Growing pains

Everyone knew this was coming.

The long-term, high quality assets commonly associated with infrastructure debt have always seemed like a ripe opportunity for non-bank asset managers. In a post-recession environment fraught with regulatory uncertainty for banks and other traditional lenders, it seems as though those managers are finally taking notice of the opportunity.

“The real leading indicator in all of this is that there are a lot of smart people focusing on the area. The fundamentals make sense, and there are some obvious reasons that it’s not happening right now,” says John Ryan of infrastructure debt specialist Greengate.

Not right now, but definitely very soon. Ryan’s comments preceded French insurer AXA Group’s announcement that it had allocated up to €10 billion for direct infrastructure debt investments over the next five years – a significant bet on a sector most sources have called a natural fit for institutional investors.

“If you look at US insurance companies, they already allocate more to non-liquid assets. In Europe, we are now beginning to move in that direction,” AXA’s head of real estate asset finance Isabelle Scemama told sister publication Infrastructure Investor at the time of the commitment.

AXA’s decision to dive head first into infrastructure debt can be attributed to several factors. Namely, as with traditional debt or credit investment, regulatory pressures have forced European banks to delever their balance sheets, resulting in a situation one source labeled a “perfect combination” for new entrants to the strategy.

“This is a long term structural change in the infrastructure debt market and Basel III is a catalyst of that. Banks can no longer compete as strongly as they once did, and that’s the fundamental thing creating an opportunity for investors,” says Nick Cleary of Hastings. “What the owners of infrastructure assets are managing is long term assets that require long term debt capital, while the banks no longer offer long term stable capital. That creates uncertainty for everyone.”

Basel III requires banks to hold more capital against long-term loans and the financial derivatives associated with those loans, he adds. Those derivatives represented the “primary ancillary business line” in infrastructure lending, and as the cost of holding those assets increased, the incentive for banks to continue to lend has declined.

This has left sponsors and owners of infrastructure assets in something of a bind. The European banking industry’s pullback from the sector created a financing gap, and although institutionally-backed credit vehicles have existed for some time, they have not attracted AXA-level mandates until recently. 

“When you talk about infrastructure debt funds – senior debt funds – there has been a lot of talk and very little action. And there’s probably good reason for that,” says Ryan. “There hasn’t been as much pressure as people expected for institutions to commit to funds. The most fundamental reason has to do with yield and to a certain extent liquidity premiums.”

The push for alternative finance models for infrastructure assets has been curtailed somewhat by central bank policy. Following the onset of the financial crisis in 2008, central banks responded by flooding the market with liquidity, which has kept interest rates at an unnaturally low level, Ryan says.

“Banks can be relatively confident of the carry trade, where they’re funding themselves on a short term and still investing in long-term assets. The retreat of banks has not been as rapid because their liquidity needs have been fulfilled by policy,” says Ryan. “Is that forever? No, quantitative easing can’t last forever.”

Furthermore, although infrastructure debt possesses a limited risk profile and moderated long-term returns, it also can be relatively opaque. For institutions lacking the manpower or assets to commit to an individual mandate, the level of work that goes into each individual investment wasn’t considered to be worth the trouble (particularly as most experts in the field had gravitated towards the banks).

“There is more diligence because there is more structure around it – and understanding the risks,” says Nicholas Gole of Macquarie. “The way I think about infrastructure assets is as discreet pieces of equipment or assets, so you can diligence all aspects of the credit exposure. When I compare that to – I always think about Coca-Cola – there’s no way you could ever figure out all the individual issues are with Coca-Cola – you have to take a more macro view of it. You can actually analyze most of the issues associated with an infrastructure project, and because of that, you can do more detailed diligence.”

As certain banks have started to drift away from the strategy, investment professionals who had until recently plied their trade for traditional lenders have moved to asset management firms or institutional LPs. This is good news for the borrowers – as it transfers their contacts from the banking industry to new pools of capital that have (finally) shown a willingness to invest in their asset class.

From the borrowers’ perspective, transitioning from traditional bank lending to institutionally-backed finance has its advantages. For one, although banks have more experience with the asset class, they also must adjust their balance sheet to accommodate their short-term needs.

“If you’ve got an infrastructure asset with three year debt in it, you’re very exposed to the gyrations of the capital markets,” Cleary says. “Your asset may be performing wonderfully, but you may get caught out on a liquidity event in the banking market. Whereas, if you have a long-term debt capital structure which institutional investors can provide, we’re really able to provide that robust and stable infrastructure that everyone wants.”

Despite the migration of talent from banks to asset management groups and institutional investors, the asset class is still going through growing pains one would associate with new investors entering the market with a large pool of capital. 

“There are an awful lot of institutional investors who have gone out and promised an awful lot to borrowers and then perhaps failed to deliver. They weren’t aware of what they were getting into,” says IFM investment director for debt David Cooper. He reckons many borrowers are more comfortable dealing with banks because of the entrenched relationships they have with them, and their record of delivering on promises.

“We do find now, when we go to some of these borrowers, they’re quite sceptical – and quite rightly – the first questions are around your real ability to deliver and can you actually provide loans and extend credit? Otherwise we’ll all be wasting our time.”

Even so, Cooper quickly points out that those investors tend to be the exception. As more institutions enter the sector, borrowers have adjusted their expectations to deal with investors who have different priorities than their former creditors.

And when they have €10 billion to play with, that’s hard to ignore.