Finding the right portfolio fit with infrastructure debt

Private infrastructure debt is growing as an asset class and investors are recognising its value in asset allocation, particularly in the current climate. Here, we explore options for allocating infrastructure debt to an asset class and portfolio fit.

Real assets

A real assets portfolio may include allocations to real estate, infrastructure equity, and other physical assets such as commodities and natural resources (e.g. timber and agriculture). Allocations within this bucket are said to be tangible investments with intrinsic value due to their physical properties.

Investors may include private subordinated infrastructure debt in a real assets allocation as they share similar attributes such as:

• Physical assets with intrinsic value
• Can serve as a hedge against inflation
• Low correlation with traditional asset classes (equities and bonds)
• Long-term horizons
• Liquid asset class

These characteristics drive the overall asset allocation to real assets, which is generally a decision based on risk/return trade-offs and liquidity profile. The risk/return profile of the real assets can range widely depending on whether it is an equity or debt investment.

Additionally, the illiquid nature of this strategy may make private subordinated infrastructure debt an appropriate fit as investors would be taking a long-term view (seven to 10 years or more) in these investments. Subordinated infrastructure debt would be driven less so by macro-economic conditions than property investments, which tend to be more cyclical and sensitive to market environment.

Another benefit of private subordinated infrastructure debt in this allocation is its low correlation with the other real asset investments as well as with the broader multi-asset portfolio. From this perspective, we believe that private subordinated infrastructure debt provides diversification benefits and is an attractive complement to the real asset allocation and the multi-asset portfolio.

Infrastructure

As explored in a 2016 paper from AMP Capital, ‘Subordinated Infrastructure Debt – The Time is Now’, some investors may decide to separate their Infrastructure allocation from their real assets allocation. Within an infrastructure portfolio, which typically is mostly infrastructure equity investments, subordinated infrastructure debt can serve a variety of roles depending on an investor’s existing portfolio and investment strategy. For those investors who are seeking the low volatility, high-yielding cash flows of core infrastructure assets, but who find difficulty deploying capital at attractive return levels in the current highly competitive environment, subordinated infrastructure debt presents as an alternative.

Annual yields in subordinated infrastructure debt are around eight to 10 per cent with total net returns in-line with or even exceeding those of core equity¹. For those with exposure to higher returning value-add infrastructure equity strategies, subordinated debt can complement and drive cash yield across the portfolio on a blended basis. Value-add infrastructure equity funds will typically target lower cash yields in the first part of the fund’s life as capital is reinvested to drive business growth. Pairing such an investment with a high-yielding infrastructure debt strategy can help ensure the portfolio is highly cash generative from the outset.

Adding infrastructure debt to an infrastructure equity allocation can also serve to help balance the risk profile. Infrastructure debt tends to have much lower volatility (albeit due to lack of mark-to-market) than infrastructure equity investments and can offer more defensive characteristics to the portfolio. In a stressed market environment, subordinated debt ranks ahead of equity and will be less impacted by market shocks. Therefore, an infrastructure debt allocation can be a nice and more balanced complement to an infrastructure equity allocation.

Adding infrastructure debt to an infrastructure equity allocation can also serve to help balance the risk profile.”

Alternatives

Alternatives can be a ‘catch-all’ category that encompasses all assets that are unlisted and illiquid. A typical alternatives allocation can comprise of hedge funds and private equity investments, but it can also include infrastructure and private debt. The role of an alternatives allocation is to provide diversification relative to traditional asset classes (equities and bonds) and deliver attractive absolute risk-adjusted returns.

Investors who look to their alternatives allocation to be a diversifier, could consider private subordinated infrastructure debt as a defensive allocation due to its low correlation and low volatility characteristics. It can be grouped with more defensive hedge fund strategies that are relative value in nature and alternative beta type of strategies.

On the other hand, investors who are seeing high risk-adjusted returns from their alternatives allocation may look at private subordinated infrastructure debt for its higher yield and illiquidity and complexity premia. These types of alternative investments may include ‘growth’ strategies including private equity, mezzanine debt, leveraged buyouts and directional hedge funds. These strategies typically target mid to high-teen returns in which case, private subordinated infrastructure debt may fall short of these risk/return expectations.

The benefit of including private subordinated infrastructure debt within an alternatives allocation, is the low correlation compared to other alternative strategies within the bucket, and compared to the broader diversified portfolio. We think private subordinated infrastructure debt should be considered a ‘defensive’ alternatives investment whose main purpose is to help diversify the alternatives allocation as well as the broader multi-asset portfolio.

Private debt

We believe that private debt has been a growing allocation to investors’ portfolios in recent years². It is also sometimes referred to as private credit, alternative credit or enhanced fixed income. Within private debt, the subcategories can include corporate private debt or asset-backed lending strategies. Within corporate private debt strategies, the focus is on cash flows of the borrower to secure the loan, while asset-backed lending strategies are secured by collateral on real estate debt, infrastructure or other assets such as aircrafts.

The private-lending strategies can be in the form of private senior loans or private non-investment grade loans (subordinated or mezzanine loans) and can range in size from middle market to upper-middle market. Private lending in both senior and junior debt became much more active off the back of the global financial crisis as banks pulled away from lending activity due to risk constraints and regulatory pressures.

Another key characteristic of private debt is the unrated and illiquid nature of the strategy which is the source of illiquidity premiums. The structure of private debt strategies is similar to private equity allocations – they are typically closed-end funds with around four year investment periods followed by a four to six-year harvesting period.

Given these characteristics, we can see how private subordinated infrastructure debt could be a sensible allocation within a private debt portfolio. It may offer returns comparable to corporate and other asset-backed lending strategies, with relatively low correlation, as the drivers for return on subordinated infrastructure debt are largely independent from those seen broadly in direct lending portfolios. Namely, loans are typically provided to a ring-fenced, bankruptcy-remote entity and secured on a second lien or similar basis against an individual asset or a portfolio of specific assets. The majority of loans are at a variable rate, with call protection of three to five years. The underlying assets are backed by either long-term contracted cash flows with investment grade off-takers or regulator-determined tariffs. This insulates assets from market movements, driving down correlation with other more cyclical sectors.

Additionally, private debt strategies in general may be prone to market cyclicality. There may be certain times over a market cycle where some of these strategies are expected to perform better than others. For example, an investor can be more opportunistic with timing a distressed debt strategy after a severe market downturn and to invest in debt at cheaper levels. On the other hand, strategies such a middle-market direct lending have a larger opportunity set in a pro-cyclical market where liquidity and deal flow is high. We believe that private subordinated infrastructure debt can be more consistent and resilient throughout a market cycle than other private debt strategies given its lower default rates and the fact that loans are backed by long-term contracts with high-grade off-takers in noncyclical industries.

Therefore, an allocation of subordinated infrastructure debt within a private-debt allocation could be viewed as a long-term investment opportunity that offers diversification and resilience compared the traditional and publicly listed allocation of your portfolio.

Fixed income

The fixed income allocation generally includes investments in liquid and public markets such as treasuries, corporate credit (e.g. investment grade or high-yield debt) or sovereign credit (e.g. emerging market debt). The main drivers of a fixed income allocation are the yield and lower volatility of the investment. Investors who may consider private subordinated infrastructure debt as part of their fixed income allocation sometimes look to the allocation as a liability match from cash flows. They are not necessarily allocating to the space to generate outsized risk/returns, but rather for stable cash yield.

However, due to the illiquid nature of private subordinated infrastructure debt, we would not generally consider it a typical allocation in the traditional fixed income bucket.

Conclusion

Different institutional investors will consider a potential investment in subordinated infrastructure debt from different asset allocations. Infrastructure debt can play a valuable role in diversifying an investor’s overall portfolio while providing an attractive source of risk-adjusted returns and cash yield. For more information about AMP Capital’s research on this topic, you can read our latest whitepaper, ‘Using Infrastructure Debt in a Diversified Portfolio’.

¹ As at February 2020. These returns are merely estimates. There can be no assurances or guarantees that the strategy will achieve the target returns. Past performance is not a reliable indicator of future performance. Source: AMP Capital.
² Source, AMP Capital research 2020