Infrastructure debt is a unique and growing private debt strategy, differentiated through the diversity of its underlying assets. It is suitable for long term investments and offers a risk / return profile spanning sub to high investment grades, with fixed and floating rate investments in various currencies. These characteristics are seldom seen in a single asset class.
McKinsey & Company’s 2013 Infrastructure Productivity report outlined a global infrastructure investment need of $57 trillion by 2030. Standard and Poor’s 2014 Global Infrastructure report saw this investment need creating a $500 billion annual funding gap due to public funding shortfalls.
US insurers’ established strategy of allocating 5-10 percent of their assets to private placement bonds is one perspective on the potential growth of private debt. During 2011-2013 we saw this growth materialise in Europe as large institutional investors sought to de-risk and diversify their corporate and sovereign public bond portfolios with private infrastructure debt.
Tim Cable, who leads Hastings’ infrastructure debt business in Europe, shares his local perspective. “Peripheral sovereign and corporate credit spreads have materially tightened, removing a relatively capital efficient way of insurers to capture higher returns. In this environment private debt is increasingly relevant and infrastructure is a common preference,” he says.
Diversity is a rare commodity
Diversity is an attractive attribute yet hard to realise in a connected global investment market. One reason investors are attracted to private debt is the perceived diversification away from market or economic risks often associated with widely accessible public bonds and equities.
Infrastructure debt’s diversity is in part due to the nature of the underlying infrastructure asset. The essential services provided by infrastructure combined with typically high barriers to entry support lower volatility in credit quality not seen to the same degree in other asset classes.
Moody’s 2014 Infrastructure Default and Recovery Study comparing infrastructure and non-financial corporate rated assets provides some insight into this diversity by highlighting the lower volatility.
Diversity and resilience to economic and market cycles lead to another feature of infrastructure debt: its suitability as a long term investment. Investors with medium to long term liabilities have few choices to match these liabilities without increasing investment volatility that is associated with higher risk equity investments. Long dated sovereign bonds were one common option, but committing to long term low returns offered today and increasing duration risk can be unpalatable.
For investors seeking to de-risk while reducing investment volatility infrastructure debt can be attractive. The appeal is multifaceted and enhanced by infrastructure’s de-risking profile. This de-risking profile relative to bonds offers an additional benefit that returns may become more attractive relative to the risk overtime. Marginal default rates of project finance debt, where infrastructure debt is the lowest risk sub-set highlights this de-risking feature relative to other credit assets classes.
Infrastructure debt’s lower volatility and default risk can offer improved risk-adjusted returns that often take on a higher significance for sub-investment grade investors. The 30-year track record of infrastructure debt documented by Moody’s in 2014 demonstrates that defaults occur less often than other sectors and when it does default the recoveries are higher relative to corporate bonds and private loans to other sectors. This mitigation of downside risks is an important consideration for sub-investment grade assets.
To illustrate what lower default and higher recoveries may offer in terms of value we estimate infrastructure’s theoretical annual return premium using a simple expected loss calculation. This perspective suggests infrastructure debt may have offered in the order of 50 basis points of value annually for sub-investment grade assets.
Evolving to include investment grade
More than 15 years ago, junior infrastructure debt was the first introduction for many investors to the asset class when Hastings launched its first infrastructure debt fund. Today the opportunity has evolved and grown with the global implementation of the Basel III banking regulation. This means bank capital is no longer the most efficient source of long term senior debt financing which long dated and low risk assets such as infrastructure require in large volumes. This opens up a consistently large senior debt opportunity that is well suited to growing investor demand for private and long term investments that can offer attractive returns.
Steve Rankine, who leads Hastings infrastructure debt business globally, sums up the change concisely: “In the over 25 years I’ve been in debt capital markets this is the most exciting change I have witnessed for institutional investors. As banks have withdrawn from the long end of infrastructure debt the door has been opened to institutional investors to invest at a time when these assets are in high demand. Opening the door to infrastructure debt for institutional investors is and will continue to revolutionize the long term global Infrastructure market.”
Hastings responded to these developments as they were emerging back in 2011 by expanding its existing junior debt platform with a senior debt capability to provide access to the largest and most compelling opportunities in Australasia, Europe and North America.
For Hastings and the newer entrants to the infrastructure debt market it is this senior debt opportunity that is most compelling because it offers a large and stable supply of assets with a consistently attractive risk adjusted returns. The alignment of long term need for infrastructure investment, debt capital funding the majority of this capital and a large demand to diversify away from public bonds are expected to underpin the growth and appeal of private infrastructure debt for many years.
Infrastructure debt is one of the few large and robust investment grade asset classes that have not been widely financed in the bond markets. Globally the supply of infrastructure debt is consistently c. $70-100 billion each year, yet only c. 20 percent has been financed in the capital markets. This is a result of the banks choosing to retain these assets, in part due to the attractive mix of risk and return, and partly due to the complexity that requires specialist skills to structure and assess the credit, and then to manage the assets prudently throughout their lives.
The 2014 Goldman Sachs Asset Management Insurance Survey highlighted the growing importance of infrastructure debt for CIOs. Their survey of insurance CIOs included four typical private debt classes in the top-ten allocations CIOs were looking to increase. Infrastructure debt was at the top of the list.
A single strategy or asset class is unlikely to be the solution to the challenges facing CIOs, portfolio managers and other investment professionals. Having multiple options is a clear preference to navigate today and tomorrow’s challenges.
Infrastructure debt’s role in addressing these challenges is established and supports the continued growth of private debt. Importantly it opens the door of private debt to a wider universe of investors seeking greater diversity, a lower risk alternative within private debt, and a wider set of options to manage long term investing and liability matching.
Nick Cleary, an investment director, is based in New York where he leads Hastings’ North American Infrastructure Debt business. He is a senior member of the global Infrastructure Debt team.
Hastings is a specialist global infrastructure debt and equity fund and asset manager with more than 20 years’ experience in infrastructure. It currently manages c.$7 billion of client funds across 9 funds and separate account relationships.