Roundtable: When size matters in infrastructure debt

Infrastructure debt appears to be weathering the covid-19 storm with its resilience credentials intact. Even airports, undoubtedly the hardest hit sector, are keeping their heads above water. “The fact that airports have been all but closed for a substantial period of time without going under is testament to the structuring and ultimately to shareholder support,” says Darryl Murphy, managing director of infrastructure at Aviva Investors at our latest infrastructure debt virtual roundtable. “Other asset classes simply don’t benefit from the same levels of asset level liquidity.”

“Manufacturing plants importing parts from all over the world and faced with unprecedented health and safety requirements faced the biggest challenges”

Pieter Welman
Barings

Of course, the asset class is not immune to the pandemic. Idiosyncratic risks were exposed in sectors ranging from biomass to student housing, while assets that rely on international supply chains were left vulnerable to the vagaries of lockdowns. “It was the assets with manufacturing plants importing parts from all over the world and faced with unprecedented health and safety requirements that faced the biggest challenges,” says Pieter Welman, managing director at Barings. “The risk faced by some assets in construction phase was arguably greater than for airports that had been in business for decades.”

But the protections inherent in the way infrastructure deals are structured, and particularly the maintenance reserves in place, meant that infrastructure debt did not suffer the same fallout as real estate, for example, or corporate debt. “As far as I am aware, there have been no detailed restructurings in the infrastructure sector as might be expected in, say, the hospitality and retail property sectors,” says Murphy.

Managing director of infrastructure debt investment solutions at Macquarie, Tom van Rijsewijk, recalls bracing for a deluge of calls from investors when the crisis first stuck, only to find institutions had more pressing issues to deal with elsewhere in their portfolio.

“It may not feel like it now, but things will return to normal at some point, so the key issue is solvency”

Ian Simes
Brookfield

And, of course, the asset class benefits from its extremely long-term investment horizons. “If you consider covid in the context of a 20 or 30-year asset or even perpetual assets, the impact will be relatively short-term,” says Ian Simes, managing director of infrastructure at Brookfield. “It may not feel like it now, but things will return to normal at some point, so the key issue is solvency. Many assets proved their resilience and the assets hit hardest by the pandemic have had the liquidity and shareholder support to stay afloat.”

“Shareholders have been willing to put in that extra bit of capital if required and lenders have been willing to accommodate some delay in payment to get through these short-term issues,” adds Paul Nash, partner and head of infrastructure debt at DIF Capital Partners.

“Rolling stock took a bit of a hit due to a decline in manufacturing. Toll roads were down around 60 percent at the lowest point and are now back to minus 15 or 20 percent. Midstream oil and gas, particularly anything associated with jet fuel, saw fallout. But telecoms are up. Data centres are up. Midstream strategic storage is looking good and so are utilities. This has really just served to underline the strength of infrastructure as a broad asset class to invest in.”

“Expected losses in senior infrastructure debt are roughly half that for corporate debt of the same rating”

Paul Nash
DIF Capital Partners

Dealflow deadlock

But while infrastructure debt’s resilience has stood existing assets in good stead, getting new deals away has proved harder. “After that initial information gathering stage, I think a lot of people started to think about opportunities, trying to lock in some of that spread,” says van Rijsewijk.

“But while we did make a couple of investments in safer sectors, there wasn’t that surge in situational dealflow that we might have expected. Rather like the stock market, the window was short, before normal market conditions resumed.”

Primarily this was because there were no pressing maturities, forcing borrowers to raise debt. “I can’t think of anyone that had exposed themselves to big maturities, just months in the future, that left them desperately scrambling to find finance,” says Simes. “There just wasn’t that volume of distressed financing. Senior banks were supportive, even where borrowers were challenged.”

There were pockets of opportunity to be found, particularly in the US, however. “There was more of a blowout in the US. For whatever reason, that market appears to track the corporate market more closely than in Europe,” says Welman. That blowout was particularly evident for midstream energy.

“I think it would be very difficult to make a business case for setting up a boutique infrastructure debt fund to manage external capital today”

Darryl Murphy
Aviva Investors

Simes also pointed out that the term loan B financing market, which does not really exist in Europe, but which is an alternative source of lending for some borrowers in the US, closed down. “Then there was the US securitisation market which has a role to play in sectors such as residential solar, which shut as well,” he adds. “Having those alternative sources of capital disappear did open up opportunities for us in North America.”

Even in Europe, dealflow was back with a vengeance by the time the fourth quarter arrived. “Q4 was massive as the market played catch-up with the pipeline,” van Rijsewijk explains. “All the drivers are still there – capex, refinancings, M&A – although the latter remains a bit slower than usual. Not only does the asset class offer a good risk/return profile to underlying investors, it also offers them dealflow, which can’t be said of every asset class, at the moment.”

Infrastructure debt is widely perceived as a covid winner from a fundraising perspective. Brookfield raised a $2.7 billion credit fund, largely during the pandemic, for example. “If anything, covid helped the story,” Simes says. “The defensive nature of the asset class was highlighted during those volatile months.”

Senior vs junior

As the senior infrastructure debt space becomes increasingly competitive, there are those mulling the move to high yielding, more junior products.

But DIF Capital’s Paul Nash refutes the idea that senior investment grade debt no longer offers an enticing return proposition. “Just look at the Moody’s data. Expected losses in senior infrastructure debt are roughly half that for corporate debt of the same rating,” he says. “What’s that, if it isn’t an attractive asset class?”

Brookfield’s Ian Simes agrees. “We can all sit here and reminisce about the returns we were generating five years ago. Wherever you are operating in the capital structure those returns have compressed over time,” he says. “But the question is, does it still represent a good investment on a relative value basis? When you look at the decline in returns in other asset classes or sectors, I think senior infrastructure debt continues to offer an attractive proposition.”

Meanwhile, it is a gross over-simplification to suggest investors can replace senior debt with junior debt to address that returns compression, not least because junior debt means different things to different people. Target returns for junior debt can vary wildly, even surpassing those for equity strategies.

“There is a big difference between what I would historically have called stretched senior debt, where you may have mezzanine that is very well covenanted, and deeply subordinated mezz with equity kickers,” says Nash. “Junior debt as a term means nothing and it is important that LPs don’t jump to conclusions without understanding the structures.”

According to Barings’ Pieter Welman, differentiation between investment grade and sub-investment grade is the more important distinction for institutional investors, because it speaks to the capital charges that need to be held against the loans: “Insurers will have a big bucket for investment-grade risk and a smaller bucket for sub-investment grade. That is driven by the regulatory charges. Even pension funds have governance around how much investment grade infrastructure debt and how much high yield infrastructure debt they can do. Typically, clients start at the safer end and then venture towards greater risk as they get more comfortable with the sector.”

Others believe that covid will help shift the debate around relative risk and reward. “Sometimes investors challenge us on the ability to achieve extra yield on BBB real estate or corporate debt compared to our BBB infrastructure, at no extra risk,” says van Rijsewijk. “I think those conversations will go differently now.”

“Not only does the asset class offer a good risk/return profile to underlying investors, it also offers them dealflow”

Tom van Rijsewijk
Macquarie

However, there is unlikely to be a spate of new entrants coming into the market to soak up demand. Not least, according to Murphy, because to make money out of debt you need volume. “We can’t charge the same fees for managing money as you can for equity, so you need that volume. I think it would be very difficult to make a business case for setting up a boutique infrastructure debt fund to manage external capital today.”

Market consolidation

The complexities of the regulatory requirements also make it more likely that equity players will make lateral moves into the debt space, rather than start-ups. DIF Capital is one example of a firm that has made this transition.

“Broadly speaking, the diligence for infrastructure is the same as for debt, the emphasis just changes,” says Nash. “It is about acceptance of risk, which is on a spectrum depending where in the structure you are playing. Some individuals can’t do both. You get dyed-in-the-wool bankers or pure equity guys. But there is absolutely no reason why an institution can’t operate across both asset classes.”

Brookfield has followed a similar path and Simes agrees debt can be a logical extension for an equity investor, adding that it is less challenging to move from equity to debt than vice versa.

Is digital infrastructure an investment grade opportunity?

With infrastructure parameters widening, infrastructure debt players are continually faced with new types of risk proposition to assess.

Nowhere has this been more obvious than in the explosive digital infrastructure sector. “I don’t think it is controversial to say that fibre feels like a sub-investment grade space at the moment,” says Aviva Investors’ Darryl Murphy. “That market is in roll-out stage and many assets have five to seven-year facilities with banks. But the businesses will stabilise, and it will undoubtedly be an exciting sector for institutional debt investors in the future. I think it is currently a great opportunity for sub-investment grade capital.”

After all, Murphy muses, sub-investment grade is not a pejorative term. “We see offshore wind construction as sub-investment grade. We see waste-to-energy construction as sub-investment grade. Both of which should see positive rating migration over time. That is not to say putting money into those opportunities right now is a bad thing. If you have investor capital that aligns with that, that is great news. There are interesting deals to be done.”

Barings’ Pieter Welman agrees: “If you believe in a business, and it is performing well, it doesn’t necessarily matter if it is investment grade. It is about the risk/reward proposition and intrinsic value, not just credit ratings. After all, even Tesla is not an investment-grade company, but nobody could argue that it isn’t a successful investment.”

Macquarie’s Tom van Rijsewijk points out that it is impossible to generalise across industries. “Take fibre,” he says. “There are huge differences. There are established assets with strong monopolistic characteristics and there are players dependent on single operators. That can present real variations in risk. The UK is a good example of a jurisdiction where fibre is still at a relatively early stage and the winners are only just emerging. That is fantastic for equity, because there is a lot of upside available, but it may not be for everyone in the debt space and we expect many investors to wait until the networks are more established.”

Ian Simes of Brookfield agrees that the risk profile of fibre assets varies significantly by region. “The fibre-to-the-home set up is far more infrastructure-like in France, for example, than it is in the UK or Germany,” he says. “Assets in the data centre universe, meanwhile, can have an infrastructure risk profile, but can also have risk profiles akin to private equity. You can only address these things on a case-by-case basis.”

“New technology is always difficult to assess,” adds DIF Capital’s Paul Nash. “Data centres can be attractive, although we have seen a lot of price compression in that space. But then you look at something like battery storage and charging assets. At the moment, those feel too small and too nascent. The risks are more about planning permission, permits and rights of use. If anything, it seems more like real estate development. And yet, at the same time, we all know they will become important elements of the infrastructure landscape at some point. It is just a question of when.”

“In a world where LPs are increasingly focusing on fewer GP relationships, it is advantageous to be part of a firm that offers a range of products and has a role as a diversified global owner and operator,” says Simes.

Macquarie, meanwhile, launched its infrastructure debt business back in 2012 and van Rijsewijk agrees that scale is becoming increasingly important. “Having that depth of technical knowledge matters. You need to understand capital regulation from an insurance perspective. You need specialist fixed income knowledge, as well as infrastructure expertise. You need excellent governance processes. All of that lends itself to institutions of scale,” he says. “In the long-run, I don’t believe we will see 20 different names in this market. It isn’t the same as for equity. I think there will be market consolidation.”

Participants

Tom van Rijsewijk
Managing director, Macquarie Infrastructure Debt Investment Solutions
Van Rijsewijk is responsible for asset origination, due diligence, deal structuring and asset oversight. He previously worked in infrastructure financing and advisory for ING Bank.

Ian Simes
Managing director, infrastructure, Brookfield
Simes oversees the origination, execution and asset management of Brookfield’s infrastructure credit investments in Europe. He was previously a director in the capital markets origination group at Citigroup.

Pieter Welman
Managing director, Barings
Welman is a member of Barings’ Global Infrastructure Debt Group, responsible for the identification and execution of debt transactions in EMEA. He previously worked for Crédit Agricole and Barclays.

Paul Nash
Partner and head of infrastructure debt at DIF Capital
Nash leads the infrastructure debt team, which includes responsibility for the debt strategy and portfolio. Previously a director at XL Capital Assurance, he was responsible for writing AAA-rated financial guarantees for infrastructure bonds across Europe. He also worked at Rabobank International.

Darryl Murphy
Managing director, infrastructure, Aviva Investors
Murphy is responsible for origination, structuring and execution of new infrastructure debt transactions. Previously, he was a partner in the infrastructure advisory practice at KPMG and has also worked at Hambros, Newcourt Capital, RBC and HSBC.