Are investors’ objectives better met by investing in debt or equity? Greg Taylor investigates
Many reasons are cited by investors for their interest in infrastructure, including decorrelated returns, long-term stable cash flows, security over valuable assets, a socially useful purpose, and potentially an inflation hedge.
Investors should also consider whether their objectives are better met by investing in infrastructure debt or equity. While in the past only the latter has been an option for institutional investors (since banks used to dominate the debt market), one of the consequences of the financial crisis has been to open up European infrastructure debt to a broad range of investors for the first time.
Based on proprietary and industry data, Sequoia Investment Management has undertaken a side-by-side comparison of infrastructure equity and debt, from an investor’s perspective. There is very little depth to the infrastructure mezzanine market, so Sequoia has focused on senior debt.
Historically, infrastructure equity has returned 11% (net IRR) and senior debt 4.5%. However, debt yields are higher since the crisis and equity yields are arguably under pressure, so the gap in returns between infrastructure debt and equity is certainly relatively narrow now.
What ought to matter, though, is not just absolute returns but returns in the context of risk and capital. One of the main findings of Sequoia’s analysis is that investments in infrastructure debt are significantly more predictable than equity. The standard deviation of returns on a single infrastructure loan is approximately 0.9%, compared with 7.5% for an equity fund, according to the latest data from Preqin. This is hardly surprising since equity investors absorb losses before lenders and – specifically to infrastructure debt – lenders are often explicitly compensated in certain circumstances such as an early termination of a concession.
In addition, the ‘portfolio effect’ is more powerful for infrastructure loans than equity because so much of the credit risk is idiosyncratic. In other words, a diversified portfolio of loans is much less risky than an individual loan. Sequoia’s research (based on observed performance trends) indicates that the standard deviation of returns for a portfolio of 30 infrastructure loans falls to approximately 0.14% (note than annual changes in price may be more volatile – what is measured is the realised return for a buy-and-hold investor).
Infrastructure debt therefore has attractive risk-return characteristics. Sequoia calculated a Sharpe ratio of 21.9 for infrastructure debt compared to just 1.3 for infrastructure
equity. This means that compared to equity, debt yields more than 16 times the expected return per unit of given risk exposure. For insurance companies, this is also reflected in return on capital measures, including under Solvency II.
Figure 2 compares the expected distribution of returns for infrastructure debt and equity – where the equity portfolio has been blended with a risk-free asset to give the same expected return as a debt portfolio, in order to compare like with like. As can be seen, debt returns are relatively predictable (an almost-vertical line), but an investment in equity has a ‘fat tail’ with a 5-10% chance of losing money.
In Sequoia’s opinion, therefore, for a risk-or capital-constrained investor, the case for infrastructure debt is compelling. Of course, equity investment can generate real upside – but at the expense of volatility. An allocation to infrastructure debt would reduce that volatility, while retaining an investor’s exposure to the features of infrastructure that presumably attracted them in the first place.
As already noted, the returns on infrastructure debt have increased considerably in recent years. The main cause seems to be straightforward supply and demand, rather than a change in risk profile. Many banks have pulled back from long-term infrastructure lending, or are just focusing on their domestic markets, leaving gaps in the market. While some institutions, such as Allianz and MetLife, have started lending to infrastructure projects, they have not yet come close to replacing the lost financing capacity.
Moreover, as many European governments look to step up infrastructure spending (actually a decision made a couple of years ago – but the wheels of infrastructure turn slowly), they will probably need more private sector financing. Most of this new financing will be debt not equity: 80-90% of a typical European infrastructure project will be financed by debt.
For equity, the supply and dynamics are less attractive, implying equity returns may be under pressure. Indeed, this is not a new phenomenon: the best performing infrastructure equity funds were the 2000-03 vintages. The recent low M&A activity (a five-year low) has resulted in a large build-up of uninvested capital ($81bn globally according to Preqin). To exacerbate the problem, infrastructure equity fundraising continues at a frenetic pace.
The supply-and-demand dynamics of debt and equity influence not only returns but also the J-curve. All the equity chasing deals result in equity funds needing a long investment period, whereas debt can be deployed more quickly. Additionally, equity returns can often themselves be back-ended while debt generates an immediate cash-on-cash return.
Sequoia also assessed the qualitative considerations of investing in infrastructure debt and equity. While returns, risk and the J-curve are important, they are not the only considerations. For example, investment liquidity may be relevant to some investors: infrastructure debt mostly consists of loans (rather than bonds) and, therefore, is not easily traded, but nonetheless it is substantially more liquid than an equity investment. In part that is because loans can be valued more accurately and objectively than most private equity investments.
Another important aspect is operational risk – an equity investment is an ownership role which typically requires much more day-to-day involvement and responsibility than that between a lender and a borrower. An owner has many more difficult decisions to make than a lender.
While the investment case for investing in infrastructure equity has been made over the last decade, it is not the only part of the capital structure that yields interesting returns. Investors should consider which instrument in this asset class gives them the optimal return.
Greg Taylor is founding partner and co-portfolio manager at Sequoia Investment Management Company