Infrastructure

Hunting for the holy grail of investing in the 2020s

By Giles Gray
Associate Director, Infrastructure Debt London, United Kingdom

Here, we explore why private infrastructure debt is gaining advocates, as a combination of returns, solid yields and low volatility gets tougher to find.

Solid yields, low volatility, returns that beat other asset classes – the holy grail of investing. At any time of the investment cycle, finding such assets isn’t easy. But when global interest rates are around historical lows, it’s nigh impossible.

It is why private infrastructure debt is gaining advocates. While it may not always have all the attributes of a holy grail investment, it has enough of them to be worthy of consideration.

A relatively new asset class in the world of funds management, private infrastructure debt is about providing funds to infrastructure businesses. AMP Capital is among the most experienced players having been in the market for 20 years.

What is infrastructure debt?

Infrastructure debt strategies originate and secure debt investments against infrastructure assets. In this world, infrastructure is defined as the physical structures and networks used within society to provide essential services. The core group of assets are within the transport, energy, utilities and telecommunications sectors.

These defensive, non-cyclical, real assets provide critical infrastructure for essential services, and benefit from high barriers to entry and limited competition. Cashflow generation from infrastructure assets is generally stable and predictable.

The defensive nature of infrastructure assets is typically expected to afford the sector a lower correlation to equity and fixed-income asset classes than that normally expected of direct corporate lending. It means an allocation to infrastructure debt typically offers enhanced diversification benefits to investors.

Infrastructure assets are typically financed with a combination of senior debt, equity and occasionally a tranche of subordinated debt. Senior infrastructure debt strategies typically look to build a portfolio of first ranking loans secured against a diversified suite of infrastructure assets. The long-term nature of the facilities, and the complexity associated with the origination and structuring, mean the investments generally earn both a complexity and illiquidity premium over liquid corporate bonds of a similar quality.

Investments in infrastructure debt also benefit from the use of covenant packages and security structures that are typically more comprehensive and robust than those in other private credit investment strategies. In our view, the inherently stable nature of the cash flows generated by infrastructure assets, combined with the restrictive, business-specific covenant packages inherent to infrastructure loan instruments, make them especially well suited to the use of subordinated, or mezzanine, loan facilities.

Key features of the infrastructure debt market

The market is global. The 10 largest players come from an assortment of countries, including the United States, the United Kingdom, France, Germany, Switzerland and Australia. AMP Capital is ranked number five1 globally in terms of capital raised, having attracted US$7.4 billion to invest in 76 businesses.

The assets are often monopolistic style businesses, with high barriers to entry. Critically, they mostly operate in regulated or contracted environments. These arise in politically stable economies, with mature legal, tax and accounting frameworks.

Almost all investments are long term – typically seven or eight years – and so are fairly illiquid.

What investors like most are the strong risk-adjusted returns, the long-term yield and the risk diversification from traditional assets. This has been increasingly relevant in recent years, as investors look for yield-generating assets during the current prolonged period of low interest rates.

Why invest in private credit assets like infrastructure debt?

Private credit is an umbrella term used to describe all types of investments, from loans and bonds, to notes and securitisation issues. The key factor is that they are not publicly traded or originated and held by non-bank lenders.

Assets under management in the infrastructure debt sector have gone from less than $300 million a decade ago, to almost $800 million in June last year2. It’s a relatively new asset class and as such is continuing to attract the interest of an ever larger swathe of investors.

The sector has been helped by the reduction in the size of loan books within banks, due to tougher capital requirements since the global financial crisis. However, there is more to it. The asset class itself has a number of benefits, which together differentiate infrastructure debt:

  1.  Portfolio diversification – typically private debt has a low correlation to the performance of publicly-listed debt and equity instruments. Why? Because borrowers on the other end of these private debt deals are very different from large corporations who access public equity and debt capital markets.
  2. The investments are illiquid and long term. This typically provides an opportunity to earn an illiquidity premium within the overall investment returns. 
  3. They are also generally low-volatility assets. Being long term, they typically have lower default rates. Valuations are less price sensitive to wider market movements.
  4. There is also an information advantage. Investors have good access to management and company information, allowing a greater understanding of the credit risk involved. And there is an advantage in bilateral deals – it means greater flexibility over structural elements of the financing and often faster processing times.

Infrastructure debt isn’t an easy asset class to understand. Deals are relatively complex, from origination, through to the structuring and monitoring of the instrument. Experienced investment managers are needed to complete the necessary due diligence and ensure deals are structured in a way that matches the desired risk and return parameters of the underlying investors.

Types of private debt strategy

Notwithstanding its relative youthfulness, the private debt universe is now large enough to offer different strategic uses. For most investors’ strategies, private debt offers long-term capital preservation and/or maximises returns.

Capital preservation

Private debt offers an alternate to fixed income products. The instruments generate returns from upfront fees, regular coupon payments and occasionally prepayment fees. They are highly attractive to investors looking to match assets and liabilities in a portfolio because of the long term and steady cash flow.

Maximising returns

Strategies focused on maximising returns typically have a shorter time horizon and invest in assets with more potential upside. Those assets might be distressed assets, or based on contrarian or event-driven positions, or are assets that are expected to capitalise on wider market disruption.

Private subordinated infrastructure debt

Private subordinated infrastructure debt, as an asset class, is still relatively nascent, but the current low-interest-rate climate is lifting its profile. Not only can private subordinated infrastructure debt play a defensive role in a portfolio, it also has other highly attractive characteristics.

  • Businesses have visible, long-term contacts and the subordinated loans can provide stable coupons. Risk-adjusted returns are attractive with typically strong cash yields.
  • There is high resilience to market downturns. Debt is provided to businesses that have entered into long-term contracts, often in noncyclical businesses providing essential services. As a result, default rates are lower and recovery rates are higher.
  • There is a natural hedge against inflation because earnings of investee companies are typically linked to inflation.

In short, a private subordinated infrastructure debt investment can provide strong returns while benefitting from downside protection.

Private credit investment strategies

Corporate direct lending

Corporate direct lending strategies typically provide credit facilities to small-and-medium size companies without credit ratings. Investment mandates normally cut across sectors and the underlying facilities are generally senior-secured, have floating rate coupons and lower levels of volatility.

The market grew significantly in the years following the global financial crisis. Regulation and capital constraints placed on banks reduced their capacity to originate and hold exposure to mid-market businesses, opening the way for corporate direct lending.

Senior corporate direct lending strategies could be viewed as an alternative to fixed income strategies because they provide exposure to similar types of businesses while garnering illiquidity and complexity premiums. These loans can also feature greater lender protection – enhanced security packages, stronger covenant packages and more extensive information and financial reporting requirements.

The strategy does typically offer investors less diversification than other more specialised private debt strategies. This is driven by the fact that the performance of the underlying businesses are often more cyclical, and therefore more closely correlated to the performance of the larger corporates that make up the universe of fixed-income issuers.

Corporate mezzanine

Corporate mezzanine direct lending strategies also typically invest in small to mid-market businesses. But they generate higher returns by taking a subordinated position in the capital structure, between the senior debt and equity.

The returns are often characterised as being more equity-like because, in addition to generating returns through arrangement fees and regular coupons, corporate mezzanine facilities will often include payment-in-kind (PIK) features and/or equity warrants.

In more recent years, the popularity of unitranche structures, where a single facility replaces separate senior and mezzanine facilities and carries a blended margin, has helped the financing of smaller groups. Businesses targeted by corporate mezzanine and unitranche funds are typically more cyclical, and so fund performance is also often more closely correlated with that of traditional fixed income.

Distressed debt

Distressed corporate credit managers generate returns by acquiring deeply discounted debt securities, typically from medium-to-large companies, with the conviction that the discounted price is below the actual market value of the debt.

Because the strategy typically invests in heavily discounted debt securities, a significant element of the return is from capital appreciation.

These investments can often be viewed as an alternate to equity because of the level of risk involved. Distressed debt may offer significant diversification benefits as its returns generally have a low correlation with that of the wider listed equities market.

Real estate

Real estate private debt strategies typically feature mandates that seek senior or mezzanine loans secured against an asset, or portfolio, of real estate assets.

These loans are secured by way of a mortgage to the underlying assets, and typically generate a steady income through the payment of regular coupons on the amount invested.

The majority of the real estate funds in the market focus their mandate on a specific investment thesis or market segment – residential construction facilities, development loans for retail developments, industrial and hospitality.

The higher risk associated with the commercial real estate asset class’ correlation with economic growth, combined with the illiquidity typically associated with direct investing in real estate, enables the strategy to expect to generate a yield premium over corporate bonds of a similar credit risk. The strategy also benefits from senior asset level security over physical assets.

Conclusion

The private debt investment universe features a broad and diverse range of investment strategies. The selection of private debt investment strategy ultimately comes down to an understanding of what attributes are most beneficial to the risk/return dynamic of the overall investors’ investment portfolio.

Investments in a subordinated infrastructure debt strategy can offer investors an attractive combination of an enhanced risk-adjusted return, a stable cash yield and exposure to resilient assets that typically have a low correlation to growth and the performance of other traditional asset classes.

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Giles Gray, Associate Director | Infrastructure Debt

1 Infrastructure Investor Debt 10 as at August 2019
2 Preqin: Future of Alternatives 2018; Preqin Quarterly Update: Private Debt Q1 2020


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Important notes

While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455)  (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

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