Institutional infrastructure debt markets are evolving fast, including a growing interest from investors in mezzanine strategies 

One thing more numerous than infrastructure debt funds today is the body of papers setting out their rationale to pension fund investors.

Investors have allocated significant amounts of capital to infrastructure investment strategies, both in equity and debt, in recent years. In the past year, some new trends have emerged. While the total amount of infrastructure capital put to work globally declined sharply in 2017, to $337bn (€275bn) from $470bn in 2016, transactions held steady, according to Preqin, dipping to 2,378 from 2,529 in 2016.

The infrastructure debt business is dramatically evolving. The aggregate capital trend reflects the broad infrastructure equity business. According to Preqin, as of the end of November 2017, the total amount of capital raised for debt funds dropped from $2.2bn in 17 funds in 2016 to just $500m in 14 vehicles (figure 1). 

But, as figure 2 shows, debt deals soared in 2017 to 83 transactions with an aggregate value of $37.7bn – an increase of about 25% over the 67 debt deals totalling $20.7bn that Preqin recorded for 2016, and more than double the 41 deals in 2015. 

The recent data shows one way the market is evolving. Deals are becoming more numerous – and many managers report their deal pipelines contain enough prospective transactions to keep their teams busy underwriting for the next two years.

But mega-loans are inflating the total value of infrastructure debt deals being completed. Managers say this largely reflects the heated bidding for the largest, truly core assets that offer long-term revenue streams secured by strong contractual terms, often with, or backed by, governments. Those assets attract the most bidders – including insurance companies as well as pension funds – because the quality of underlying cash flows and related credit factors makes debt to such projects eligible for ownership by insurance company portfolios governed by Solvency II regulations.

A group of infrastructure debt managers who spoke with IPE Real Assets highlighted other, deeper currents driving change in the sector. Chief among them is opening the frontier of infrastructure lending. Most managers today will at least consider lending to assets that would not have been considered infrastructure 10 years ago; and some funds focus on riskier, often greenfield, projects that offer higher yields. Yet, at the same time debt managers are increasingly focusing on credit quality, security of cash flows, and total leverage in any given project. The implications for investors are positive – managers have adopted varied approaches to the business as they strive to differentiate their offerings in a crowded marketplace.

The situation on the demand side is more straightforward: infrastructure debt strategies generate attractive cash yields and provide capital stability. So, particularly in the current environment where fixed-income yield is so hard to come by, those characteristics attract insurers and pension plans facing the prospect that interest rates will remain low for the duration of the typical asset-allocation plan now in effect.

“One of the reasons there is so much interest at the moment from institutional investors to invest more in infrastructure debt is that, although investors that have been in the market for a long time may view yields as being historically low, compared to alternative forms of credit that institutional investors might otherwise invest in, infrastructure debt still looks very attractive,” says David Cooper, regional head of EMEA for IFM Investors’ infrastructure debt group.

Like a toll road in need of a new loan to pay for repairs, there will be potholes along the way. Among the key challenges is the potential that too much leverage is used in a project, and the willingness of some investors and managers to pay high prices to secure long income streams. 

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Perhaps the greatest risk is that the expanding definition of infrastructure assets will dilute the basic risk-reward proposition of the asset class by blurring the line between loans to an operating or well-contracted project and leveraged loans to speculative businesses that happen to be engaged in infrastructure activities.

But no sector of the financial market grows without facing challenges. Overall, providers and users of infrastructure debt capital expect a positive few years for infrastructure debt – as long as managers underwrite diligently and investors keep return expectations in check.

“It’s a very positive story,” says Cooper. “As in any market, some things we see either don’t work for us from a pricing perspective, or they don’t work from a credit perspective. But so far we haven’t seen a weakening of credit covenants that has characterised some other markets.”

Most managers agree there is a good supply of potential transactions, although efforts to find attractive yields in alternative asset classes have compressed premiums. “With more money chasing the same amount of deals, clearly asset values increase, and premiums compress,” says Declan O’Brien, senior analyst at UBS Asset Management. “I think that’s certainly the case in the infrastructure debt market as well.”

However, O’Brien says for assets with broadly investment-grade risk characteristics sought by UBS “a relatively limited amount of funds has been raised”. In 2016, he says, there was $2.6bn of fund capital in the market in Europe, a modest amount compared with the European infrastructure financing market as a whole, which stood at $142bn. “Funds make up a relatively small portion relative to the size of the market,” he says. “When we speak to investors, we’re not seeing dry powder as being a key concern at the moment. We’re seeing quite a lot of interest.”

The safest deals are of greatest interest. “In Europe we are seeing a lot of capital chasing few deals in the very-low-risk element end of the market in terms of revenue risk,” says O’Brien. This means, availability-based public-private partnerships (PPPs), he says. In such large loans, which are heavily syndicated by banks, “big institutions can put big tickets to work”, says O’Brien. “We’re seeing those transactions trade very tightly.”

But for UBS and other managers, the sweet spot is transactions that require bi-lateral negotiation and structuring expertise, many of which are smaller loans. UBS notes that a large portion of the European infrastructure debt market is comprised of loans of $100m or less. “It’s quite a fragmented market,” says O’Brien.

Therein lies the art of investing. Large PPP projects enjoy the support of availability contracts, but they can also carry very high leverage, O’Brien notes. “We’re looking at projects which are heavily contracted, but we use conservative leverage to make it a lower-risk investment,” he says. 

“The strategy, in a nutshell, is to focus on mid-cap transactions where the financing has been used to support essential infrastructure. It’s to source directly and structure bi-laterally, putting in place sensible leverage and sensible covenants.” 

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The goal, he adds, is to “find transactions that are not heavily syndicated to ensure that we capture the best risk-adjusted return for our investors”. Such gems “are rarely the mega deals. It’s often the ones that are slightly under the radar and need a bit more structuring and TLC.”

Such deals are filling the pipeline for infrastructure debt managers. “Deal flow is quite good,” says Cooper. “Albeit, to really exploit that you need to be able to do transactions in energy and not just in social infrastructure and transport. And you probably also need to look at deals in places like Spain, Portugal and Italy, and not just Germany and the Netherlands. It depends how broadly you cast the infrastructure net.”

Rothschild, hailing from the family dynasty that financed the Suez Canal and innumerable railroads across Europe, launched an infrastructure debt business in 2014 that has invested $1.25bn across three funds and one managed account. Jean Francis Dusch, head of infrastructure debt at Edmond de Rothschild Asset Management, says. “We wanted to develop an innovative asset management product in which the core clients of Rothschild were interested in investing.”

The range of assets includes renewable energy such as onshore and offshore wind and biomass, energy transmission, high-speed rail and rolling stock, as well as data centres and networks, water treatment and, most recently, a port project sourced through early-stage discussions with an equity sponsor. “We’re totally relaxed about the pipeline,” Dusch says. “Because we source deals at an early stage from sponsors, we do not have challenges to have enough deals.”

Some investors believe that infrastructure debt is best used as a component of multi-asset portfolios rather than being segregated into fund buckets. John Mayhew, head of infrastructure finance at M&G Investments says “we manage a pretty big number in infrastructure debt, but there isn’t a fund that’s called the M&G Infrastructure Debt Fund. The unit, which grew from the infrastructure finance business of UK insurer Prudential in the 1930s, manages over £45bn (£50bn) in debt, including public, private, junior and senior loans.

The distinction, Mayhew says, is that “all that capital is actually in multi-asset funds that can invest in other asset classes as well”. The current market illustrates the value of viewing infrastructure debt in the context of other income sources. With some sectors of the infrastructure debt market being bid up to lofty levels, “is it right to deploy investors into it?”, asks Mayhew. “Perhaps not so much if you can find higher spreads elsewhere. That’s how we look at it.”

Another way to look at infrastructure debt is being developed by BlackRock. The firm questions the conventional view that infrastructure debt yields are boosted by an inherent illiquidity premium. 

“We call it a private-debt premium, recognising this asset is not illiquid in the classic sense, but less liquid,” says Jonathan Stevens, who runs the investment team in London for BlackRock’s $8bn infrastructure debt business and sits on the investment committee for North America. Infrastructure debt, he explains, “is a fixed-income instrument originated and executed private-equity style”. But unlike a company 100% owned by a private equity fund, and thus illiquid, you can sell part of a loan or bond and a degree of secondary market activity can take place. “The majority of the investments we’re making in debt are not necessarily sole investments,” says Stevens, “providing a potential universe of buyers than can trade quickly.”

BlackRock invests in infrastructure debt through separate accounts and funds, but do not expect an infrastructure debt iShares vehicle – the long duration and limited liquidity of the asset class means it is not a good candidate for the highly-liquid iShares wrapper. “iShares are a very efficient way to hold exposure to capital markets, but it’s liquid,” says Stevens. 

For borrowers, the boom in debt finance is a plus. Stephen O’Shea, director of infrastructure investment at First State Investments, says: “The depth and quantum of capital that is available continues to increase very substantially and very quickly. Institutions have really carved out a niche in the ability to offer tenor,” he says, referring to long-term debt. 

Reliable, long-term financing helps investors seeking yield on their capital and infrastructure operators seeking to deliver services to consumers, says O’Shea. “Long-tenor debt allows us to focus on operating the business rather than having to worry about debt financing every few years.”

Q&A: View from the mezzanine 

Andrew Jones is Global head of infrastructure debt for AMP Capital 

Andrew Jones had a hunch that the infrastructure finance market had grown large enough that a strategy focused solely on mezzanine debt would present an attractive investment proposition. More than $4bn (€3.4bn) in capital commitments from institutional investors says his hunch was spot on.

Last year, AMP reached final close for its AMP Capital Infrastructure Debt Fund III (IDF III), raising $2.5bn for a strategy targeting mezzanine loans for infrastructure projects, and securing additional commitments of $800m for co-investment rights and $800m from investors seeking access to deals.

What is the strategy?
AMP’s mezzanine strategy has been very much focused on defensive core assets that are non-cyclical, with highly visible cash flows. A typical structure in the companies that we lend to will have first-lien debt, typically provided by banks, and we’ll sit between that first-lien debt and the equity, which ranks behind us.

How do you assess mezzanine risk?
Our analysis focuses on whether we are comfortable that our debt can be amortised or refinanced within the life of the contracts that the particular company that we’re lending to has in place, or the period of regulation, for some companies. We want to satisfy ourselves that even in a scenario where that business needed to be sold, and might be sold for less, there will be sufficient cash flow to comfortably repay its current debt.

How can you find those situations?
There are fundamentally two types of debt investment managers. There are managers that take prepackaged deals that have been structured and negotiated by investment banks, and then there are teams like ourselves that take on that role and come up with a structure that suits our investors’ needs and also meets the needs of the sponsor. We feel we’re able to secure attractive investments through that structuring and arranging work.

What does such an approach entail daily?
It’s a combination of analysis by our team, with people on the ground in our key investment markets in Europe, North America, and Australia, supplemented with advice from external consultants who are experts in their fields. As in most private credit strategies, our team has the appropriate skills to negotiate loan structures, to understand the risks that they’re taking on, and to find ways where appropriate to mitigate those risks. Legal, technology and accounting due diligence are areas where we lean on external support, so the ability to properly instruct and be advised by external consultants is a key ingredient to successful underwriting.

Where are you finding opportunities today?
Infrastructure is a constantly evolving space. There are always new sectors being identified as having characteristics that are appropriate for infrastructure investors. Most recently, sectors like data centres, and telecommunications more importantly, have been targeted by infrastructure managers. In Europe at the moment we’re seeing quite a lot of activity in the Nordics, with district energy businesses and electricity distribution networks. The US is positive, with opportunities at the moment related to the energy sector. The other key opportunity for us at the moment in the US is telecommunications

Are these new sectors viable long term?
It’s a matter of looking through the labelling of the types of businesses and looking into the cash-flow projections for those businesses to make ourselves comfortable that they are in fact defensive. We typically lend at eight or nine years’ legal maturity, and the average holding period of our loans is about five years, so generally, they are repaid ahead of their legal maturity date.

Besides reading balance sheets, what keeps you up at night?
A lesson we’ve learned is to be very careful with the amount of senior leverage. It’s not that it’s not appropriate. It’s about the company taking on the risk that the senior debt will need to refinanced in three or four years’ time in quite a different environment. That’s one to watch.