The growth of private debt strategies has continued apace since the beginning of the global financial crisis. What’s more, the rapid growth of this asset class is largely a consequence of the crisis: private investors have absorbed market share that was previously provided by banks. With lending to businesses gradually increasing over the past decade, 2017 at last saw deployment and fundraising surpass pre-crisis highs1.
The financial crisis altered the lending landscape
One of the key drivers of the recent private debt explosion is the pull-back of traditional bank lenders due to increased regulations implemented following the global financial crisis, that have increased the amount of capital that must be set aside against loans. This has been especially punitive in infrastructure and other real economy lending, where the higher loan-to-value ratios appropriate for monopolistic, regulated and long-term contracted assets are particularly punished, without considering the risk mitigation provided by infrastructure’s ring-fenced structure and stable characteristics.
An alternative to bank lending, capital market solutions (also referred to as project bonds in the infrastructure space) offer borrowers attractive, long-term fixed interest rates; the key advantages capital markets hold compared to bank loans are tenor and price. However, banks have historically been able to hold such a large share of the infrastructure lending market despite these factors because of their ability to underwrite the esoteric risks and provide the flexibility demanded for infrastructure transactions. Broadly syndicated project bonds are not well suited to borrowers who require any type of structural flexibility. Project bond buyers are typically insurance companies who require the bonds to carry investment grade ratings meaning bond issues must meet strict criteria outlined in the rating agency’s methodologies.
Capital market products typically do not offer desirable features like delayed funding or multi-currency availability. These - as well as less common features like an ability to pay-in-kind and contractual and/or structural subordination - can be immensely valuable to certain projects and borrowers.
Institutional investors can reap the benefits
Institutional private capital is exceptionally well positioned to provide the advantages that capital market borrowing and banks cannot. Unconstrained by one-size-fits-all capital adequacy regulations or the need to satisfy ratings agency criteria, private lenders can analyse and price idiosyncratic risks associated with the required features and circumstances.
From the perspective of institutional investors, the draw of the private debt asset class in general is clear: it offers returns that exceed most defined benefit plan actuarial return assumptions, whilst providing better downside protection than other private market asset classes, both through capital structure seniority and faster distribution-to-paid-in (DPI) capital return. The median private debt fund reaches a 1.0x DPI in its sixth year, compared to the eighth year for private equity2.
The stable business models and reliable cash yields of infrastructure providers make them a highly attractive proposition for liability-driven investors, so while playing an essential role in the funding landscape, managers – especially those in less competitive, higher-yielding niches such as mezzanine debt – can deliver attractive returns for their clients.
With its defensive infrastructure characteristics, the infrastructure debt sector brings less economic sensitivity than other parts of the private debt space, and with its fixed income return profile, offers more predictable returns than other parts of the real assets space.
1Source: PitchBook, ‘Private Debt Performance Warrants A Closer Look’, 1Q 2018
2Source: PitchBook, ‘Private Debt Performance Warrants a Closer Look’, September 2018
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