Posted by Macquarie Asset Management
September 10, 2019
Over the last two decades private capital has played a major role in the financing of infrastructure projects around the world, with infrastructure becoming an established asset class for many institutional investors. The emergence of infrastructure debt is a more recent phenomenon, which gained in popularity following the financial crisis as banks faced more restrictive capital and liquidity requirements.
We feel the opportunity for private capital in infrastructure is vast. A study from McKinsey has calculated that there is a $600bn per annum shortfall in spending globally to maintain and upgrade existing infrastructure so it can keep pace with community needs. Given around 75% of this infrastructure spending will be debt financed, we expect to see significant growth in the asset class for insurance companies, who are attracted to the stable revenue streams, high quality credit and return premium that infrastructure debt offers.
We don’t agree with this assessment. In addition to the current shortfall required to maintain current infrastructure, estimates suggest an additional $8.8trn of investment in low-carbon and energy efficiency technologies will be required to meet the Paris Agreement’s 2C goal.
Also, sustainable infrastructure should not only be thought of in terms of new greenfield development – all infrastructure needs to be sustainable and resilient in the face of a changing climate and major demographic changes. Retrofitting, repurposing and redesigning assets to be more efficient, cleaner, and more resilient can have an enormous upside for investors, both in terms of risk mitigation and value creation.
In North America alone, infrastructure deal volumes typically exceed $100bn each year. Much of this has been financed in the traditional project finance market dominated by European and Asian commercial banks. As banking regulations in those markets start to bite, the opportunity for meaningful, long term investment in infrastructure debt will continue to grow.
Infrastructure can contribute positively to the environment in a number of ways – from producing clean energy, to using raw materials more efficiently, or taking steps to enhance the natural environment. Renewable energy assets are a prime example, helping to directly reduce carbon emissions by displacing more traditional energy sources. This type of impact is often measurable and some of our clients even request reporting on the carbon impact of their investments.
However, measurement of the environmental contribution is only half of the picture.
Infrastructure, by its very definition, must provide a social benefit. Well-designed and well-functioning infrastructure plays a pivotal role in social and economic advancement, living conditions, quality of life and social transformation. As such, it is really important that investors measure factors like user access and availability of services, the employment and economic contribution of assets, and the value for money they offer the community.
When looking at infrastructure debt, insurance companies often face two key challenges – access to transaction flow and the required expertise to adequately assess the underlying assets.
We therefore see some insurance companies take a generalist approach, utilising corporate credit analysts to select infrastructure related deals which are typically public or widely syndicated private placements.
Others access the market using a specialist approach, utilising internal analysts that focus on infrastructure and project finance investment. This approach can be challenging given the expertise required to assess the credit. Much of this knowledge was historically contained within European commercial banks who provided a large portion of infrastructure financing. This has led to many insurers partnering with specialist asset managers in order to gain access to this expertise.
The European Commission’s decision in 2016 saw infrastructure defined as a separate asset class for insurers using the standard formula. The changes meant “Qualifying Infrastructure” saw a c.30% reduction in the amount of capital required to be held, relative to equivalently rated corporate bonds.
The move, which was based on a large amount of data provided by rating agencies and banks, recognised that infrastructure assets have historically experienced significantly lower probability of defaults than equivalently rated corporate credits. It also highlighted that the recovery rate for infrastructure assets is nearly twice as high as traditional corporate debt, and that infrastructure assets have experienced far less ratings migration historically due to the stability of the underlying revenue streams.
These conclusions demonstrate that credit rating alone can be a blunt measure when comparing different assets. Our view is that any risk-based capital approach that more accurately captures the expected economic loss to investors is likely to lead to better risk managed outcomes.
The opportunity in infrastructure debt is vast, with the space around 2/3 size of infrastructure equity. As such, we feel there is some room to go before the market becomes overcrowded.
We are also seeing a number of opportunities for US insurance companies in particular. The diversification benefits, larger deal flows, and cross-currency opportunities presented by investing in Europe currently look attractive for US insurers.
Insurers are also finding sub-investment grade deals, particularly in the BB Space, work under a capital adjusted yield framework. Additionally, the increasing utilisation of securitisation structures to access the asset class are also creating new opportunities for insurers who are always under pressure to optimise return on capital.