This article is sponsored by Schroders
What makes infrastructure debt an attractive space right now?
Claire Smith: Investors are starting to think about what assets they would want in their portfolios if we were to enter a downturn. Debt obviously has the benefit of contractual cashflows and greater protections than equity. We have seen spreads compress across the entire market, however, infrastructure debt continues to offer attractive spreads relative to more liquid asset classes. It also offers a better recovery rate and better default experience.
Investors are searching for yield at the moment and, in my mind, infrastructure debt is an asset class where you can attract an increased return – not for increased credit risk, but rather for lower liquidity. If investors are happy to have that illiquidity in their portfolio, it’s a good risk-return trade-off.
How would you describe investor demand for the asset class?
CS: I have certainly noticed a change. A lot of clients that have previously only invested in infrastructure equity are now looking to complement their allocations with debt. We are definitely seeing more interest.
The traditional buyers of infrastructure debt have always been insurance companies because they get the capital benefits in terms of Solvency II. However, we are now seeing a wider range of investors outside insurance looking at the asset class as a risk diversifier and as a complement to their equity portfolios.
Charles Dupont: I think it is partly a consequence of where we are in the cycle. We are approaching the top of the market and so investors are considering more defensive strategies. But it is also about the growing maturity of the asset class. Infrastructure debt has become mainstream and more conservative investors can see there are now a number of large and solid players, like us, leading and structuring the infrastructure debt market.
Given that increased investor appetite, just how frothy is the market becoming and how are managers evolving strategies to preserve returns?
CS: I think we are still seeing sufficient high-quality opportunities for asset managers, but you have to be a lot more selective about the deals you do. We have invested in less than 9 percent of the deals we have screened in the infrastructure debt space to date.
We see transactions in the market with a high level of construction risk but without pre-payment protection, or pricing we don’t think is reflective of the risk. It is certainly much more difficult to source good opportunities but I think where you have a clear edge, for example speed of execution, you can still make it work. You just have to avoid the busy parts of the market – the parts that everyone understands – and seek out opportunities where there is still good value.
In some ways, it is easier to check you are achieving adequate value in debt markets than in equity markets because you have very clear benchmarks when you are pricing debt. You have listed corporate bonds, listed infrastructure bonds, government debt and the high-yield market to compare against. When you are pricing debt you can be clear about whether you are getting value above what you would get in more liquid markets. It is far harder to judge value in the equity market, where in current fund offerings a significant component of the value results from capital gain and you don’t know what price you are going to get on exit. I think that is a great deal more challenging.
What is your approach to origination?
CD: There are plenty of opportunities in every sector and every geography. There is a strong need for debt to help bridge the infrastructure-financing gap everywhere, but strong demand attracts a lot of lenders of different nature, including infrastructure debt investors. What ultimately makes the difference for borrowers and sponsors is your reputation, your track record, your experience in these sectors and geographies, the way you are perceived.
Starting from a long list of around 20, lenders are usually whittled down to a shortlist of just three or four. To make that shortlist, it is important to be one of the market leaders.
CS: I would add that it is not just the reputation of the lending institution that counts, it is very much about the individuals. Individuals in this market need to be known for making quick decisions, sticking with those decisions, knowing the market and being reliable to work with.
To what extent has the infrastructure debt market been affected by Brexit?
CS: Brexit could create great opportunities for lending in the UK, particularly if you have sterling liabilities. On the whole, investors aren’t worried about UK infrastructure itself underperforming after Brexit, they are only concerned about currency.
If you have sterling liabilities and can find sterling-denominated assets, thereby insulating yourself from currency risk, you will likely benefit from less foreign money competing for deals while foreign currency investors wait out Brexit.
If the European Investment Bank isn’t lending anymore, once the UK is out of the EU, that should also push up spreads in the market, which would be valuable for UK investors lending on home turf.
What about rising interest rates? What impact is that having?
CS: We are starting to see some investors having more of a preference for floating-rate debt, particularly in the junior space, so that they can benefit from rising rates.
CD: But we continue to see a strong interest in fixed rates, especially from insurance companies where demand is also driven by liability management considerations.
There is growing demand for junior debt in the infrastructure space. What is driving that and what are the advantages?
CS: Our junior debt product is a fixed-income solution, and not a quasi-equity solution. It provides investors with the same access to high-quality infrastructure debt assets, with financial covenants and solid security packages, and with higher yields than in the senior space. At present, it is particularly attractive and relatively uncrowded in light of Basel III and Solvency II regulations pushing banks and insurance companies towards the senior investment-grade space.
It is an interesting niche because investors pick up quite a big increase in return for what has historically proved to be a very modest increase in risk. There is still a bit of education to be done, given investors aren’t as familiar with this part of the market, but demand is growing as awareness grows.
Supply is also increasing because infrastructure equity sponsors are using this type of junior debt to add more leverage, in order to increase their IRR, as equity multiples are rising.
There are junior debt specialists, but Schroders invests across the capital structure. What are the advantages?
CS: The benefit of being able to invest across the capital structure is that you can provide options to investors depending on their risk-return preferences, or the regulatory regime they are operating under.
We are even seeing some investors creating blended combinations of our senior and junior debt funds to create a specific risk-return profile that suits their needs. We are seeing blended strategies in order to get the right mix of duration, the right mix of fixed- and floating-rate assets, the right risk-return profile – and being able to invest across the capital structure allows us to offer that flexibility to create tailored solutions.
CD: If you only have a single product to offer, you have to offer that product even if the market has shifted. If you have a wide range of products, you are more flexible and better able to adapt to changing market conditions. We believe that this is ultimately beneficial to investors and aligns interests over the long term.
In addition, infrastructure gathers a wide range of risks. Having investment-grade and non-investment-grade debt offerings, senior and junior debt funds, also contributes to clarifying the fund strategy for investors. We believe that greater transparency should foster a long and trusting relationship with investors for the long term.