We don’t know if you’ve noticed but a funny thing has happened over the last four years. Private infrastructure debt, initially an opportunistic play created by banks’ retreat from project finance in the aftermath of the 2008 financial crisis, has solidified into a fully-fledged asset class.
And here’s the rub: it might soon outgrow infra equity.
In a recent conversation, IFM Investors chief executive Bret Himbury pointed out that while the firm’s infrastructure equity business has registered the most growth over the last few years, he expects infrastructure debt to potentially grow more significantly over the next five years.
The reason is simple, but powerfully compelling – and will certainly be a key talking point at Infrastructure Investor’s Debt and Project Finance Forum in Berlin this month. Institutional investors are allocating to infrastructure debt out of their fixed income buckets.
The latter are much larger than their alternatives allocations, which fund their infrastructure equity investments. With more and more investors looking for alternatives to traditional fixed income instruments, a relatively modest shift to infrastructure debt from this very large pool can lead to significant growth.
Take German institutional investors. They have been allocating strongly to infrastructure debt.
According to a recent survey by Greenwich Associates, based on interviews with 274 professionals from Germany’s largest institutional investors, average fixed income allocations stood at 74 percent in 2015. Alternatives? A mere 3 percent.
Of course, an important factor in this scenario is whether infrastructure debt has truly outgrown its origins as an opportunistic play. The other key question is whether the asset class has the long-term drivers needed to sustain the kind of growth that could, in five years’ time, turn it into a force to be reckoned with? Both answers seem to be yes.
There are two big drivers fuelling the fledgling asset class. The first is that banks, while very much back in the market now, are not providing the kind of long-term lending they were before the crisis. That is unlikely to change anytime soon given regulatory constraints.
The second is that, while the current low interest rate environment might have prompted the ongoing fixed income diversification, that trend is not expected to violently reverse when rates go up.
That’s not to say a rate rise might not curb investors’ risk appetite. But, having suffered from the collapse in yields prompted by successive rounds of quantitative easing, diversification is now firmly on the agenda.
Investors are creating increasingly larger allocations for infrastructure debt, attracted by its low-risk and liability-matching characteristics. With regulation, particularly in Europe, becoming increasingly favourable to infrastructure investments, those allocations are not expected to shrink anytime soon.
Like any nascent asset class, infrastructure debt offers plenty of challenges, too – the number of managers is still limited and the amount of products being offered has only recently started to grow.
The senior debt space is already fiercely competitive, with the associated return compression that comes with that. Subordinated debt, which is less competitive, offers better pricing. But there are easily 50 shades of subordination out there, from fairly conservative subordinated debt to racy quasi-equity investments.
Investors need to know what kind of strategy they are buying into, which isn’t always easy, since some migrate up and down the risk spectrum.
Still, these are the growing pains necessary for any asset class’s maturation. Plus, they’re the kind of growing pains that hint at depth.