Segmentation now

We have just held the most successful edition of our annual Infrastructure Investor debt roundtable – with six leading industry professionals around the table – and the key takeaway from it is that, as one participant aptly pointed out, it might not make sense to keep holding it in this format for much longer.

Confused? Blame it on infrastructure debt’s increasing maturation, which is generating the kind of segmentation that could easily give birth to multiple infrastructure debt roundtables. Granted, we are still a few years away from this, but you could already see the growing heterogeneity around the table this year.

For example, Alexander Waller and Ian Simes, of Whitehelm Capital and Brookfield Asset Management respectively, are focusing predominantly on junior/mezzanine/high-yield, while Allianz Global Investors’ Claus Fintzen and Schroders’ Charles Dupont are more inclined to invest in senior debt. Emeka Onukwugha, of Barings, could perhaps be classed as primarily investing in senior debt, while Tim Cable, of Hastings Funds Management, can move up and down the capital stack.

While flexibility was very much the key word around the table, the differences in strategy are palpable.

“Initially, everyone said infrastructure debt is long-dated, senior and fixed rate – that’s what it was all about and that’s what was most appealing to institutions. As the market started to evolve, you’ve started to have more differentiated strategies, whether through separate accounts or pooled funds. Not every investor is looking for long-dated, fixed-rate senior debt,” comments Simes.

“I think there really is more segmentation,” agrees Cable. “There’s senior, there’s junior and even within senior, you have people insisting on senior-secured, but others are open to different things – depending, of course, on whether it provides whatever outcome they are looking for. It’s much more nuanced.”

Waller gives an example: “If capital ratios are causing headaches for a European insurer, then they will most likely be looking at those types of senior products that enjoy superior capital treatment under Solvency II. If it’s a pension fund hunting for yield in Germany, Denmark or Sweden, then they will be positively inclined towards high-yielding products.”

In a way, this increased segmentation is one of the classic signals that an asset class is beginning to go mainstream. “We started investing in infrastructure debt almost five years ago,” recalls Fintzen, “and in Europe at least, only very big investors would look at the asset class.

“Now, a lot of chief investment officers from smaller insurance companies and pensions are looking at infrastructure debt. In fact, we are seeing more demand than there are assets to support it, depending on how you position yourself in the market”.

That demand has allowed Dupont, who joined Schroders in August 2015 to head a dedicated infrastructure debt unit, “to raise nearly €1 billion in 2016 […] having started from scratch. My surprise is that the capital is still there even in the case of investors which have opted not to recruit their own teams, but rely on third-party asset managers instead,” he adds.

It has also given Barings’ Onukwugha what he describes as “a very strong fundraising environment in the US”.

He adds: “We started actively fundraising mid- to late last year and have received a lot of interest from institutional investors looking for infrastructure exposure as an extension of their core fixed income strategies. We’ve also had a lot of inquiries from Asia, where Barings has a big operation in leveraged loans and high-yield bonds. Overall, the level of interest, especially from insurance companies and state pensions in North America and Asia, has been high.”

“I think it was interesting in 2016 that there’s a wider group of investors allocating to the market and we certainly saw a number of those [new players] in Asia. Asia is still a small part of the overall pie, but perhaps a high-growth part of the pie,” says Cable.

INEVITABLY SENIOR
Still, despite the increased fragmentation, senior debt is always going to be where the biggest amount of capital is invested. Partly, that is just because of the way infrastructure deals are financed. But it is also because senior debt is the natural port of call for investors looking to diversify their fixed income allocations.

On top of that, regulation is also fuelling investments in the space. “Banks are still extremely active in the infrastructure market and regulations have driven them to focus on senior investment grade. On the regulatory side, institutions are also being pushed into the senior investment grade space. That, however, is hurting returns,” Simes says.
Fintzen sees the pile up of investors into the senior-secured, core infrastructure space hitting not only margins, but also deal terms. “We wouldn’t bid on a German road at this point because the terms are simply not investment grade and the margins are ridiculous.”

“Plus, it’s not just more investors coming into the market,” Fintzen continues. “You also have to deal with crowding out from the multilaterals. For example, the European Investment Bank is the biggest threat in that kind of market for us. So, the real question is: how can you find areas of the senior-secured space where you still get paid for the risk and the complexity you are taking?”

“We see very good opportunities for senior debt as long as you remain within mid-caps and not large-caps,” answers Dupont. “This opportunity appears to be more on the short duration segment – five to 10 years’ maturity – where we see there is a significant dealflow and still very good relative value. That is, as long as debt advisors or bond arrangers don’t just try to chase the cheapest cost of capital, but focus instead on attracting reliable investors.”

That is where the importance of strong origination capabilities comes into play, all around the table agree. “We added origination so we can proactively seek out sectors and geographies in the infrastructure debt space where you can still find relative value,” explains Onukwugha. “It’s not obvious these days and if you’re looking for banks to provide dealflow, all you get are market deals where it’s difficult to add alpha.

“The last point I’d make is that having a global platform allows you flexibility. PPPs in most of Western Europe, for example, have been extremely tight on a spread and yield basis. However, in certain US states or in post-crisis Ireland, you’ve been able to pick up some value while providing portfolio diversity. In the US, contracted renewables have come down, but there remain pockets where you can find value. The ability to scour the globe and take a multi-sector approach in order to deliver relative value and a well-constructed portfolio is crucial.”

MEZZ: BETTER THAN CORE EQUITY?
Of course, if you ask Simes and Waller where they think the best value can be found today, they will point you firmly in the direction of the mezzanine and high-yield space.

“We think mezzanine debt offers much better relative value in relation to senior debt and potentially even relative to core equity – especially when compared to mature infrastructure, such as operational regulated assets,” asserts Simes.

He continues: “We’re seeing core infrastructure equity at sub-10 percent IRRs and that doesn’t seem to put very much return on risks like regulatory changes or exit multiples. If you’re a 10-year closed-ended equity fund and you buy something today at a very high multiple, and you’re expecting to sell it in 10 years’ time for that same high multiple, if discount rates are higher and general values have come down for whatever reason, then you may not achieve the IRR you were expecting.”

Simes sees core equity which, by definition, does not have much room for upside, exposed to significant downsides. “Much of what we’ve seen in the last 10 years in terms of upside is a reduction in discount rates,” Simes argues – or as Waller calls it, “a massive beta play”.

“If that reverses,” Simes continues, “then suddenly all of those investments become exposed. So we quite like the risk/return profile of high-yielding, subordinated debt-type strategies. Yes, you get a slightly lower return, but with much more downside protection than some of those core equity deals.”

Unsurprisingly, regulation is also driving the mezzanine/subordinated debt opportunity, and that is because the same rules that are driving banks and investors into the senior debt space are also limiting the amount of leverage they are willing to put on deals. According to Simes and Waller, that is creating a gap that high-yield investors can fill.

“Actually, that’s the most fertile hunting ground for us: where the senior debt can be financed in investment-grade markets but the company requires an additional tier of debt on top; that’s where we can earn some more yield at low incremental risk,” Waller explains.

The challenges on the high-yield side, according to Waller, are to do with structuring and refinancing. “I feel we’re turning down more deals because of structuring rather than pricing. We’re seeing people trying to push some fairly audacious structures and it feels a bit like a return to 2006-07,” he argues. “If there is a big risk for us, it’s refinancing risk. If we can sit above easy-to-refinance senior debt, then we are generally happy as investors. But we’ve got to remain core and not play in those tangential, private equity-style parts of the market.”

THE IMPORTANCE OF BEING NIMBLE
Hastings’ Cable drives home an important point: that flexibility is essential to finding relative value, regardless of where you play in the capital stack.

“The key thing for us is to make sure we are not going head-to-head with big pools of liquidity. That’s part of the reason our investors pay us a fee: to find the best relative value opportunities available at any point in time. And that should be by trying to provide marginal liquidity for a transaction in some way, shape or form. The point is that the opportunity set today will be different than in six months. In fact, we’ve seen that the market changes and evolves every six months so you need to have flexibility to go [after it].”

Onukwugha very much agrees: “We can provide multiple currencies, fixed and floating debt, rated and unrated, listed and unlisted, bank and bond documentation, as well as M&A bridge and term-out financing. We underwrite construction and provide delayed-draw financings. We form deal trees in different global offices to back different buyout groups and can hold spreads for 90 to 180 days. All of these capabilities allow us to access transactions that many institutions don’t normally have access to – that’s also how you get relative value.”

Flexibility, however, does not marry well with the preferred structure of choice on the equity side – the blind-pool unlisted fund – which is why infrastructure debt is likely to remain mostly a separate accounts game. You can see that in the data, with placement agent Probitas Partners reporting in a survey last year that infrastructure debt funds accounted for a mere 5 percent of the overall fundraising market during the first half of 2016, compared with a peak of 23 percent in 2013.

It is not just that a closed-ended fund is not the best structure to mix and match debt instruments – it is also about scale. “Most of the debt funds today have AUMs below $500 million – that is relatively small scale for an investment-grade strategy,” stresses Dupont. “Infrastructure debt is appealing as a diversification from investment-grade fixed income strategies and as such it requires scale to be sustainable and attractive to investors.”

Depending on where you are, you might also find that regulation will work against you. As Fintzen points out, before January 2017, German insurance companies would treat a pooled debt fund as equity from a regulatory perspective (that is now finally changing due to Solvency II). When it comes to capital treatment, Onukwugha points to a similar story in the US, which is why, “for insurers who are looking at infrastructure debt in the context of their asset liability management as well as their own regulatory sensitivities, having a separate account is often the way to go”.

That is not to say there are not geographies that treat pooled debt funds favourably, but generally a pooled fund is a better vehicle if an investor’s primary objective is to generate yield, meaning it is much better suited to junior debt or high-yield strategies.

Despite that, Waller urges caution: “We are evaluating a fund route to market. It’s important for us and investors to have a sensible investment period, which we think should be around 18 months from close. We know the opportunity exists now, the transaction flow is strong, but I can’t tell you if those attractive transaction parameters will still be there in four or five years.”

PRICING QUICKSAND
As our conversation comes to an end, three main conclusions emerge: firstly, infrastructure debt is segmenting and not just between senior and junior debt; secondly, it needs scale and flexibility, which make separate accounts the better way to tackle it; and thirdly, you need strong origination capabilities to follow the market’s half-yearly shifts.

What, then, stands in the way of further growth? For Dupont, too many players with too little capital under management are the main problem, and will almost certainly lead to manager consolidation down the road; Cable cites a lack of data on metrics like correlation and returns – as well as fragmented benchmarking – as a hindrance; Waller reckons it is difficult to gauge the size of the high-yield market, given the different definitions going around.

But Fintzen points to regulation, which he feels is always one step behind the market, as a potentially bigger problem in the future:

“On the senior debt side, if you look at the European Central Bank buying sovereign and corporate bonds, you just don’t know how to position yourself on the private debt side. You might say you want to position yourself 100 basis points above the liquid stuff […] but then the liquid stuff is priced too tight in the market because of the ECB bond buying programme. If the ECB stopped buying, margins could immediately jump by 100 basis points in Italy and Spain. I find it challenging to find a price point to rely on because you don’t know how much distortion has already happened to the market.” ?