This article is sponsored by Apex Group
How have you seen the infrastructure debt market evolve over the course of the past decade?
Agnes Mazurek: In less than 10 years, infrastructure debt has taken off and matured to become an asset class in its own right. In the early days, institutional investors were looking to diversify away from falling returns on sovereign and corporate bonds. Infrastructure debt investments exhibited cashflow predictability and longer durations that were particularly attractive for liability matching investors, along with low default rates and less correlation to economic cycles.
The key evolution has been the diversification of strategies, with higher risk acceptance on the part of LPs as to the underlying investments, and of course the new theme of ESG. If you look at the underlying assets in infrastructure, they often offer an avenue for putting sustainable principles into action, because some have a high carbon footprint to start with. What we saw in 2021 and 2022 was a flurry of new ESG-themed funds, with GPs ready to embrace the opportunity created by regulatory change, particularly in the EU.
Keith Miller: These are long-term assets that investors are backing, and the shift to sustainable investing has been dramatic in the debt space in a relatively short space of time. The EU’s Sustainable Finance Disclosure Regulation has precipitated a move to more prescriptive disclosures, and GPs are now grappling with that requirement for additional granularity.
Infrastructure debt showed impressive resilience during the pandemic; how can investors mitigate future risks in this asset class?
KM: Default rates are low, fundraising is still pretty good and the number of experienced managers setting up infrastructure debt funds continue to grow. That is really driven by a maturation of the asset class and its ability to provide strong risk-adjusted returns, alongside a general demand for good debt investments.
There are several important differentiators of this product against shorter term corporate debt. It is a longer-term illiquid asset class designed to perform through credit cycles and protect investors against those. Projects are generally aligned to systemic or strategically important assets or political strategies, which again means they shouldn’t be impacted by short-term blips in the cycle.
The bulk of infrastructure transactions are made up of energy assets, and the long term buy-in of governments to shift towards sustainability is a positive headwind. Infrastructure debt is also focused on capital assets that are core to infrastructure, so even if there is a liquidity crunch, that probably creates more opportunities because investments in that infrastructure need to take place and there are widening spreads for such stable investments.
When we look at non-core assets, their long-term nature means they are underpinned by long term investment strategies. Fibre, for example, is now a significant infrastructure challenge across the globe, so despite more competition for those assets they are clearly protected from changes in the economic climate.
Finally, from a documentation perspective, these investments are better protected, with stronger covenants, conditionality and the liquidity of borrowers embedded into agreements. There is a lot built into agreements to focus on ongoing cashflows.
Where do you believe the most interesting opportunities lie for infrastructure debt deployment today?
AM: The investor universe is incredibly broad, encompassing insurance companies, public and private pension schemes, sovereign wealth funds, family offices and potentially ultra-high-net-worth individuals. Most of those have been allocating to illiquid credit for many years, and infrastructure debt has found its place in the allocation mix.
Given their knowledge of the asset class, investors are opening up to investment at various levels of the capital stack, hence the advent of subordinated and mezzanine infrastructure debt funds. We have seen several junior infrastructure debt fund strategies raise significant capital in recent years, and investors are also willing to embrace new sectors like decarbonised transport and digital infrastructure.
Clean energy will remain an opportunity, but managers will need to be creative with dealflow to find opportunities beyond solar PV and onshore and offshore wind, as those have become highly commoditised with demand for assets far outstripping the offer.
Social and transportation infrastructure could see a revival if the current trends we are seeing across the economy – such as digitisation, automation and sustainability – can be incorporated into those assets in a smart way.
Infrastructure is an asset class that often benefits from a degree of inflation hedge, but what challenges will the new macroeconomic environment bring?
KM: Infrastructure debt shows consistency over time of providing strong real term returns regardless of inflation. There are several reasons for that. First, the underlying investments are typically regulated by long term contracts that are government-backed and inflation-linked, so returns are well protected. Meanwhile other investments that are less core are strategically important, so costs can be pushed back to end users.
But you also need to look at how transactions are structured to ensure costs are passed on. The cost of debt may be linked to inflation but there is a natural time lag of these cost increases being passed on. This time lag can result in squeezed margins. It is also important to ensure the debt is hedged against the correct measure of inflation, so whilst infrastructure is one of the best protected asset classes, it is not 100 percent immune.
What do you think it will take to be successful in the infrastructure debt industry going forward?
AM: There is a huge amount of dry powder available and more than ever in infrastructure debt. That means origination capabilities are going to be critical in an environment where sustained fundraising is met with a strong degree of deal attrition and demand for deals outstrips supply.
Focusing on origination is key, and with that comes the ability to scale up. The pandemic has taught us that big is beautiful from a manager’s perspective, so fundraising has continued as fewer managers have consolidated much larger assets under management. Those managers will continue to dominate the market and will have more investors and more complex structures, incorporating multi-currency sleeves, leverage at various levels of the structure and master-feeder arrangements.
That impacts servicing, which is becoming more complex both from a loan servicing and agency perspective and for fund accounting. Accordingly, bespoke reporting tools will be a key differentiator among managers and experts who know how to make the most of those systems to deliver the reporting service that will be required.
KM: New funds setting up need a significant track record to compete with established players and must place a lot of focus on due diligencing underlying projects and geographies. The ESG credentials of underlying projects are also critical for nearly all investors today, and no more so than in infrastructure, which is by its nature long term and has significant impact.