We have been here before. Investments in infrastructure-like assets have been taking place for years, with acquisitions of laundry companies and crematoria making market veterans reach into their dictionaries to double-check their definitions of infrastructure. Yet these deals have been relatively few and far between, and there has not been any concerted wave of interest in these niche sectors.
However, recent investments by managers across the asset-leasing spectrum could change that. Aircraft financing, residential heating and cooling systems and transport-based leasing companies have attracted the interest of some of infrastructure’s largest GPs. Although LPs largely place these investments in their core-plus buckets, you could argue that, unlike laundry companies and crematoria, most asset-leasing sectors have their roots in core infrastructure.
The question then becomes: are these transport and energy deals with a twist, still backed by steady revenue streams and long-term contracts? Or are they more complex assets, belonging to other markets, perhaps more heavily correlated to GDP and whose contracts are not actually that long-term? Crucially, is asset leasing providing LPs with what they originally signed up for? The ‘devil-in-the-detail’ cliché has always held a special resonance for infrastructure investors, and asset leasing is no exception.
Flying off the shelf?
One of the most recent asset-leasing sectors to land in the infrastructure bucket has been in the aviation space, following KKR’s $1 billion deal in January to buy 50 percent of aircraft-asset manager Altavair. KKR said it had been interested in pursuing this kind of deal for “several years”, and it doesn’t appear to have been alone.
“That’s the case not just in the West but also in the East,” says David Yu, adjunct professor of finance at New York University Shanghai and an advisor in the sector. “In Korea and Japan, a lot of infrastructure players are starting to look at aircraft leasing.”
Yu believes the motivations behind this are twofold. “It’s not large returns on average, but it is stable returns,” he says. “Also, it’s large dollar sizes, and infrastructure funds are having difficulty deploying capital, so this is a good way of doing so. The profiles are similar, and it is generally good on the credit spectrum.”
“If an investor wants higher returns, then you can move into an opportunistic approach with older aircraft or go into transactions with shorter leases. In this respect, you could get double-digit returns”
Christian Schloemann, KGAL
Christian Schloemann, head of transaction management at KGAL, says returns in the sector depend on the age of the aircraft and the length of the leases. The company, in addition to its suite of renewables funds, runs a separate aircraft leasing fund business.
“New-to-medium [aged] aircraft you would probably end up with a 6-7 percent IRR,” he says. “If an investor wants higher returns, then you can move into an opportunistic approach with older aircraft or go into transactions with shorter leases. In this respect, you could get double-digit returns.”
The prevalent theme among players in the aircraft leasing sector is that the risks are low and the assets are backed by long-term contracts, typically ranging from eight to 12 years. But low risk is not the same as no risk – or even insignificant risk.
Macquarie is another actor in the sector, albeit through its Macquarie Asset Finance division, using its balance sheet to invest instead of its infrastructure funds business. It maintains that aircraft require specialist day-to-day management and expertise and that they are “infrastructure-like” without being pure infrastructure.
“While assets are strong, the leasing counterparties are typically not as strong as those for traditional infrastructure assets,” a spokesman for the group says.
Even so, this did not deter pension fund manager PGGM from taking a 25 percent stake in Macquarie AirFinance in May via its infrastructure fund, following the spokesman’s initial comments. Furthermore, the Dutch outfit was described as the “ideal partner” by Stephen Cook, head of transportation finance at Macquarie, after the deal was announced. Both parties declined to comment further for this piece.
There has been a litany of airlines in financial trouble, particularly in Europe, leaving the fate of aircraft somewhat uncertain. Remarketing aircraft is a key component of the industry, with Scope Ratings estimating that this can take a minimum of six months at a time.
“If you own a power plant in a certain jurisdiction and the counterparty goes bust, you’re stuck with that,. With aircraft, there’s a tried and tested method of retrieving it”
Brandon Frieman, KKR
Yet Brandon Freiman, head of North American infrastructure at KKR, says remarketing remains less of a risk than some of the challenges faced by more traditional infrastructure assets.
“If you own a power plant in a certain jurisdiction and the counterparty goes bust, you’re stuck with that,” he says. “With aircraft, there’s a tried and tested method of retrieving it, and you can put it back on lease to someone else. The sector has good fundamentals in terms of supply and demand, which helps in the event you need to re-lease aircraft.”
Although Schloemann believes there remain significant differences between aircraft leasing and infrastructure businesses, he has a similar assessment to Freiman. “The commodity is very simple: there is a limited range of aircraft available,” he says. “You have only two manufacturers in Airbus and Boeing. If the airline defaults, you bring it to another airline.”
As to whether aircraft leasing is infrastructure, Freiman is reluctant to subscribe to a general definition of infrastructure, preferring to focus instead on an asset’s characteristics.
“We’ve always had a risk-based approach to infrastructure, not a sector-based one,” he says. “The sector-based approach might say toll roads are infrastructure and aircraft are not because they’re not fixed to the ground. A risk-based approach leads us to not do a toll road that’s 90 percent levered. But a portfolio of diversified aircraft with good counterparties and long-term contracts is infrastructure for us.”
KKR’s deal for Altavair fits in with the group’s approach to risk, with the firm investing on a 50:50 basis via its infrastructure and credit units. However, it was not seen as suitable for KKR’s private equity arm.
“Asset leasing tends not to be a great fit for private equity,” Freiman says. “The returns tend to be lower than what you would take in private equity. On both the risk and return perspectives, it would be further down on the spectrum.”
Although infrastructure investors have only dipped their toes into aircraft leasing, GPs have certainly found their feet in Canada’s residential energy leasing market – or “household infrastructure”, as Hong Kong-based Cheung Kong Property Holdings termed it in 2017. The firm bought Reliance Home Comfort for C$2.8 billion ($2.2 billion; €1.9 billion) in March 2017, syndicating 25 percent to its Cheung Kong Infrastructure arm.
This was followed almost 18 months later by Brookfield Asset Management and iCON Infrastructure, which acquired Enercare and Vista Credit respectively. Within this small timeframe, infrastructure investors had bought out three of the four largest “household infrastructure” players.
So, what exactly is “household infrastructure” and how does it work? Simply put, it involves leasing water heaters and home cooling and heating equipment to residential properties, predominantly in Canada.
After announcing the Enercare deal, Brookfield Infrastructure chief executive Sam Pollock explained the company’s appeal during an earnings call with investors: “From installation, these assets provide revenues underpinned by long-term, inflation-linked contracts. Recurring revenues from equipment rentals and protection plans generate approximately 80 percent of the company’s revenue, resulting in predictable, long-term cashflows.”
Michael Smerdon, iCON’s head of North America, is aware that some infrastructure investors will not regard air conditioners and heating equipment as infrastructure assets. However, he believes they play an essential role in Canadian life.
“Household infrastructure is an asset class that, while it is considered core infrastructure, may not be the first thing that comes to mind,” he says. “We thought it might be a little less competitive.” Smerdon adds that scepticism of the Vista Credit deal might be fuelled by the fact that many observers remain unaware of that company’s business model, which he describes as “largely an Ontario phenomenon”.
“Ninety percent of people in Ontario rent their water heaters, which is unusual, and you don’t find that in too many places in the world,” he adds. “The homeowner will rent the heater and Vista will own it, and take the risk of warranty, service and the quality of the asset. As a homeowner, rather than buying a piece of equipment, you’re buying a service.”
Whereas Enercare and Reliance have an approximately 80 percent share of the household infrastructure market, Vista uses a network of dealers to source its customers. Enercare and Reliance together have about three million leased installations, with rentals comprising about 70 percent of Enercare’s $1.3 billion revenue in 2017. All of the rental revenue was a result of the “Ontario phenomenon”, though this is not a limiting factor for the companies’ business models. Enercare has begun expanding into the US, and Vista is planning a similar move.
If the model looks and sounds like a utility, that’s because it basically is. Enercare and Reliance trace their history back to Canadian gas giants Union Gas and Consumers’ Gas. Smerdon says two-thirds of Vista’s income is paid through utility bills and the contract lengths are similar to those seen in aircraft leasing.
Bank sales to drive dealflow
We almost certainly have not seen the last of asset leasing deals, particularly in transport subsectors such as aircraft, maritime vessels and freight leasing.
This is because Basel III and IV regulations are driving banks to divest their leasing businesses, and asset managers are filling the gap. JPMorgan estimates that core-plus transportation assets could require $4.5 trillion in financing over the next 10 years.
In JPMorgan’s 2019 Global Alternatives Outlook, the group highlighted the strong link between such businesses and GDP, noting that transport assets are vulnerable to any “major trade-induced GDP slowdown”. However, it also identified the “consistent and upwardly moving” growth of the transport industry since 2000, the 2008 global financial crisis aside.
Core-plus transportation assets also derive returns from income on a far greater level than real estate or core infrastructure, which sits at about 60 percent and 70 percent, respectively. In transportation, this tends to be closer to 90 or 95 percent. “That suggests that most of your return in core-plus transportation investing can come from contracted income – which is attractive, clearly, if you’re focused on yield,” Anurag Agarwal, head of portfolio management at the company’s global transportation group, told a media briefing in April.
Like some of the industry players we spoke to, JPMorgan also warns that “differentiated assets, counterparties and lease maturities – and specific industry knowledge – are most critical to long-term, predictable income generation”. The question remains as to which type of owner is best placed to deliver this.
“Water heaters, furnaces and air conditioners are generally 10 years,” he says. “That is a big part of why and how it fits into a core infrastructure investment. These are long-dated contracts and there is an inflation-linked element to them, where our contracts have prescribed escalators. We tend to escalate by 2.5 percent per annum. At the end of the 10-year contract, customers switch to a month-to-month contract.”
However, Smerdon says there is often little reason for customers to change at the end of this timeframe: “The stickiness of customers is what makes it fit into a 10-year or 20-year fund.”
One person’s long-term…
Smerdon’s final point is especially pertinent. As much as the definitions of what constitutes core, core-plus or even infrastructure in general continue to change, there also remains a debate around what constitutes the ‘long-term stable cashflows’ for which the market continually pines.
When public-private partnerships were the modus operandi of infrastructure investors, governments defined the lengths – with 20- or 25-year concessions or much longer in some cases. Now that PPPs are on the periphery, managers can be more flexible.
“The contracts must fit into the fund’s duration,” says Uwe Fleischhauer, founding partner of Yielco Investments, which has invested in asset leasing through its infrastructure funds of funds.
Fleischhauer’s view is, in principle, correct, on the simple basis that a fund will have difficulty delivering on its promised long-term cashflows if they are underpinned by contracts with shorter life spans than the vehicle that holds them. Yet funds rarely hold assets for their entire duration, and sometimes divest them years in advance.
“There will be no single answer for any institutional investor,” says Darryl Murphy, head of infrastructure debt at Aviva Investors. “Even among our own clients, there are some pension funds which actually don’t want very long-term investments, and that may work for that particular client.
“Insurance investors will define ‘long-term’ as an average lifespan of at least 10 years, which generally means upper teens in terms of the tenor of the lending. They are not going to be that excited by eight to 10 years. The breadth of what institutions want is often very different.”
Insurers’ priorities also differ from those of pension funds. To fully benefit from the EU’s Solvency II regulations, insurance companies’ investments need to meet the qualifying definition of infrastructure.
“I’m not sure if aircraft leasing would qualify,” says Murphy. “That can be an issue more for the borrower. You need a borrower who’s willing to have fixed drawdowns, fixed repayment profiles and it has to be investment grade. The client would also need an appetite for that duration.
“What’s important is what your respective clients are expecting. If people are giving you money to invest in infrastructure, what do they actually require from that? Some managers have probably deliberately been imprecise on their definition of infrastructure. “If investors see a reasonable business with long-term, stable cashflows, then they’ll look at it on that basis.”
iCON says the responses from its LPs to the deal was a largely positive one, which Smerdon partly attributes to the makeup of the LP base in its fourth fund.
“There were not a lot of queries from LPs,” he says. “There was a fair amount of familiarity amongst our LP base because a significant number are Canadian. There were plenty who understood why it’s infrastructure, but who still wanted to find out how it works and why iCON considers it to be infrastructure. People were either educated or very open-minded.”
Eye of the beholder
One open-minded investor was the UK’s £4.2 billion ($5.5 billion; €4.9 billion) East Riding of Yorkshire County Council Pension Fund, which has asset leasing deals via its investment in both of the I Squared Capital funds.
“Asset leasing can be fairly short-term contracts in terms of what we’re looking for”
Kevin Dervey, East Riding of Yorkshire Pension Fund
Kevin Dervey, the scheme’s head of investments, declines to comment on specific transactions. However, he admits that asset-leasing deals required “a bit of an education process” before the pension fund became comfortable with them. He adds that asset leasing “can be fairly short-term contracts in terms of what we’re looking for”.
Fleischhauer’s level of comfort depends on the types of asset-leasing businesses being discussed. “Aviation or shipping are much more heavily asset-backed compared to a logistics deal,” he says. “Aircraft leasing is more a strategy for specialty lending. This kind of asset is not a typical infrastructure equity move we would pursue.”
He nevertheless believes that leasing deals are part of the evolution of infrastructure as an asset class. “The market develops, and new ideas come along,” he says. “New financing solutions come along to the market and asset leasing is one way of investing in asset-backed infrastructure.”
Although Murphy acknowledges the general increased interest in aviation finance, he rules it out as an infrastructure investment for Aviva. “It’s very different to the rolling stock deals we have done,” he says. “We see the aircraft industry as a very specialised industry where you need to understand the assets and the fundamentals around the airlines themselves. We wouldn’t see those lease arrangements as an infrastructure play.”
What makes rolling stock different?
As Darryl Murphy, head of infrastructure debt at Aviva Investors, attests, aviation finance and other leasing deals are “very different” to the rolling stock transactions of the past.
Although the principle of asset leasing is present in rolling stock, the market for this, at least in the UK, was a rather different picture.
The UK rolling stock market for several years benefited from Section 54 agreements: government guarantees ensuring trains would continue to be leased for defined periods. In effect, this gave the market its ‘infrastructure’ label. Whereas with aircraft leasing there is a residual risk of having to find a new counterparty if an airline goes bust, rolling stock benefitting from Section 54 had a stickiness that prevented this from happening.
Nowadays though, rolling stock contracts are signed without Section 54 agreements and face a significant displacement risk, as has already happened to some trains on the UK’s rail network. In addition, newer entrants have come on to the market with more aggressive pricing and shorter term contracts.
So is rolling stock today still that different? Essentially, it all comes down to government support, albeit in a different format. Generally speaking, governments are unlikely to bail out airlines that have gone out of business, which means the aircraft will be displaced – at least for a short period. If a UK rail operator is liquidated or underperforms significantly, the government is likely to step in and run the line itself, as it is too essential to the network, thereby giving the trains a continued place of operation.
When the UK government stepped in to run the East Coast franchise in May 2018, it described it as an “operation of last resort”. That support, however grudgingly it was given, guaranteed continuity for most stakeholders, including the companies leasing rolling stock. It is a luxury that other corners of the asset-leasing world simply do not have.
And that, in the end, may be the more important issue, especially for LPs. Just how comfortable are they with investments that may share many of the characteristics of ‘regular’ infrastructure, but which often take place in essentially specialised sectors?
In that sense, Murphy’s words echo what Jang Dong-hun, chief investment officer of Korea’s $11 billion Public Officials Benefit Association, told us last October, when we probed several LPs on their appetites for infrastructure-like investments: “When we invest, we really care about the GP’s expertise in an area and their proven track record. I am afraid that for these new, infrastructure-like assets, there might be a very short track record, and it is too much of a niche area to invest in comfortably. That’s our main concern.”
As infrastructure players wade into sectors traditionally populated by other actors, questions about track record – more than philosophical discussions of whether the assets really are infrastructure – will determine how popular they actually become.