As an asset type, infrastructure has long appealed to pension schemes for its potential to deliver strong inflation-linked returns with low levels of long-term volatility. Traditionally, this has been through equity investments, but new opportunities are developing in the debt markets.
Historically, companies have raised finance for infrastructure projects privately from banks and publicly via the capital markets, but the reduction in the availability of bank lending is leading to opportunities for institutional investors, including pension schemes and insurance companies, to step in and directly fund the debt part of infrastructure projects.
As a result, new sources of finance have emerged, including infrastructure debt funds and direct private debt placements from large institutions.
The amounts of money, skill and time needed to assess, transact and monitor individual loans make investing through an infrastructure debt fund the most realistic option for most investors. Therefore trustees should ensure they are especially comfortable with the depth of due diligence and research expertise behind any recommendations in this space from their adviser.
There are quite a few differences in the debt facilities used to finance infrastructure projects, and these can have a significant effect on cash flows. Anyone wanting to go down this route needs to make sure they understand the various options.
Some examples are:
• Senior or junior debt facilities — senior debt ranks above junior debt in the capital structure and has a lower risk and return profile.
• Loans or bonds — loans are privately held and terms can be negotiated whereas bonds are publicly traded.
• Floating or fixed rate, or inflation-linked instruments.
• Short or long-term facilities — can range from short-term bridging loans to long-term loans lasting 30 years.
In addition to seniority to equity, debt providers are usually protected in a number of ways including a security package over the project’s assets and undertakings, financial covenants and direct agreements allowing the lender to ‘step in’ to manage the project if necessary.
Infrastructure projects tend to default rarely, as they are low risk with stable cash flows, and have high recovery rates due to protection under the security package.
Returns from investing in infrastructure debt usually include regular interest payments. Lenders also sometimes receive an upfront fee for new loans or refinancings. Expected returns vary depending on the type of debt but are typically in the range of Libor plus 2.5 per cent a year on senior debt rising to Libor plus 8 per cent a year from more junior debt offerings.
Whatever the choice of seniority, you will benefit from the fact that infrastructure debt has low correlations to other asset classes.
Opportunities for debt providers include taking advantage of utility companies selling off their assets, upgrades for existing infrastructure, and renewable energy projects.
Potential opportunities partly depend on the ability and willingness of banks to continue to offer funding, and the liquidity of other financing sources such as the debt capital markets.
Currently, we are seeing banks holding onto their infrastructure loan books and continuing to want to lend (albeit for lower terms than before). Coupled with strong liquidity in the debt capital markets, we are yet to see a meaningful level of capital raising and deployment by infrastructure debt funds. We are also seeing pressure on yields due to competition.
However, more favourable investment opportunities may develop at any time. As a result, we would encourage trustees to familiarise themselves with this sector to make sure they can react quickly when opportunities arise.
John Belgrove is a senior partner in Aon Hewitt’s Investment Consulting practice