Financing infrastructure assets rather than investing equity in them has become increasingly attractive to institutional investors. Cécile Sourbes reports
In September last year, APG, the Dutch asset manager for the €261bn civil pension service scheme ABP, announced its first-ever inflation-related loan for an infrastructure project. The deal was to finance €80m of debt for the reconstruction of the N33, a local road-building project in the Netherlands. At the time, the asset manager predicted that the infrastructure market would develop into a “new asset class”.
APG was not far from the truth. After all, other asset managers across Europe showed a strong appetite for infrastructure lending in 2012. Allianz Global Investors, the asset management branch of German insurer Allianz, hired a whole new team dedicated to infrastructure debt in July. The team, led by Deborah Zurkow, was set up to develop an investment-grade debt platform to participate in the structuring of new infrastructure projects.
BlackRock also launched a European infrastructure debt investment unit based in London. It hired Philippe Benaroya, Chris Wrenn and Gilles Lengaigne to lead the team, while AMP Capital launched its second infrastructure debt vehicle.
According to the asset managers themselves, all those moves were in response to the requests made by institutional investors. “The goal of our new platform is to help our institutional clients to access the infrastructure debt market and find the best investment opportunities to meet their objectives,” says Wrenn, co-head of the newly lauched platform at BlackRock.
The Universities Superannuation Scheme (USS) has also moved into infrastructure financing. In February, the UK pension fund announced it would provide close to £100m (€116m) in long-term debt to a water company, in what it said was an alternative to government debt in the current low-yield environment.
The deal, arranged by USS Investment Management, will see the £36bn pension fund provide £95m in 20-year, class-B debt to Affinity Water, which is active in the South East of England. Gavin Merchant, senior investment manager for infrastructure at USSIM, at the time outlined an investment strategy based around working with a “select number of core infrastructure companies… to offer a unique and flexible source of long-term financing”.
Until recently, pension funds and insurers seemed mainly interested in the equity side of the asset class so why has this appetite developed?
The 2007-08 financial crisis, coupled with the current sovereign debt crisis in Europe, has a lot to do with the shift. Before the crisis, banking institutions and, more precisely, European banks traditionally provided large loan tranches on infrastructure debt.
However, the necessity to satisfy the capital requirements of the Basel III regulatory framework – which itself comes as a response from regulators to the financial crisis – and in some cases, the need to pay back the large bailouts received from their governments during the crisis, have pushed many of those banks to sell off their non-core assets, including infrastructure loans.
Pension funds and insurance companies, which have traditionally provided equity tranches for infrastructure projects, have therefore been called upon to meet the lending need left by banks. In this case, institutional investors can not only fill the gap but they can also find a new source of returns in the current low-yield environment.
Gerry Jennings, head of private debt for Europe at AMP Capital and one of the principals of the firm’s first two infrastructure debt funds, agrees that the lack of lenders historically has meant that institutions are now targeting the market. “But,” he says, “the real attraction for pension funds remains the steady yield that those assets can generate, and pension funds are trying to match up their long-term liabilities with long-term, stable, steady, less volatile cash yield.”
According to Jennings, the industry also appears to be more mature than it was a few years ago when investors began moving into infrastructure equity expecting steady yields rather than the volatility and correlation with listed markets that eventually transpired. “The return on investments made in infra equity has been more volatile than originally envisaged by investors,” he says.
Many industry experts nonetheless agree that infrastructure debt is viewed as ‘largely additional’ rather than a substitute for infrastructure equity. For Wrenn, infrastructure debt is a different part of the transaction process and has a different risk-return profile to infrastructure equity, which serves different purposes.
Primary and secondary assets
The pipeline of debt investment opportunities range from PPP/PFI to energy assets. However, most asset managers seem more inclined to give priority to healthcare, educational and transportation projects in Europe.
According to Zurkow, who heads the Allianz Global Investors’ infrastructure debt team, this can be explained by the fact that these projects attract more government backing in Europe. “The deal flow on the PFI-PPP deal has a gestation period, which means that you start looking at it early but it takes time to develop”, she says. “However, it is fairly substantial the number of parties that ask us to look at those transactions.”
There are active deal flows for both primary (essentially, development projects) and secondary (existing, income-producing assets) markets but the general pattern is for primary deals to constitute the bulk of the transaction pipeline, as the macroeconomic position in Europe and the US remains more favorable to generating these types of deals.
Governments around the world are currently looking to sell or privatise their infrastructure assets, while large companies are also seeking to divest their non-core assets with a view to refinancing their debt and clearing up their balance sheet. It all works towards the creation of a healthy primary deal market.
It is also fair to say that if investors can take the transaction risk for primary assets they will probably have more influence and obtain a better yield from the deal and will, therefore, feel more comfortable about the asset itself. Many asset managers still voice a note of caution in relation to secondary market opportunities. They argue that such transactions also depend on whether the assets are trading at par or at a discount to par. Additionally, investors looking at secondary market opportunities must consider whether the assets are distressed and whether there are any technical issues in the market.
So while investors are likely to focus on primary projects, the pressure on yields might increase drastically in the years to come. According to Zurkow, several factors can have an impact on yields. “Available yields probably come from the combination of events in the sovereign debt market, in the credit market as well as the demand from investors and the supply of debt, and whether or not governments are willing to guarantee the debt,” she says.
For Jennings, yields on infrastructure assets are largely driven by how many participants are in the market. “From the debt market, we have seen a huge contraction of banks and other lending institutions,” he says. “Banks are just not lending the volume that they were lending pre 2007-08. And if you add regulatory issues like Basel II, Basel III and Solvency II into that mix, it gets even more prohibitive for banks to actually lend long term.”
This situation has clearly driven yields up. And the pricing that investors can now get on a transaction compared with a few years ago has increased drastically.
However, we have yet to see whether conditions in the banking market are going to free up more capital from the banks into the infrastructure lending sector. Of course, investors will always show a strong appetite for good assets. But, in general, there is not the level of bank liquidity in the market that we have seen historically.
Banks’ loan portfolios
Investors have had two options when seeking to invest in infrastructure: acquire loans from banks, or structure their own infrastructure debt. While the latter could increasingly gain favour with investors in the future (if they build up the necessary internal resources teams), it quickly became clear that the first option did not suit investors’ needs. Many of the negotiations between banks and institutional investors failed to result in deals. Instead, banks ended up sealing deals with other banking institutions or asset managers set up new infrastructure debt funds.
Several factors led to the collapse of deals between pension funds and insurers. First, bank loans typically offer a no or low-cost early-redemption option for the borrower. This severely curtails their duration, meaning the former maturity of many of these loans remains too short, from a regulatory perspective, to match institutions’ long-dated liabilities. And with the advent of regulatory frameworks such as Solvency II and the revised IORP Directive, institutional investors are increasingly cautious over the assets they hold in their portfolio.
Second, loans on banks’ books usually carry a floating rate, whereas institutions’ interest goes towards fixed-rate or index-linked bonds. A third factor is the credit rating. As James Wardlaw, partner advising on global private equity and infrastructure fund placement at Campbell Lutyens, says, the most obvious reason why deals have not happened is that while the underlying credit quality is generally very good, it is just that the banks’ funding costs have risen substantially. Therefore, the loans may well be held on a banking book at their par value with no mark-to-market impairment for funding costs. But while a small discount on sale might be deemed acceptable for the removal of risk-weighted assets, the gap between this and the mark-to-market on funding is often wide.
Another factor also helped water down the negotiations – the price mismatch. Alexander Batchvarov, head of structured product research at Bank of America Merrill Lynch, says infrastructure loans were priced during the credit boom. This meant that many of them are inadequately priced based on today’s market environment. “Banks that want to dispose of a sub-performing loan therefore have to incur a loss,” he says.
Talking about the experience of Legal & General Investment Management (LGIM), Georg Grodzki, head of credit research at the firm, argues that banks were a little too “optimistic” about the price at which these loans would be attractive. “Realistic discounts to par would often have amounted to nearly 20%, given the level of credit spreads in the market and the borderline investment grade quality of many loans,”, he adds. “But, obviously, banks were not willing to sell at such a deep discount.”
So, does that mean that banks have completely deserted the infrastructure lending market? For many in the industry, banking institutions still have an important role to play. After all, even though banks currently face difficulties in accessing long-dated wholesale financing, they can still work alongside asset managers and institutions to structure infrastructure debt.
This is precisely what BlackRock is seeking to do. “The banks have been dominating this market, being large providers of the debt,” Wrenn says. “They now want to continue their role but more as an arranger or an originate-distribute model. As for us, we want to bring capacity to the banking sector to make sure that the transactions are in the right format for our investors and have the right characteristics, but we are definitely not looking to replace the banks.”
In early 2013, everything seems to indicate that banks are, indeed, set to remain in the loop. The support provided by some central banks with the rounds of quantitative easing (QE) in 2012, as well as the lobbying efforts conducted by the banking industry leading to a softer version of Basel III, show that banking institutions could find the mismatch between short-dated funding and long-dated lending manageable.