The search for yield has been a long running theme in European institutional circles. Many have turned to real assets such as infrastructure debt, due to their apparently attractive risk-return and liability-matching profiles. However, the sector is becoming overcrowded with narrowing spreads and rising prices, which is making it difficult to unearth promising prospects.
Take the recent €2.6bn sale by state-controlled Finnish utility Fortum of its power distribution grid in Finland to a consortium of institutional investors led by First State Investments and Borealis Infrastructure. Analysts tagged the price as being 10-15% higher than expected at 18 times EBITDA. This is well above the 10 or 12 times multiples that are the norm for the industry.
It is, of course, a classic case of a supply-and-demand imbalance. On the surface, there is a seemingly bottomless pit of opportunities. Figures from JP Morgan Asset Management show that in the UK alone – Europe’s most mature market – there are $1-1.5trn (€0.75-1.08trn) of investable assets with some kind of government attachment, either through price setting or regulation.
A closer look reveals, though, that the most sought-after core assets – those brownfield sites that have a strong track record with a steady and reliable income – comprise only a fraction.
Governments have been slow to put them on the block while the competition is intensifying, especially as certain banks have suddenly reappeared on the scene after retreating in the wake of the financial crisis. It is unlikely that the clock will be turned back to the time when they were a dominant lending force but they are taking advantage of current market conditions and the time lag between now and Basel III implementation in 2019.
“A couple of years ago, the banks withdrew from any long-term lending and investors could get very attractive rates,” says Nick Spencer, director, client strategy and research, EMEA at Russell Investments. “Over the last six to nine months they have come back and the rates for institutions are less attractive. For new allocations, clients are finding that there are often better opportunities elsewhere in the private debt market.”
Andrew Jones, global head of infrastructure debt at AMP Capital, adds: “I do not think the current environment is sustainable. There was a lot of excitement two years ago due to the relatively attractive risk-return expectations in the senior space where spreads were wide compared to corporate debt. However, over the past 12 months, spreads have compressed and it definitely looks less attractive. As a high-yield manager we are less impacted. Over the next 3-4 years, banks will start to feel more constrained and conservative in their lending policies due to Basel III. This will increase the opportunities in the senior space over the medium to long term.”
In the meantime, asset managers for pension funds and insurers are jockeying for position by launching a spate of debt funds. Last year Europe-focused funds raised $9.1bn, more than three times the $2.6bn raised in 2011, according to data provider Preqin. Among the more notable players are Allianz Global Investors, which recently celebrated reaching the €2bn infrastructure debt investment milestone, and AMP Capital, on its way to achieving its $1bn target, having raised an additional $450m for its global Infrastructure Debt Fund II (IDF II) to bring its total amount to $750m.
Macquarie, a well-established global player in the field also made the news, by winning a £200m (€242m) mandate from an unnamed UK pension scheme for a new UK inflation-linked infrastructure debt fund. It will target investment-grade opportunities on a smaller scale, starting from £10m in sectors such as utilities, renewables and offshore transmission owners (OFTOs).
“Our fund aims to deliver long-term inflation-linked income streams that match pension schemes’ liabilities,” says Andrew Robertson, head of investor structuring and strategy at Macquarie Infrastructure Debt Investment Solutions. “Insurers are coming in but they are mainly choosing segregated accounts for managing their money. What is a missing is a pooled fund that can better match liabilities and we are providing that access.”
Other fund managers which are hoping to make their mark include JP Morgan Asset Management, BlackRock, M&G Investments, and the European arm of Australian infrastructure specialist IFM. There are variations on the debt theme but the overriding objectives are to offer higher returns than corporate and sovereign bonds, an inflation hedge and low correlation with other asset classes.
Overall, infrastructure assets tend to have simple capital structures, typically 65-90% financed by senior ranking debt, with the balance as equity and, in some cases, subordinated debt, according to Robertson.
“Debt and equity have quite different characteristics, with debt providing a high degree of certainty in terms of cash flows,” he says. “Debt investors also have more security in the capital structure. I think many investors see infrastructure debt as a substitute for Gilts in a fixed-income portfolio but some may look at subordinated debt as part of an alternative allocation. The downside is its relative illiquidity compared to corporate and government bonds.”
Deborah Zurkow, CIO of infrastructure debt at Allianz Global Investors, also believes that equity is “a different layer of the cake”. While it can still carry equity risks, debt is much less volatile, she says. “Infrastructure debt meets our clients’s objectives to source long-dated, liability-matching stable cash flows,” she explains. “A core benefit is that infrastructure debt has low default and high recovery rates when compared to corporate debt. As a result, our investors very much view infrastructure debt as a long-dated fixed-income diversification to their existing investment portfolios.”
Standard & Poor’s research confirms the strength and creditworthiness of infrastructure debt. It shows that the average annual default rate for all project finance debt that it has rated since 1998 is just 1.5%, which is less than the 1.8% default rate for corporate debt issuers in the same period. If they do occur, the average recovery rate is about 75%, with most lenders receiving close to 100%, and very few getting shut out entirely.
“The attraction of infrastructure debt is the stability it offers,” says Mike Powell, head of private markets group at USS Investment Management. “All the evidence demonstrates that even in times of economic uncertainty the infrastructure sector is less likely to default than other sectors, so it appeals to investors seeking opportunities with low levels of risk and stable rates of return. If investors are taking that approach, there are some characteristics which are more attractive than others. For example, brownfield tends to have a lower risk-return profile than greenfield because it is more likely to have a strong track record of delivering income over time.”
USS Investment Management has a focus on securing infrastructure assets in regulated industries which are inflation linked, so they are perhaps ‘debt-like’ in the sense there is some stability and structure built into the return, according to Powell. “On the debt side, over the past 18 months we have committed some £200m in providing index-linked debt to Affinity Water & South East Water,” he says.
Tommaso Albanese, head of infrastructure debt at UBS Asset Management, agrees about its attributes but has a slightly different view as to where the asset class sits in a portfolio.
“Clearly, infrastructure debt and infrastructure equity have some similar traits, such as their long-term stable cash flows and the defensive nature of the asset class,” Albanese says. “Given this, some investors look to both when they are thinking about de-risking. While some investors do consider debt and equity as part of an infrastructure portfolio allocation, we are finding it is becoming more common for institutional investors to see infrastructure debt as part of a private debt allocation alongside real estate debt and corporate lending. From a risk-return perspective, this typically sits between traditional fixed income and alternatives and seeks to achieve an illiquidity premium over typical fixed-income products such as Gilts and listed corporate bonds.”
In terms of assets, investors are spoilt for choice. There is a broad selection, ranging from transportation such as airports, railways and motorways, to the regulated areas of utilities of water, electricity, gas transmission and distribution. Renewable energy projects including wind, solar and photovoltaic have also captured the imagination. Historically, institutional investors preferred brownfield assets that have a proven operational track record over the more complicated greenfield projects which can carry construction risk. However, building from scratch offers a higher yield and the risks can be mitigated by implementing financing packages that include guarantees or letters of credit. It will depend on the specific requirements of the scheme or insurer but many believe combining the two offers the greatest diversification and enhanced performance.
“One of the bigger risks is that less experienced pension funds and other investors may assume that all infrastructure assets have the same characteristics,” says Giles Frost, CEO of Amber Infrastructure’s International Public Partnerships (INPP). “There is a spectrum of infrastructure activities ranging from projects such as Gatwick Airport, which is regulated but also has a tie to GDP growth in terms of passenger numbers, through fully regulated utilities and public-private partnerships (PPP), to end-assets such as toll roads that are fully dependent on user revenues. Each has different risks. For lower risk infrastructure assets, I think the majority of institutions are looking to generate returns from infrastructure that are around 200 basis points above the rate they could obtain on a similarly-rated corporate bond.”
Chris Wrenn, managing director of infrastructure debt at BlackRock, adds: “When pension funds started to invest in infrastructure debt, there was a preference for established investment grade-quality assets. I think most of the appetite is still in brownfield assets spread across a few sectors and geographies based on currency. But as the understanding increases people will start to go up the complexity curve.”
While many pension schemes will take the brownfield route, the large insurance companies have been more adventurous and are broadening their horizons.
“For us, core infrastructure includes schools, transport, transmission, distribution and renewable energy which have a low risk profile and is backed by long-term government contracts,” says Laurence Monnier, fund manager at Aviva Investors. “We are large greenfield investors as long as the construction risk is properly structured and mitigated. We prefer simpler assets such as schools, versus the more complex tunnel or toll roads that depend on the flow of traffic.”
Aviva recently joined forces with Prudential, Legal & General, Standard Life, Friends Life and Scottish Widows to commit £25bn over the next five years to the UK government, which re-launched its national infrastructure plan targeting £375bn of energy, transport, flood, and waste and water schemes last year. The pledge followed the Resolution of Solvency II, which will allow insurers to invest in a wider number of assets than just the traditional equities, bonds and real estate.
The EU is also actively encouraging institutions to play a part and recently introduced a law that prevents national regulators from restricting pension funds’ investments into “instruments that have a long-term economic profile and are not traded on regulated markets.” The new law would make it clear that this includes debt instruments and loans to infrastructure projects, real estate and “unlisted companies seeking growth”. The European Commission also recently announced that it aims to raise roughly €1trn of investment in transport, new technologies, innovation and energy, among other areas, as part of its 2020 plan to boost Europe’s economy.
“In our experience, clarity on the eligibility and capital treatment of these long-term assets by their local regulators is very important to investors,” says Albanese. “Delays in providing this clarity can delay allocation decisions. At a more granular level, governments and intergovernmental agencies have been working on products to encourage institutional capital to invest in infrastructure. Instruments such as the UK Government’s Guarantee scheme and the EIB’s Project Bond Initiative have been designed to enhance the risk profile on transactions and to improve their credit ratings. Both of these products have now been successfully deployed and could continue to be of assistance on deals with a more challenging risk profile.”
Jones thinks that Europe has moved “pretty progressively” towards breaking the logjam between private finance needs and institutional appetite. “There has, so far, been limited success,” he concedes, “but if you look at the UK experience relative to the markets of the US and Australia, the government has taken a much more proactive approach.”
Henk Huizing, head of infrastructure at PGGM, which does not invest in debt, would like to see more stability. “The main risks in investing in infrastructure are political and regulatory. Unfortunately, we have seen examples in recent years where decisions by regulators or governments have had large negative impacts on investor’s returns. A reliable and consistent government policy in this respect is crucial to (long-term) investors in infrastructure, both equity and debt.”
Powell at USS agrees that governments are often interested in attracting institutional investors to provide backing for major infrastructure projects, but fall at the first hurdle because they don’t get the risk-return profile right.
“This class of investment attracts long-term investors who are seeking regulatory certainty for a period longer than the lifecycle of a typical government and often require assurances that the terms agreed will prevail a long way into the future,” he says.