Why infrastructure debt?

UBS’s Tommaso Albanese explains why pension funds should be considering infrastructure debt

Please could you provide an overview of what infrastructure debt is?
Infrastructure debt has been around for a long time, but it is a relatively new investment opportunity for UK investors. It involves the financing of infrastructure assets, which are the facilities and structures essential for the orderly operation of an economy. This includes a range of assets from airports, roads, water services, and gas pipelines, to hospitals and social housing. Generally speaking, these types of companies have monopoly characteristics and contracted or regulated revenues, which means their financial performance should not be as sensitive to the economic cycle. As a result, the investor typically receives long-term, stable cash flows from an investment in the sector. Another feature of infrastructure assets is that they are capital intensive businesses versus operationally intensive. In fact, operational costs - such as personnel costs - are relatively low compared to the value of the asset, thus providing a greater degree of certainty regarding the future cash flows, and ultimately yield back to investors.

When considering debt investments for building yield into investors’ portfolios, there are a lot of investment options to consider. Debt investment can range broadly from loans to bonds, and from senior, higher quality debt to junior or mezzanine debt and finally to lower quality or ‘junk’. Infrastructure debt, however, is typically at investment grade rating level - around the BBB or single A level. Historical analysis shows that the infrastructure sector has the lowest default rate and the highest recovery value among all corporate debt. In addition, the credit spread has been consistently less volatile – even in periods of temporary stress like the recent financial crisis -implying a lower risk than other corporate debt with a similar or higher rating. For these reasons, banks have historically been the largest lenders to companies in the infrastructure sector.

Since the majority of infrastructure debt financing has been done privately through bank loans via typically illiquid and complex debt issuances, access to the infrastructure debt sector for pension investors has previously been limited. Furthermore, public and rated debt issuance from known infrastructure issuers is a small, but growing market. Investors seeking these growing opportunities in the private and public infrastructure debt markets should therefore be cautious about making direct investments in the sector as the opportunity requires specific knowledge, such as sector, deal structuring and financing know-how.

Why should institutional investors be looking at infrastructure debt now?
First, there is a general interest from institutional investors for stable, long-term cash flows to match their long-dated liabilities. Second, there has been growing interest from investors to invest in private debt markets because of the earnings potential stemming from the illiquidity and/or complexity premium. We believe infrastructure debt meets both of these requirements.

The infrastructure debt sector is going through a major transformation. There is currently a dislocation in the infrastructure finance market, due to the deleveraging pressure among banks for regulatory reasons and the budgetary restrictions for government spending. Therefore the traditional supply of infrastructure debt from banks is very weak, whereas the supply or need for additional financing continues to grow with the OECD estimating global infrastructure spending requirements to 2030 to be around $50 trillion. This market dislocation offers institutional investors a new investment opportunity to bridge the financing gap, while benefiting from the attractive risk-return profile of infrastructure debt. In recognition of this, a range of offerings have come to market to encourage investment from pension funds and other institutional investors. The types of offerings include senior loan/bond investment platforms, mezzanine funds and secondary market offerings for bank project finance loans.

However, a key challenge for the infrastructure market is asset accessibility. While banks are stepping back from long-term lending, developers and equity sponsors are not used to certain requirements from pension funds and sources of institutional capital so there is currently not enough flow going through the market. While not such an issue for the most well-known infrastructure debt issuers, the rest of the borrowers are finding it hard to finance their activities. This is where the new investment opportunities exist.

Specifically, we believe that Europe is a very attractive market for infrastructure debt investing due to the size of the debt market dislocation. Significant debt capital requirements are expected from continental Europe. The northern countries have better ratings and stable regulation but southern countries have suffered the most in the economic crisis. They have large debt requirements and the public sector is unable to finance projects due to budget cutbacks and the banking sector’s lack of available funding. Europe, unlike the US, has never developed a private placement market for debt issuance, including infrastructure debt. Before the global financial crisis more than 90 per cent of European infrastructure financing was made through bank lending. With banks now less able to fulfil this role, a gap in funding has opened up and it is only a matter of time before institutional fixed rate loans will also develop in Europe and the UK.

How can pension funds access this opportunity?
Investment in infrastructure debt remains a complex process, and is typically funded through private debt not public markets. As such, easily accessible assets are hard to find. During the transition from bank lending to institutional capital markets, investors’ willingness to invest and investment managers’ abilities to help facilitate this shift will determine the timetable for greater access.

Some large institutional investors are building up their expertise and experience in infrastructure debt by hiring large teams from the market and pursuing direct investments. Many others are using third party investment managers to benefit from their investment expertise and to broaden their network in the marketplace. While banks will continue to lend for short-term maturities, there is a great opportunity for both investment managers and institutional investors to benefit from the gap in long-term financing.

What should pension funds be aware of when investing in infrastructure debt?
We would say that a key part of any investor’s due diligence is to look at the investment team’s experience and track record. The particular characteristics of the financing arrangements coupled with actively managing them, is a key component of the added value that can be generated from this investment opportunity. In our view, the teams that are best placed to manage these assets combine experienced investors and financing specialists. This is still quite a rare combination, but will lead to the best long-term outcome for investors.

At UBS, we are able to offer investors a tailored portfolio of debt investments in infrastructure managed by a highly experienced team of specialists.

Why should pension funds invest in infrastructure debt?
Whilst the reason for investing may depend on an investor’s specific objectives, we believe that the market opportunity for infrastructure debt could be beneficial to a range of institutional investors.

For those investors with real liabilities, the current market environment presents a key challenge. Many bond yields, particularly inflation-linked yields, are at historic lows and the impact of this is to drive expected returns down and future liabilities up. Furthermore the increasing correlation across many listed markets has made it difficult to achieve real returns. This is where infrastructure debt could provide a solution. It gives pension schemes the opportunity to invest in non-correlated real assets with an attractive risk return profile. In addition to benefiting from enhanced diversification, investors can also use infrastructure to help match their liability profile with a reasonably predictable and partly inflation-linked distribution stream. The infrastructure debt opportunity provides investors with the ability to exchange their lower yielding, 20 year government type bond investments for infrastructure debt investments with a similar rating, same long-term, stable cash flow characteristics, but higher yield.

Tommaso Albanese is UBS Global Asset Management managing director - infrastructure and private equity

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