The debt innovators

When talking to infrastructure debt managers or investors, there is an inevitable degree of similarity to their origin stories. And it goes something like this: global financial crisis gives banks a heart attack; banks stop lending, creating a liquidity drought; regulators tighten the screws, hampering banks from lending long; canny private investor spots a gap and moves to fill it.

In this sense, the genesis of Macquarie Infrastructure Debt Investment Solutions pretty much fits the bill, though there are some peculiarities as to how its two co-heads – Andrew Robertson and James Wilson – came together that are worth recounting.

“Initially, I was focused on insurance companies and looking at solutions that would help manage their transition into Solvency II, looking at the challenges on the investment side for annuity insurers in particular,” recalls Robertson. “In the course of doing that, it became clear there were a number of challenges in terms of their access to fixed income portfolios that would lead them to a search for yield, longer-dated assets and very secure income streams.”

Wilson, who at the time advised on the borrower side, was dealing with the challenge of getting banks to lend to Macquarie’s clients. “We were increasingly seeing banks pulling back from long-term financing and, as a consequence, we were increasingly approaching institutional investors directly.”

The problem, in the beginning, was connecting the dots between borrowers and private investors, with both Robertson and Wilson frustrated at seeing deals that made economic sense fall by the wayside. What was missing, Wilson explains, was a fiduciary layer. “If you weren’t able to offer investors a fiduciary layer, you wouldn’t get the deals done. That spoke directly to the idea of building a fiduciary asset management platform,” explains Wilson.

Macquarie Group chief executive Nicholas Moore, no doubt spotting the synergies that creating a debt unit would bring to Macquarie’s industry-leading equity and advisory businesses, helped the pair get together in 2012 to solve this problem. Fortuitously, that coincided with a process being run by reinsurer SwissRe, who was looking to find a manager to help it access the burgeoning infrastructure debt opportunity. SwissRe, the co-heads recall, believed that banks’ retreat from long-dated lending was not just a temporary opportunity, but a permanent one anchored in regulatory change. Macquarie helped convince them that it was best-placed to make good on that vision and the rest, as they say, is history.

Still, while the co-heads admit that MIDIS too was born out of the opportunity created by retreating banks, they are keen to stress that they never wanted to be just a bank replacement.

“We were very keen not just to fill a bank gap,” stresses Robertson. “We had a sense very early on that institutions had specific needs and that we could structure assets that generated a better return on capital.”

Adds Wilson: “Because of the experience we had in advising a wide range of infrastructure equity investors, we had the insight of really understanding what they needed in the leverage they were putting on their assets – what really made a difference for them. It wasn’t just a question of replicating a bank product: there’s often another way of providing financing for a borrower that actually gives them a better result and allows our investors to also get a better return.”

That desire to differentiate led to a bet on inflation-indexing that would, in time, result in the UK’s first inflation-linked infrastructure debt fund, which closed on £829 million ($1 billion; €917 million) last year.

“Traditionally, a UK borrower – let’s say for a PFI project or a regulated utility – would go out and borrow floating rate debt from a bank and would then enter into a separate inflation swap with the same bank (or another bank) and have two separate products, none of them ideal on their own. We came in and provided direct inflation-linked lending, which works perfectly for our clients, but also matches exactly what borrowers need, without them having to enter into a long hedging transaction,” explains Wilson.

Demand for inflation-linked infrastructure debt was strong on both the investor side – particularly among UK corporate defined-benefit schemes – and borrowers, Wilson says. It is also “one of the characteristics of the UK market that there are a lot of assets with direct links to inflation – through RPI or increasingly CPI, or via regulation, availability payments or renewables subsidies”.

In an early white paper, MIDIS quantified the UK inflation-linked infrastructure debt opportunity as a £4 billion a year market and has since invested over £1 billion in it. Predictably, though, it wasn’t all smooth sailing in the beginning.

“We identified that there were assets with this need and investors with this need, but then there didn’t seem to be dealflow between the two. So we spent time going out to investors and asking them: ‘Would you like this product?’ And they said: ‘We’d love it but there’s no dealflow, so there’s no point’. We then went to borrowers and asked them if they would like this kind of product and they said they would but there was no investor demand. So we had a classic chicken and egg situation,” remembers Robertson.

The deadlock was broken by one of MIDIS’s UK pension separate account clients, who was willing to back them and demonstrate that the demand was there. That, in turn, gave MIDIS the push it needed to eventually raise its UK-focused inflation-linked infrastructure debt vehicle. With Fund I now 95 percent invested – and Fund II, targeting £1 billion, currently being raised – how happy is MIDIS with its inflation-linked vehicle?

“We are very happy with the returns,” answers Wilson. “We were targeting 200 basis points over the benchmark and we’ve outperformed that; we were targeting 12-year duration and we’ve outperformed that too. We’ve got significant inflation-linkage all the way through the fund, so if you track back the value that has been created to our investors through both the liquidity premium and the duration, I think it will have had a significant positive impact on our clients’ funding deficits.”

AN ACTIVIST APPROACH

If innovation is one of the pillars of MIDIS’s investment approach, the other is surely activism. The co-heads point out that, at around 40 people, MIDIS probably has one of the largest teams in the infrastructure debt industry. It also prides itself on its deep relationships with borrowers – where the Macquarie brand is leveraged to its full extent – from which it directly sources most of its opportunities.

“We like situations where we can engage with the borrower early enough so that we can structure the transactions in a way that makes sense for our investors,” says Robertson. “We have a number of assets where we underwrite 100 percent of the lending, but [that engagement] is not constrained just to situations where we are 100 percent investors – we also work with commercial banks in situations where we think we can be very complementary.”

Those situations can include scenarios where banks provide revolving credit facilities, or shorter-term, seven to 10-year financing, with MIDIS sitting alongside them and providing long-term debt; or instances where banks are providing construction financing and MIDIS provides term financing once construction finishes, for example. Ticket sizes can be as large as £250 million, with MIDIS’s longest asset stretching to 47 years.

So far, the meat of MIDIS’s investments have been in the senior debt space. “That was driven by the insurance industry to begin with, because of their Solvency II requirements. When you’re looking for long-dated assets it makes a lot of sense to stay in the senior secured part of the capital spectrum,” says Robertson.

“Frankly, though, it’s also where the biggest amount of opportunities in infrastructure are, as infrastructure is inherently an investment-grade sector,” adds Wilson.

Broadly speaking, the co-heads stress, that has allowed MIDIS to generate average returns across its senior debt portfolio of over 2 percent above the relevant risk-free benchmark, weighted towards long-dated assets offering some type of hedging – be it fixed rate or inflation-linked. MIDIS can also opportunistically take on floating rate assets, though. Overall, its $3.1billion portfolio consists of some 35 investments across renewables and regulated assets, to name just two sectors.

NEW GEOGRAPHIES, NEW CLIENTS

With the UK and Europe conquered, the US emerges as the next target in MIDIS’s global expansion. As we recently reported, senior vice-president Ariel Jankelson is leading the US expansion effort out of New York, with Sunil Malhotra, an investment team senior associate, relocating from London. The team will focus on energy, including both generation and midstream; telecoms, including broadband; transportation; and social infrastructure, including P3s.

So what lessons from Europe is MIDIS taking to the US? “We are definitely carrying over our activist approach. There are opportunities to be had in engaging directly with borrowers and being able to develop a product that specifically caters to their needs as well as being able to compete through certainty and quality of execution,” answers Robertson.

Certainty of execution is, in fact, another one of MIDIS’s investment pillars. “We know as a result of our experience that execution capability allows you to achieve a superior return. For many borrowers, it’s not just about price – it’s also about certainty of execution – and they value that in a very tangible way,” explains Wilson.

“And of course we are also sub-selecting for areas where that certainty of execution nets a premium,” adds Robertson.

But Wilson admits the US differs from the UK and Europe in one important respect: “There aren’t that many assets with the same inflation linkage in the US. It’s a different market that traditionally hasn’t been that reliant on banks – it’s been much more of a bond market, private placement, or tax exempt municipal bond market.”

MIDIS’s other area of expansion is partly geographic, but mostly has to do with its client base, which at the moment is predominantly made up of pension funds (about 70 percent). In its most recent white paper, the firm has pointed out that UK pension funds could net a £270 million deficit reduction per every £1 billion shifted from corporate bonds to infrastructure debt.

“Pension funds are now facing a real challenge due to falling gilt yields. A pension fund with a typical hedging strategy will have seen its funding deficit increase by more than double over the last couple of years – and around 15 percent over the last three months since Brexit. So many of them have started to look to private debt. But we think they are only accessing private debt based on the headline liquidity spread and they are missing the point around how long-dated hedging characteristics within [infrastructure] assets are incredibly important as well,” says Robertson.

Wilson elaborates: “The benefit a pension fund or an insurer gets [from private debt] is certainly generated in part by a liquidity premium. But almost twice the value of the liquidity premium comes from the hedging characteristics and the duration that you get from an asset.”

And then there is the opportunity of using MIDIS’s European expertise to net clients in other parts of the globe. “You’re actually seeing Solvency II style insurance regulation penetrating markets like China. Also, the low yield challenge is affecting pensions across the globe. There’s a sense that there’s a huge pool of investors out there – and a huge pool of assets too,” Robertson points out.

“In addition, banking regulation is unlikely to become less conservative, so there is a real shift towards institutional lending. Some institutions will invest directly, but the majority won’t, so that’s where Macquarie can be as important as we are on the equity and advisory sides,” adds Wilson.

Considering that the majority of infrastructure is financed using debt that is what is called room for growth.