“I think in the next five years we will probably see more significant growth in infrastructure debt [compared to infrastructure equity].” That is precisely the kind of statement you would expect when you gather four top infrastructure debt professionals around a table to discuss the state of the market – right?
And yet, it was not AllianceBernstein’s Gerry Jennings, nor Aviva Investor’s Laurence Monnier, nor DC Placement Advisors Nina Dohr-Pawlowitz, nor even Hastings Funds Management’s Tim Cable who uttered that rosy prediction. It was IFM Investors chief executive Brett Himbury, in a completely separate conversation about how he expected the Australian asset manager’s infrastructure business to grow in the future.
That is not to say our roundtable participants might not share it. Or that they are not optimistic about the state of the infrastructure debt market – they are and what emerges from our hour-long discussion is that 2015 was a year of record institutional investor interest in infrastructure debt.
The reason why it is so important that bullish prediction did not come from our assembled professionals is both simple and powerfully telling. And it boils down to this: you do not need a table full of dedicated professionals anymore to recognise just how big the infrastructure debt opportunity has become. Its maturity is now in plain sight for all to see.
BIRTH OF AN ASSET CLASS
“If you looked at investor interest in infrastructure debt four years ago, it was quite opportunistic. Over the last couple of years, it’s become much more a part of a strategic asset allocation. And now the appeal is widening out, which in turn is driving products according to the needs of these new investors. For example, the large single mandates have always been in the market, but funds are now increasingly relevant to smaller investors coming into this market,” says Hastings’ Cable.
DCPLA’s Dohr-Pawlowitz agrees: “Two years ago, investors’ demand for infrastructure debt was limited, but that demand is now growing fast. This is mainly driven by two factors: the low yield environment in fixed income markets and the favourable regulatory treatment according to the Solvency II framework, especially with the latest developments, which shift the focus of life insurers towards the infrastructure debt market as a substitute for maturing bonds in their fixed income portfolios. This creates opportunities for funds as allocations in infrastructure debt are rising within the insurance industry. For example, we know of some mid- to large-sized insurers in Germany that have €2 billion infrastructure debt allocations each year.”
The consensus around the table is that insurance companies are, in fact, leading the charge into infrastructure debt. “We have seen an increase in appetite across the board from institutional clients over the last 12 months. The insurance companies, in particular, have really stepped up to the plate,” argues AllianceBernstein’s Jennings. “The impression we get from talking to insurers is that they have been waiting on the sidelines and now they’ve decided to move in on this market. Their appetite spans both senior and subordinated infrastructure debt opportunities.”
It is Aviva’s Monnier, however, that really drives home the size of the insurance opportunity. “Even if you look just at the European market, insurance companies manage some €14 trillion of assets and I believe about 58 percent are under-allocated to infrastructure debt. So that gives you an idea of the level of interest.”
Interestingly, that record level of interest remained strong even though 2015 was not all plain sailing.
“The first half of 2015 was actually a more difficult investment environment,” says Cable. “During the second quarter of last year, we saw public bond spreads moving out while private market spreads were still moving in. So the value equation – the illiquidity premium – was compressed during the first half of 2015. Some investors picked up on that, with interest waning a little bit during the first half. Either side of that has been pretty strong though.”
THE GREAT DISLOCATION
At this point in time, the drivers behind infrastructure debt – fixed income diversification, liability matching – are well known. But it is worth dwelling for a moment on just how big of an opportunity the ongoing search for alternatives to fixed income – “what we call next generation fixed income products,” Jennings quips – is.
As IFM’s Himbury pointed out, the main reason why he expects infrastructure debt to grow at a quicker pace than infrastructure equity is because investors’ fixed income allocations, which are now being partly diverted to infrastructure debt, are much larger than their alternative buckets, which typically fund infrastructure equity investments.
With 2015 potentially emerging as a key year in the consolidation of infrastructure debt as an asset class in its own right, the next logical question to our participants becomes: what is the industry doing to capture this substantial dislocation?
“As general partners (GPs), our role is to act as conduits between pools of institutional capital on one side and investment opportunities on the other,” offers Jennings. “So the first question we have to ask is: what do investors want? That’s your first challenge, because there are big investors, small ones – no two are ever the same. With so many different requirements and products, you need to have the flexibility, as a fund manager, to navigate through what your clients are looking for and have those products in your armoury. In our experience institutional investors are looking for yield, stability and diversification. It’s a bit like the old Rubik’s cube – you need to get all those different sides to match up.”
Getting all the different sides to match up, though, can get very tricky very quickly. “Most infrastructure debt managers come to market with AIFMD [Alternative Investment Fund Managers Directive] compliant fund structures – typically 10-year, closed-ended funds. But the infrastructure debt fund managers are talking more and more to traditional fixed income investors. This frequently poses a structural challenge, because fixed income managers often use totally different investment platforms, which have been designed and created for ‘liquid’ fixed income products, not built for an investment in an alternative fund structure,” explains Dohr-Pawlowitz.
Still, those allocations are coming through. “The largest allocations are going into the senior debt space,” Dohr-Pawlowitz says. “But given the senior loan market is so competitive and investors are not achieving the spread targets they need to, I think the recent trend is for investors to turn to direct investments and to also include some riskier assets to enhance their overall return. Hence, we see an increasing appetite for well-diversified, subordinated global infrastructure debt funds. For this asset class, the selection at the best and most experienced asset managers is essential.”
Monnier broadly agrees, but is keen to point out that not all senior debt investments are compressed equally. “I think there’s been a margin compression in the senior debt space, but having said this, most of that compression was in the core area, especially northern European PPPs [public-private partnerships], a sector where you have a lot of competition. You can find very attractive senior debt opportunities – you just have to stray from the crowd and find ways to source interesting deals. Also, let’s not forget yield compression suits some investors’ risk adjusted return expectations,” she argues.
For Jennings, one of the reasons why pricing on subordinated debt still looks attractive is because there is much less competition in the space. However, he warns that subordinated debt strategies often lack the same focus as senior debt plays. “I think senior strategies are a little bit clearer. With subordinated debt, you have huge variation in degrees of subordination, until you end up in equity. Some of the subordinated debt strategies out there stretch from the higher, less risky end to the lower end, where they offer almost preferred equity type of returns. That’s a big difference in strategy, so investors need to know what they are getting themselves into.”
“The good thing for investors,” adds Cable, “is that there are quite a few different managers with different options for them now. So infrastructure debt, as an industry, is responding with products to cater to those needs”. That kind of choice, Jennings is quick to point out, is very much a development of the last year.
But it is an important development in infrastructure debt’s maturation as an asset class. “If I compare infrastructure debt’s development with real estate debt, where you have a variety of sub-asset classes like residential, commercial, warehouses, office buildings, shopping centres, I think infrastructure is progressing along a similar path,” adds Monnier.
RISING RATES, RISING RISK OR OPPORTUNITY?
The other telling sign of infrastructure debt’s crystalisation into a fully-fledged asset class is that no one around the table seems particularly fazed by the potential impact of a rise in interest rates. That is to say, no one believes that a rise in rates will prompt a rush to the exits, although it might dampen interest in fixed income alternatives.
“Interest rate risk is not necessarily allocated to us so rates going up doesn’t necessarily impact on the opportunity,” claims Cable. “I do think that it’s true that if rates get above, say, 4 percent (to pick a number) in the sovereign market, that might have an impact on the risk appetite of investors.”
However, like Cable, Jennings doesn’t believe that impact will be existential. “I think infrastructure debt is part of a long-term trend. We have institutional investors looking for fixed income alternatives and they have started doing that for stability and diversification purposes. I believe it’s wrong to look at a certain point on a graph and say: ‘Oh, spreads are here today so now is the time to get into infrastructure debt.’ This is a long-term asset class and investors are now aware of it – that trend is not going to reverse.”
“Actually, a slight increase in interest rates might be positive,” Monnier points out. “In Europe, the infrastructure market has traditionally been financed with bank debt and interest rate swaps. At the moment, there’s a huge cost to unwinding those swaps, but if rates increase, there will actually be more refinancing opportunities. So I don’t think investor interest will wane. On the contrary, an increase in rates could unlock quite a bit of the market.” Plus, Monnier adds, “a rate increase will hurt floating rate borrowers much more than infrastructure debt”.
Our roundtable participants are also not overly concerned about a noticeable return of the banks to the infrastructure debt market, particularly in the senior debt space. “Banks will always be in this market in some way, shape or form, but I think what is true is the theme that banks are not going to provide long-dated liquidity anymore. That trend offers a strong basis for why there’s a strong opportunity in the sector,” says Cable.
“On the senior side, you’ve seen the banks provide more liquidity, particularly at the shorter end, the 3- to 5-year space, but when you go up to 7- to 10-years, you see much less competition,” adds Jennings. That is not to say fund managers are immune to being scooped by banks. After all, “fund managers need to earn at least 2 to 3 percent yield on a fixed rate level per annum for their clients, while banks can sometimes do these deals for a lower return – but just as a loan for a period of 5 to 7 years maximum,” argues Dohr-Pawlowitz.
But banks have different drivers, stresses Monnier, which inherently limit their competition with private debt providers. “Bank appetite is driven largely by internal funding and client servicing considerations. But their clients are the borrowers, not investors. That creates an interesting dynamic when you develop a partnership model with a bank. We have seen banks trying to intermediate the origination of loans to institutional investors. However, the interesting thing we find when we talk to banks to source deals is that they sometimes have a different focus, because their clients are not our clients.”
Fortunately, investors are also gradually getting more sophisticated, which means they increasingly know exactly what they are looking for from their infrastructure debt investments.
“Investors are much more sophisticated,” says Monnier, “so the debate goes beyond chasing yield now to target returns, risks, investment duration and the like. I expect investors will become even more sophisticated in this space. And that means they are looking for people that are here to stay and will discriminate more in terms of providers and fund managers.”
So how else will that increased sophistication translate in terms of product demand? “There are more investors with much bigger allocations and they all want to partner with experienced global managers,” emphasises Dohr-Pawlowitz. “From the product side, I think the trend will be for more managed accounts. The large insurers will build up their platforms, same as GPs would, and these platforms will also offer services to smaller insurers. But we will still see funds, because investors cannot do everything by themselves – they need to partner with external fund managers and funds to have a broad diversification from day one.”
Sophisticated investors, long-term drivers and a multitude of products to cater to their needs – sounds like infrastructure debt has truly come of age now.