productive and has contributed to stifling investment in both public and private infrastructure, particularly since the original GFC (Global Financial Crisis)-induced stimulus packages washed through OECD (Organisation for Economic Cooperation and Development) economies.
One of the main targets of increased regulation has been the banking sector. The phase-in of Basel III regulation will impose significant additional costs. Under the new regulations, long tenor and lower loan quality are especially penalised. This will particularly impact bank financing of infrastructure, which traditionally has relied on moderately priced, long-tenor BBB-rated bank financing.
Assuming a constant capital reserve requirement, under Basel III rules a B-rated loan can only have about half the tenor of an A-rated loan.
The clear inference here is that banks will have strong incentives to reduce loan tenors and/or move to higher loan quality. Such a trend is already evident in infrastructure financing. For example, the median tenor for new project debt in the OECD dropped from 19 to 13 years from 2005 to 2012. As Basel III is progressively introduced, its provisions may lead to even further tenor compression.
As is often the case when bureaucrats attempt to regulate markets, closing one door opens opportunities in other directions. Basel III’s one-size-fits-all approach fails to recognise that infrastructure debt has consistently outperformed other sectors, as can be seen in the following graph. The secure, long duration cash flows that characterise infrastructure investments mean that infrastructure debt has the lowest level of loan default of all industrial sectors.
Other infrastructure debt providers don’t face the same regulatory impositions as banks. The potential vulnerability of banks creates opportunities for other sources of debt. Recent surveys reveal a significantly increased level of interest in infrastructure by institutional investors.
Banks will fight back
Regulatory restrictions aside, banks are unlikely to take such competition lying down. We expect to see a raft of innovative debt structures emerge, in which banks will lay off some of the financing risk to third parties. For example, any closed-end fund structure adopted by institutional investors would limit tenor to the life of the fund, or about 10 years. Banks can match this tenor by moving their loan quality requirements from a BBB to an A rating.
Of course, this would create a gap in the funding structure, given the higher capital reserve coverage ratio requirements of the A-rated loan. This creates an opportunity for a tranche of subordinated debt from a non-bank provider.
AMP Capital has undertaken modeling of such hybrid senior and subordinated debt funding models. The following chart illustrates the conditions under which this funding model would be competitive.
For example, assuming a margin of 550 points on the subordinated debt component of a hybrid funding model, the hybrid becomes competitive against traditional infrastructure debt funding arrangements once the margin between A- and BBB-rated debt exceeds 87 basis points.
Our modeling confirmed this result for infrastructure assets with asset (ungeared) betas ranging from 0.25 to 0.65. This effectively covers the range from low-risk utilities through to economic infrastructure assets such as airports.
Reverse engineering of the potential Basel III capital reserve requirements for an A-rated and BBB-rated debt structure suggests that the future differential between these two classes of debt will be in the order of 100 basis points, i.e., in excess of the 87-point threshold calculated in the modelling. Historically the differential has only dropped briefly below the threshold level once since the GFC. Looking forward, we expect that the imposition of Basel III will structurally lock in such margins for bank debt.
How investors may benefit
The first fund set up to exploit this opportunity was the Aviva Investors Hadrian Capital Fund 1, which targeted European public-private partnerships (PPPs). This fund was designed to provide long-tenor total funding packages in competition to banks. The resulting A-rated notes would be subsequently sold into long-term bond markets, while the fund provides the subordinated B rated notes. Overall target margins were 210 basis points, which implies a margin of 450 basis points on the B-rated notes, assuming an 80 percent A to 20 percent B split between tranches.
However, AMP Capital modeling also suggests that:
- Such structures may have much broader application than PPPs and could compete with shorter-tenor institutional BBB-rated funding of economic infrastructure.
- For tenors up to 10 years, banks are the natural providers of the A-rated senior tranche. They offer both better flexibility and cost advantages over bond markets for typical infrastructure debt tranche sizes. A specialist subordinated debt fund could provide the residual debt component.
This is a good example of change driving innovation. In the medium term, the move of institutions into infrastructure debt will provide greater competition for financing new projects, while the trend to shorter loan tenor will create many more refinancing opportunities, which are inherently lower risk than greenfield projects. These considerations suggest that subordinated debt, in particular, will find a significantly expanded role in future infrastructure financing and refinancing structures.
Specialist subordinated debt funds provide an opportunity to work with, rather than against, banks and their higher returns could prove an attractive alternative to fixed income investments for institutional investors.