Enticing the institutions

A report from McKinsey & Co puts global infrastructure financing needs at $57 trillion by 2030. In our view, this is an opportune moment for institutional investors to step in and fill some of the huge gap created by public funding shortfalls – which we estimate at $500 billion per year until 2030. Indeed, many of the characteristics unique to project finance assets are very attractive to investors.

Using our base-case assumptions, institutional investors could provide an estimated $200 billion per year – or $3.2 trillion by 2030 – given recent industry-stipulated asset allocation targets for infrastructure financing. Needless to say, this will require a significant increase on existing allocations.

A DIFFERENT PROJECT FINANCE MARKET

The evidence suggests that some have already begun to increase their allocations to this asset class. For instance, six large insurers plan to invest £25 billion (€31 million; $41 billion) in the UK government’s National Infrastructure Plan, which aims to provide energy, transportation, and waste and water projects with £375 billion (€458 million; $620 billion) over the next five years and beyond.

Moreover, institutional investors’ allocations worldwide could increase to a weighted average of 4 percent, which would provide around $200 billion in additional funding for the sector, annually. We estimate that investors are targeting allocations of 3 percent to 8 percent in the next five years – a significant increase on traditional allocation ranges – based on figures from research firm Preqin and the OECD.

Preqin’s research shows that 58 percent of investors intend to increase their funding allocation for infrastructure in the long term. And nearly two-thirds said they plan to increase capital allocations to the sector in the next 12 months, compared with the previous year. In total, this could correspond to as much as $3.2 trillion in new investment for an asset class that is showing steady growth.

Some 40 percent of this investment would come from pension funds – already the largest private-sector funders of infrastructure in North America and Australia. Currently, a handful of banks and a number of capital markets players – including insurers, infrastructure fund managers and investors in public bonds – make up the long-term global project finance market, and institutional investors have shown more enthusiasm for increasing investments into infrastructure than others.

What’s more, asset consultants Mercer found that the percentage of Canadian pension plans investing in infrastructure jumped from 8 percent to 24 percent from 2010 to 2013. Indeed, the Canadian model is often held up as an example that pension funds around the world hope to follow.

UNDERSTANDING RISKS AND REWARDS

This kind of increase in participation would be helped by nurturing a better understanding of the risks associated with this type of lending among investors. To this end, Justin Lin, former chief economist at the World Bank, and Kevin Lu, director of the World Bank Group’s Multilateral Investment Guarantee Agency for the Asia-Pacific region, suggested the establishment of a fund to help non-traditional, private sector lenders become more comfortable with infrastructure investment.

In an editorial for the Huffington Post published in October 2013, they discussed the deeper level of expertise necessary for infrastructure investment compared with that needed to invest in other asset classes. As such, “most long-term capital holders such as pension funds are unlikely to have the expertise already in place”.

Lenders with the ability to think of infrastructure as a discrete asset class – with well-defined risks and rewards – will be more at ease investing in it. Certainly, the benefits are many and include:

*Higher yields than similarly-rated government and corporate bonds (mainly because of the “illiquidity premium” on project debt, combined with the fact that infrastructure bonds are not usually backed by the full faith and credit of the government sponsor);
*The capacity to match long-dated assets and liabilities;
*Relatively low default totals and higher recovery rates than corporate bonds;
*The opportunity to diversify into a broader investment pool with low correlation to other asset classes.

STRONG SIGNS OF CREDITWORTHINESS

Our default and recovery statistics show that infrastructure projects display strong signs of creditworthiness – a trend we expect to continue. The average annual default rate for all rated project finance debt is only 1.5 percent since 1998 – when the first default of a rated project occurred – which is below the 1.8 percent default rate for corporate issuers in the same period.

At comparable rating levels, infrastructure projects are generally no more risky than corporate entities. Even as defaults among corporate borrowers increased during the global financial crisis in 2008 to 2009, project finance transactions were relatively resilient. The annual global default rate for rated project finance deals was about 0.5 percent in 2007, increasing to 0.75 percent in 2009.

A range of contractual protections, including those providing projects with stable revenues, can mostly account for this comparatively low rate of default. Also worth noting is that this data comes from a significantly smaller set of rated transactions – around 200 – than the rated corporate issues (at over 4,000).

Yet project finance debt also delivers a better rate of recovery when defaults do happen. The average recovery rate across our rated project finance portfolio is around 75 percent. In practice, most lenders receive close to 100 percent, and very few receive nothing. This can be partly attributed to the unique qualities of project debt, which typically gains advantage from strong collateral, while lenders benefit from first-priority security.

What’s more, strong collateral combined with certain contractual features allows projects that default to stay as going concerns in many cases, ensuring cash flow and strengthening prospects of recovery. Typical unrated project loans also often enjoy full recovery, which we define as 91 percent to 100 percent, according to data collated by S&P Capital IQ. In any case, it's clear that the prospect of a healthy post-default recovery is significantly better for project finance than the average of about 45 percent among corporate borrowers.

Of course, the market’s success depends on yields and prices being attractive to both lenders and borrowers. As it stands, historically low yields on long-term government debt and tight credit spreads throughout the capital markets make for pricing on project bonds that favours borrowers.

GRASPING THE OPPORTUNITY

Overall, institutional investors look ready to exploit what we find to be an unprecedented opportunity to invest in infrastructure, worldwide. Although only time will tell whether institutions’ financing of projects reaches the tipping point necessary to completely offset public funding shortfalls, the signs outlined above point to it plugging a considerable amount of the gap that governments leave, with other – more traditional – sources of capital providing the rest.

Michael Wilkins is managing director of infrastructure finance at Standard & Poor’s Ratings Services