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Infrastructure debt: The point of no return

18 Mar 2019

In January, Minas Gerais’ green landscape turned brown. A dam bursting at an iron ore mine sent a sea of sludgy waste through the state in south-eastern Brazil causing a humanitarian and environmental disaster. At the time of writing 65 people were confirmed dead, while hundreds more were unaccounted for. It was a bad case of déjà vu for the state’s residents as a similar disaster occurred there four years earlier. Accusations have been flying as to who should be blamed.

The list includes the mining company and the government, but one point is clear: this was not a natural disaster; it was man-made.

This is an unfortunate example of why there is a need to maintain and build new bridges, roads, hospitals, power plants, airports and dams. But replacing creaking infrastructure and preparing the world for the transport, energy and communication demands of the future is an expensive task. Indeed, the UN predicts that the world needs to spend $3.3trn a year between 2016 and 2030 on infrastructure to support economic growth predictions.

This is too big a tab for governments around the world to pick up on their own. So private investment has stepped in, raising $43bn globally to repair and upgrade the world’s infrastructure in the five years to the end of 2018, according to Private Debt Investor, a credit market data specialist.

UK institutions are part of this. Their desire to fund the construction of schools, roads and wind-farms has been demonstrated through backing the Pensions Infrastructure Platform, which was created to channel retirement funds into such projects, as well as GLIL Infrastructure, a fund worth almost £2bn that was created by five local government schemes.

Yet popularity for an asset class and its investment returns are rarely high at the same time. The debt market for infrastructure has become a victim of its own success with many investors being priced out of the market.

Indeed, Preqin reports that the dry powder allocated to infrastructure, covering equity and debt, stood at $172bn at the end of 2018.

NO RETURN

When it comes to infrastructure debt, the returns are not there for the risks taken, says Chetan Ghosh, chief investment officer of Centrica’s pension schemes.

“If and when infrastructure debt was to price at a high yield that would be the moment we would take up an allocation,” he adds.

Accurate data on returns in this market is hard to come by as different strategies have various return profiles, but the consensus appears to be that increasing competition has forced returns lower.

John Greaves, RPMI Railpen’s head of investment strategy, holds such debt, but the only comment he would make on the size of the return generated from those assets was to describe it as “low”.

“These assets are highly bid. It is very difficult to find value,” he adds.

“It is a good diversifying exposure, but it is just very expensive.”

It seems that the lack of value means some schemes have had to find other ways to gain exposure to these assets. Indeed, professional trustee Giles Payne, a client director at Capital Cranfield, explains that one of his schemes looks for private finance initiatives (PFI) and equity in the infrastructure space. “We believe that that is where better value comes from,” he adds.

So with the popularity of such debt having pushed yields lower, more investors may have to follow that scheme’s lead and look for other ways to gain access to these assets if they want it in their portfolio.

“The market grew up doing long-dated BBB, steady and stable deals,” says John Mayhew, head of infrastructure finance at M&G Investments. “If you are still looking at that BBB long-dated part, there is an imbalance between supply and demand of capital in the UK.”

WAYS TO PLAY

This is a blow to pension schemes that are either late to the party or want to increase their existing allocations in this space. Yes, they are missing out on a stable long-term investment that could provide a consistent and predictable cash return, but this asset class offers much more.

Indeed, infrastructure is less sensitive to the health of the economy than other areas of the booming private debt market. It also has a low correlation to equities and so is less volatile in times of market and economic turbulence. Another plus is that, depending on the terms of a deal’s agreement, it could protect against inflation.

Defaults are also low. AMP Capital, which manages $5.4bn of institutional assets in this market, has recorded a loss rate of less than 0.1% a year for the past 19 years.

While the default rate is low, the recovery rate is high. In the majority of cases where a loan has ceased making the agreed interest payment, the entire debt has been recovered in 60% of such situations, according to Schroders. This highlights the benefit of securing a loan against an asset. The opportunities to fund the world’s roads, bridges, hospitals, schools, power plants and train-tracks might be limited when compared to the amount of capital looking to get into such projects, but there are numerous options of how to structure a deal.

It is a good diversifying exposure, but it is just very expensive.

John Greaves, RPMI Railpen

There is a difference between the funding of infrastructure and the financing of it. Infrastructure in the UK is funded from two sources. One is tax and the other is by the user.

The work needed to sufficiently generate, clean, store or distribute water and power is largely funded by the customer through their bills, but if you drive around the M25 you will not be asked to pay every time you join or leave that motorway thanks to it being funded out of taxation.

The financing side of it – debt and equity – is where private capital comes in. Threequarters of this is debt and it takes many forms – public or private; bond or loan; liquid or illiquid; index-linked, floating rate or fixed; senior or junior; various currencies; amortising or making bullet repayments.

Last year the infrastructure debt transactions that M&G Investments completed had maturities that ranged from six to 46 years and were rated AA down to B. The terms were varied paying a floating rate, fixed rate, RPI, CPI, RPI with a collar and CPI with a collar.

“Within infrastructure there is a wide array of private finance deployed across a whole swathe of infrastructure sectors,” says Mayhew, who has more than £40bn under management in infrastructure debt.

“That has been very important and can be going forward,” he adds.

It appears that more institutional capital will be adding to the existing cash pile looking for a home in this market, despite concerns over supply and the returns being offered.

The majority of advisers (62%) will be looking to increase their clients’ allocations to infrastructure in the next three years, according to a survey by infrastructure and private equity manager Foresight.

This is almost double the 32% who had the same intention a year earlier, research based on the thoughts of 200 intermediaries has found.

This is due to investors de-risking in the face of an expected rise in volatility and lower economic growth by reducing their huge exposures to equities and bonds.

PICKING A WINNER

With yields low and a supply-demand imbalance leaving so much dry powder sitting on the sidelines, picking the right manger is crucial. Access and origination should be at the top of an investor’s wishlist when appointing a manager in this market.

Indeed, capital is still being allocated here, despite its problems. Investment manager AMP Capital invested $3bn of institutional funds in infrastructure debt globally in 2018, a record in its 19-year history.

M&G Investments part-funded several offshore wind-farms during 2018, including lending more than £200m to the construction of the world’s largest offshore windfarm, which is off the coast of Cumbria.

The £1bn project has almost 200 turbines, covers the size of 20,000 football pitches and can power 600,000 homes. It structured the loan to provide various return streams, including fixed rate and CPI.

It was also the sole investor in a £95m student accommodation development at Durham University.

Mayhew picked these deals because they offered the best relative value. “We see an awful lot of deals but the proportion that we invest in is quite low,” he says.

This is the result of a combination of M&G’s international ratings and if it considers the price to be good value. “In the parts of the market where demand exceeds supply, the thing that gives is price.

“There can be a business that we know would be great as a credit within a client’s portfolio, but the price isn’t good. That is where the discipline of the investment manager comes in.

“We could deploy a lot of money for our pension fund clients’ quite quickly, but it would not look very pretty,” Mayhew says. “That is not why they appointed a fund manager. They are looking to gain an asset class but at good relative value.”

A WAY IN

Infrastructure lending is just one area of the private debt market that has become a growing fixture in institutional portfolios since the financial crisis.

Investors’ cutting out the middleman, which typically means a bank, to lend money directly to companies and projects is a market that has boomed in the past decade for pension schemes and insurers.

New regulation means that banks need to keep more of their capital in reserve against the risk they carry in their loan book. With gilts offering disappointing returns, institutional investors have looked to fill the gap in the market that was created when the banks pulled out and have been lending directly to those building roads, bridges and renewable energy projects since. However, despite the benefits of gaining such exposure and ignoring the yields on offer, it does not suit every scheme’s needs.

Capital Cranfield’s Giles Payne says that the majority of smaller schemes do not specifically ask about infrastructure debt. “They will be looking more at a broader offering from investment managers.”

He adds that larger schemes, such as those with more than £500m under management, will start looking at specific asset classes.

For those that are interested in gaining exposure or building a portfolio, the lack of new projects compared to the amount of cash looking to get in is an issue.

The supply of greenfield projects has been hit by the lack of PFI deals, which were popular in the 2000s but have faced criticism that the schools and hospitals that they built cost the tax-payer more than they should have done.

This has left many investors to buy brownfield assets in the secondary market. RPMI Railpen’s infrastructure debt book has been built mostly in the secondary market and Greaves describes the approach to expanding its exposure in this space as “opportunistic”.

In the parts of the market where demand exceeds supply, the thing that gives is price.

John Mayhew, M&G Investments

“We are not going out there looking for that type of cash-flow profile for that long, necessarily,” he adds. “It is more about good risk-adjusted returns for now. On that basis, that asset class is quite often difficult to build an investment case for.”

A spike in new pipeline assets could make the market more accessible and returns more favourable, but with more capital expected to join the billions of pounds already waiting on the sidelines it looks like many will continue to be locked out.

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