Something old, something new

Infrastructure debt is a proven, stable asset class. It’s proven because banks, which until recently funded 80 percent of infrastructure projects globally, have been active in project finance for the past 30 years.

“When you talk to people who have been doing infrastructure debt for many years in the banking community, they are very familiar with what the risks are, how to manage it, how to structure it, how to run the business,” says Nick Cleary, New York-based investment director of infrastructure debt at Hastings Funds Management, the Australian fund manager.

But the banks have withdrawn from the sector not because it is unattractive but because of changing bank regulations. “I view Basel III as the catalyst,” Cleary says.

“And really what it means is that banks can and will still provide debt to infrastructure projects but the cost of them providing the long-term debt capital is increasingly prohibitively high.”

Markus Christen, who before running his own financial advisory firm MC Capital Partners worked for Credit Suisse for close to 20 years and helped the Swiss bank create its project finance division in the early 1990s, agrees: “The 15 year-, 20 year-deals are not really favoured by the banks anymore,” since Basel II and Basel III have made these deals less attractive.

OPPORTUNITY

This has created an opportunity for institutional investors. “Pension plans, insurance companies and other institutional investors want to have the long-dated paper; that’s why I always thought that those parties are best equipped to provide funding for infrastructure deals,” Christen explains. “So, it’s a perfect marriage between institutions and their desire to place money for the longer term to match their liabilities.”

Low interest rates have also made a difference. The bond markets that institutional investors favoured for their fixed-income characteristics are no longer delivering the returns investors such as pension funds need.

“Right now, interest rates on more vanilla fixed-income assets are terribly low. They’re intentionally terrible because that’s the point of current monetary policy – to make interest rates absurdly low,” explains John Ryan, managing director of Greengate, a Washington D.C.-based financial advisory firm specialising in infrastructure and project finance.

While low interest rates may help some parts of the economy, they make it more difficult for what Ryan calls defeasance- oriented investors. “So infrastructure project finance, with a little more risk but still with very good recovery and mitigation parametres is a natural [fit],” he notes.

HIGH RECOVERY

Cleary also emphasises infrastructure’s high recovery rate. “The recovery is quite the interesting piece because these are really tangible assets with long lives, their value is quite stable – high and stable. So what that means, when you correctly structure a debt facility applying established project finance techniques and it defaults, the average industry recovery is 80 percent and 65 percent of projects achieved 100 percent recovery,” he explains. “The public data backs up our experience on this point. This compares favourably to non-financial corporate credit where recoveries have been around 35 percent to 50 percent.”

But if infrastructure debt and institutional investors are such a good fit, why has the relationship not yet matured?

The resounding answer is education. “Infrastructure finance is a solid story […] but it only works if you’re very careful and you know what you’re doing,” says Ryan. Christen echoes that view: “To do project finance deals you need to have a certain expertise. Some of the institutions have that expertise internally, but a lot of them don’t – especially the pension plans.”

UNDERSTANDING RISK

Educating institutional investors about this asset class will need to be a team effort. “It’s going to come from the infrastructure community as a whole,” Cleary explains.

“No one group is going to solve this.” Education is also the critical factor in understanding the risks of the asset class. “There’s a lot of experience in understanding the risks, analysing the risks, managing the risks, and equally important, pricing those risks,” says Cleary.

“So the first question for those investors is: ‘How do I access that experience so I know that when I start making decisions I have the right partners alongside me to help guide me?’ That might involve finding a long-term partner to support investors the whole way through the life cycle; or it might be a shorter term partnership of people trying to understand how they can participate in the sector,” he says.

Once institutional investors conquer the learning curve, infrastructure debt will be on its way to becoming an established asset class due to “fundamental forces”, which Ryan says will not change any time soon.

“On the demand side, there’s going to be demand from fiscally-strapped governments,” he notes, referring specifically to OECD (Organisation for Economic Cooperation and Development) countries.

Governments, whether on a national level in Europe or a federal or state/local level in the US, will face numerous fiscal issues for all sorts of different reasons. “It’s anything from changing demographics, to changing expectations of economic growth, to public pension plans’ liabilities, to healthcare obligations,” and they’re not going away, he argues.

While there are giant liabilities on the public sector side, at the same time, there’s a need for either renewed infrastructure or maintained infrastructure and there’s a need for privatisation simply to raise financing.

Renewable energy, especially in the US, is another critical driver. “Renewable energy is going to have to go forward with fewer subsidies and fewer mandates. To get transactions done will require more specialised and dedicated financing that will need to grow along those lines,” Ryan notes.

ALL HAIL SHALE

The third aspect is non-renewable energy build out, such as shale oil and gas. “The growth in this sector, particularly in the US, is going to be tremendous and there’s going to be a huge need for capital.”

Ryan is not the only one who thinks so. “The change that is occurring because of the shale oil and gas plays here is creating a number of very attractive opportunities – I don’t think anyone yet fully understands the magnitude of that change. It is phenomenal,” Cleary says.

To further illustrate the point, Cleary refers to his first LNG (liquified natural gas) financing for a project in the Middle East in 2005. “The story was all about the US’ insatiable demand for gas and how the US is going to be a gas importer for many years. Within five to 10 years, that story has been turned upside down.”

Energy developments in the US are part of the reason energy-related deals have been more prevalent. Another, as Cleary points out, is that historically the energy sector has been more closely linked with the private sector. Non-energy infrastructure, on the other hand, has been a public market, which is appropriate given infrastructure’s social character. That, however, has also been one of the impediments to private sector engagement.

Ryan believes this will inevitably change. “P3s [public-private partnerships] are here and many more P3s are going to have to happen in the US. They will be a fundamental part of the solution for addressing fiscal issues,” he says.
So then the obvious question is ‘when?’ The answer, unfortunately, is not so easy to come by.

“Predicting exactly when this will happen is really a political question and trying to predict what politicians are going to do in the short term, or in this specific year is impossible,” he says. “But to know what politicians will have to do in the long run is fairly certain because growing liabilities and crumbling infrastructure are just unavoidable facts.”