Posted by Macquarie Asset Management
February 20, 2020
Tim Humphrey: In this low-yield environment, there is pressure on pension fund and insurance company solvency levels. These institutions traditionally invested heavily in high quality corporate and government bonds but are now looking to other asset classes in search of higher returns. Infrastructure debt can offer similar economic characteristics to more traditional public bond allocations, but it can also deliver additional returns through acceptance of the greater complexity and illiquidity associated with private markets.
In addition, investors are increasingly recognising the portfolio diversification benefits it can offer, mainly because the assets can deliver stable cash flows with low correlation to GDP. This makes them well positioned to weather a downturn.
TH: A lot of our early capital was raised out of Europe, with the European Union’s Solvency II Directive pushing local insurers towards high quality, long-dated, fixed income products for liability matching. At the same time sophisticated defined benefit pension funds, particularly in the UK, were similarly looking to better match their assets and liabilities to reduce volatility on their corporate sponsors’ balance sheets. More recently though, we have seen strong interest from Asia, particularly Japan and Korea, in addition to promising signs in the US.
It is fair to say that investors in these regions are at different stages in their journeys of allocating to private markets. A lot of our clients were early adopters, but it now feels as though a second wave is coming through. Many of the more recent investors we are seeing started out in infrastructure equity. Others started out in direct corporate lending or real estate debt and are now looking for diversification.
TH: Historically, our investors typically allocated to either investment grade or sub-investment grade strategies. However, we are increasingly seeing allocations across a combination of the two, with more flexibility being given to asset managers to find the best opportunities within the capital structure.
Investment grade infrastructure debt typically involves lending to core infrastructure and can replace high quality corporate or government bonds in a portfolio. An investment grade portfolio can typically deliver a yield uplift of 0.5 per cent to 1 per cent relative to corporate bonds of similar credit quality and duration, although that will vary by transaction depending on the complexity and asset sourcing channel. Those returns might not sound very exciting, but when those investors can lock-in that return for 20 or more years, that can have a meaningful solvency impact.
Sub-investment grade infrastructure debt, meanwhile, may involve increased leverage or revenue uncertainty. This could include core-plus borrowers or be more junior in the capital structure for core borrowers. So, it comes with additional yield. Our sub-investment grade strategy is still targeting well-structured transactions with a focus on capital preservation, which distinguishes it from mezzanine debt strategies.
In current conditions we see portfolio returns of around four to five per cent above government bonds, although that can vary significantly by deal type. Investors committing to this kind of strategy are generally looking at a five to ten-year maturity with allocations coming out of return-seeking buckets, rather than liability matching. For example, we have seen investors selling publicly listed equities at their current historically high levels and using the proceeds to fund their allocations to assets with attractive cash flow and diversification characteristics.
Kit Hamilton, Co-head of Macquarie Infrastructure Debt Investment Solutions
Kit Hamilton: Our platform was established with a global focus and broad sector coverage. To provide our clients with the most attractive opportunities, we look to invest in those parts of the market that are the least competed at any point in time.
In just the last few months, we have invested in the UK, France and the Nordics, as well as Ohio and California in the US. We have also been very active in Spain, with our team executing five investments in the country’s solar sector in the last couple of years.
We see a greatly increased pipeline in the digital infrastructure space and have recently helped finance the roll-out of fibre broadband networks in Europe. The other theme to mention is renewables, which is where we have found the richest supply/demand balance. Today, around 35 percent of our portfolio is in renewables and we see no signs of that diminishing over the next few years. These transactions not only involve solar and wind, but increasingly energy-from-waste facilities and biomass. We are also seeing opportunities in the related infrastructure around grid connections and the associated networks that need to be upgraded in order to facilitate the additional capacity.
KH: You can’t say that either sub-investment grade or investment grade is more popular than the other at the moment, as there are disparities across geographies, sectors and individual capital structures. With our debt offering spanning the majority of the capital structure, we find that we can best align capital to the area most in need whilst avoiding the more competed parts of the market.
TH: Investor demand for sub-investment grade came as the search for additional yield intensified. Investors who were not constrained by regulatory capital or liability matching requirements found that they could achieve an attractive yield uplift for modest levels of additional risk. At the same time, on the borrower side we saw significant fundraising into private equity infrastructure funds. Junior debt has become a useful part of the M&A toolkit for sponsors seeking to enhance returns or increase ticket size to bid for larger transactions.
Tim Humphrey, Co-head of Macquarie Infrastructure Debt Investment Solutions
TH: In some ways, if the cycle turns it would be positive for infrastructure debt. It would showcase some of the characteristics of the asset class, and help more investors see the value of including infrastructure debt as part of their portfolio. Historically, the credit quality on corporate lending has been more affected by a downturn, particularly following a period where covenants have been weaker. The cycle turning should lead to a lot of deployment opportunities and good relative returns for infrastructure debt.
KH: Infrastructure debt typically has a lower correlation to GDP and is often regulated with strong government oversight. That means it is not as exposed to a change in the cycle as other parts of the market. And while terms have relaxed in the corporate lending space, that hasn’t been as pronounced in the infrastructure debt market, particularly where managers can access proprietary deal flow and avoid the most broadly marketed assets.
KH: When a borrower is looking to put together a refinancing or an acquisition package, the institutional market is now one of their very first calls. Borrowers are increasingly looking to design their capital structure around the permanent funding, before filling the gaps with bank debt and other products. That is a significant evolution. Historically, banks would provide short-dated loans at the outset and then the borrower would look to refinance. But institutional investors have proved themselves to be nimble and reliable, so why take additional execution and interest rate risk through a two-stage process when you can put long-term capital in place from day one?
TH: The bank’s share of the market is shrinking as borrowers become increasingly familiar with institutional sources of capital. It is also not getting any easier for banks from a funding or capital perspective, so I think that trend will continue. We built our business on early adopters, but are now seeing a second wave of investor capital coming into the asset class. Infrastructure debt is increasingly becoming a core element of any asset allocation process. We expect that will only accelerate as concerns around the credit cycle grow.
KH: The consideration of ESG risks really is central to all our investment decisions. ESG is hardwired into our investment committee discussions from the outset and remains front and centre throughout the period of our investment. This is not just because ESG is important to investors, it is what our people want to deliver as well.
ESG should also be recognised for the opportunities it can offer investors. Obviously, there are a great number of renewables projects that investors are allocating to, however, there are a lot of ancillary opportunities as well. For example, I was recently talking to an advisor about how they are helping an airport install on-site renewables and energy efficiency initiatives. The desire was to get the airport to carbon neutral, and aspirationally to zero-carbon. There are lots of exciting opportunities in the ESG space currently, and even more to come.
TH: A substantial proportion of investors’ due diligence is now spent on the topic of ESG, and rightly so. Whilst we may not own the assets or operate the infrastructure, the high level of scrutiny we apply makes it clear to borrowers that they need to up their game. Ultimately, the assets we finance underpin economies, so it is really important that they are focused on the contribution they are making to the environment and communities they serve.