Laying foundations

With opportunities in infrastructure debt on the rise, fund managers have begun to seek capital from institutional investors for new vehicles or mandates, and the limited partner universe has started to respond in kind. 

In November, Macquarie received a $500 million mandate from Swiss Re to invest in the senior secured debt of Northern European infrastructure companies. Only a few months prior to that announcement, the RBS Group Pension Fund granted Hastings Funds Management approximately $1.2 billion to invest in debt or equity interests in UK infrastructure assets. Japan’s pension systems have also reportedly expressed interest in the asset class; and a first quarter AMP Capital survey of 62 global institutions found strong support of infrastructure finance strategies.

“For a while, it looked as though there was a new debt fund announcing each week,” says Hastings  infrastructure debt director Nick Cleary. “A number of large sophisticated institutions are making significant steps into the market, and these are the institutions that are very much ahead of the curve on what’s happening.”

Beyond separate accounts or co-mingled funds, Cleary says that some of the industry’s most prominent investors have started to develop in-house capabilities for direct lending to infrastructure projects.

This is to be expected. Infrastructure debt’s low-risk profile and long-term returns are well suited to the needs of public pension systems, insurance companies and endowments, says infrastructure debt specialist John Ryan of Greengate. Furthermore, management of infrastructure debt assets requires less maintenance than traditional portfolio companies, sources say.

“For decades, people have been aware that commercial banks have the wrong kind of balance sheet to build long term infrastructure finance lending,” says Ryan. “Most wholesale banks are short term funded. To put on 20 to 30 year assets that are illiquid never made any sense. It took the financial crisis in 2008 to really expose that that model is not going to work.”

“Institutional investors are sort of an obvious solution. [However], there are a number of issues associated with actually making that happen. And it’s in the midst of all those issues that’s where we are now – it’s a moving target.”

Although many perceive institutional investors to be a natural fit for the asset class, the market has yet to fully transition into making that fit a reality. The banking system provided the bulk of the financing for infrastructure assets for decades, and the institutional universe has yet to fully educate itself on the asset class. Even then, institutional investors in the US have yet to fully embrace the strategy, according to sources.

“The return profile … doesn’t seem to be overly enthusiastic toward infrastructure,” said one LP whose institution had considered the asset class.

“There’s some talk about us replacing the banks – lending against an asset. We’re not so interested here, we’re not convinced yet that we want to become bankers,” says Vince Smith of the New Mexico State Investment Council, adding that the asset class doesn’t lack for opportunity. “We’d be more interested in hiring managers to purchase existing debt from banks.”

“The security of the underlying collateral is frequently being regulated … In some cases it’s a monopoly – like a utility or something. So the underlying capital is very strong.”

General partners have recognised the strength of those assets, particularly in Europe, where banks have been regulated out of infrastructure debt by Basel III and other directives. As new asset managers pick up the slack left by the banks’ withdrawal, however, they too have had to undergo a bit of an education process.

“There’s a lot of devils in the details as far as how asset managers work these relationships with institutions; what buckets they fit into; what the benchmarks are associated with it; whether infrastructure debt will be permanently illiquid and idiosyncratic asset or if it will evolve like leveraged loans into something more liquid,” says Ryan. “There are a million different questions to work this out.”

GPs and LPs must first determine how to best approach the asset class. Although RBS and Swiss Re made their allocations through separately managed accounts, that solution wouldn’t work for a majority of smaller pension plans or endowments.

“Most US pensions will be too small to do that with any kind of effectiveness. And in a way they really shouldn’t because if they’re only doing relatively small volume, why would you create a full financial institution infrastructure?” Ryan says. “Somewhere in the middle sort of makes sense. And banks have traditionally dominated infrastructure debt, project finance debt, and they have a kind of syndication model already built in. We think that’s where it’s going to end up – along the lines of a bank-led syndication or Natixis-style partnership models.”

In June, French bank Natixis formed a partnership to manage insurance firm CNP Assurances’ infrastructure debt portfolio, which is expected to grow to €2 billion in over the next three years. CNP’s credit committee will assess deals it wants to invest in (approximately €50 million to €150 million per deal). Natixis will administer the portfolio and retain a “significant portion” of each deal on its balance, according to a report from sister publication Infrastructure Investor. Natixis signed a similar agreement with Belgian insurer Ageas last year.

According to Ryan, the Natixis model solves some of the issues that have arisen with traditional co-mingled funds, many of which come with the higher management fees one would traditionally associate with private equity vehicles. While those fees make sense for private equity – many companies require significant management or structural overhauls – infrastructure finance is comparatively low maintenance.

“A credit product is very different to an equity product, and fundamentally the business models and the pricing structures need to change to reflect the type of the asset,” says Cleary. “The traditional managers who are moving into the infrastructure credit space, applying equity-focused fee structures is not the right structure for debt.”

From Cleary’s perspective, firms must take the asset class’s lower return profile into consideration when they dictate fund terms. With yield-seeking LPs pushing back on fees in private equity and private credit funds, low interest rates have created difficulties for fund managers seeking higher management fees for infrastructure vehicles.

“The returns that are in infrastructure debt come from two components. One component is interest rates, and the other component is credit spread for interest rates,” says Cleary. “So when we think about our fees and the value we add, we only think about that in terms of the credit spread. An investor can go and buy a low cost vanilla interest rate product, and interest rates are not something that we can control or influence.”

Although the market for non-traditional credit solutions for the infrastructure space is evolving through these issues, interest – and long-term viability – doesn’t seem to be a serious concern for players in the space.

“There seems to be a lack of capital in this area,” says Smith. “There will be more interest.”