Global Head of Infrastructure Research
The Global Financial Crisis (GFC) continues to haunt financial markets. Old paradigms are being constantly challenged as investors adjust to a new environment in which returns have been compressed without a commensurate reduction in risk.
While governments seek to stimulate their economies on one hand, they are imposing stricter regulation on financial markets on the other. This seems counter-productive and has contributed to stifling investment in both public and private infrastructure, particularly since the original GFC-induced stimulus packages washed through the Organisation for Economic Co-operation and Development (OECD) economies.
One of the main targets of increased regulation has been the banking sector. The phase-in of Basel III regulation will impose significant additional costs. Under the new regulations, long tenor and lower loan quality are especially penalized. This will particularly impact bank financing of infrastructure, which traditionally, has relied on moderately priced, long tenor BBB-rated bank financing. As can be seen from the graph below, assuming a constant capital reserve requirement, under Basel III rules a B rated loan can only have about half the tenor of an A rated loan.
The clear inference here is that banks will have strong incentives to reduce loan tenors and/or move to higher loan quality. Such a trend is already evident in infrastructure financing as shown in the following graph. For example, the median tenor for new project debt in the OECD dropped from 19 to 13 years from 2005 to 2012. As Basel III is progressively introduced, its provisions may lead to even further tenor compression.
As is often the case when bureaucrats attempt to regulate markets, closing one door opens opportunities in other directions. Basel III’s one size fits all approach fails to recognise that infrastructure debt has consistently outperformed other sectors, as can be seen in the following graph. The secure, long duration cash flows that characterise infrastructure investments mean that infrastructure debt has the lowest level of loan default of all industrial sectors.1
Other infrastructure debt providers don’t face the same regulatory imposts as banks. The potential vulnerability of banks creates opportunities for other sources of debt.
Recent surveys2 reveal a significantly increased level of interest in infrastructure by institutional investors.
Banks will fight back
Regulatory restrictions aside, banks are unlikely to take such competition lying down. We expect to see a raft of innovative debt structures emerge, in which banks will lay off some of the financing risk to third parties. For example, any closed end fund structure adopted by institutional investors would limit tenor to the life of the fund, or about 10 years. Banks can match this tenor by moving their loan quality requirements from a BBB to an A rating.
Of course, this would create a gap in the funding structure, given the higher coverage ratio requirements of the A rated loan. This creates an opportunity for a tranche of subordinated debt from a non-bank provider.
AMP Capital has undertaken modelling of such hybrid senior and subordinated debt funding models. The following chart illustrates the conditions under which this funding model would be competitive. For example, assuming a margin of 550 points on the subordinated debt component of a hybrid funding model, the hybrid becomes competitive against traditional infrastructure debt funding arrangements once the margin between A and BBB-rated debt exceeds 87 basis points. Our modelling confirmed this result for infrastructure assets with asset (ungeared) betas ranging from 0.25 to 0.65. This effectively covers the range from low-risk utilities through to economic infrastructure assets such as airports.
Reverse engineering of the potential Basel III capital reserve requirements for an A rated and BBB-rated debt structure suggests that the future differential between these two classes of debt will be in the order of 100 basis points, that is, in excess of the 87 point threshold calculated in the modelling. Historically the differential has only dropped briefly below the threshold level once since the GFC. Looking forward, we expect that the imposition of Basel III will structurally lock-in such margins for bank debt.
How investors may benefit
However, AMP Capital modelling also suggests that:
Structures may have much broader application than PPPs and could compete with shorter tenor institutional BBB-rated funding of economic infrastructure
For tenors up to 10 years, banks are the natural providers of the A rated senior tranche. They offer both better flexibility and cost advantages over bond markets for typical infrastructure debt tranche sizes. A specialist subordinated debt fund could provide the residual debt component.
This is a good example of change driving innovation. In the medium term, the move of institutions into infrastructure debt will provide greater competition for financing new projects, while the trend to shorter loan tenor will create many more re-financing opportunities, which are inherently lower risk than Greenfield projects. These considerations suggest that subordinated debt, in particular, will find a significantly expanded role in future infrastructure financing and re-financing structures.
Specialist subordinated debt funds provide an opportunity to work with, rather than against, banks and their higher returns could prove an attractive alternative to fixed income investments for institutional investors.
2 Preqin 2012 Infrastructure Report.
Important Notice to all Investors: This article has been prepared by AMP Capital Investors Limited (ABN 59 001 777 591) (AFSL 232497) (“AMP Capital Investors”) for providing general information about the product referred to in this article(“Fund”) and is qualified in its entirety by any product disclosure statement, information memorandum, private placement memorandum or other disclosure or offer document and legal documentation that may be subsequently available. This article is not intended to be and does not constitute a recommendation, offer, solicitation or invitation to subscribe regarding the Fund, and is not intended for distribution or use, in any jurisdiction where it would be contrary to applicable laws, regulations or directives. Prospective investors should make their own inquiries and consult their own professional advisers as to the applicable laws, regulations and directives (including any requisite governmental or other consents and any other prescribed formalities) in any particular jurisdiction (including, in which the person comes into possession of this article) and the consequences arising from a contravention of them at any relevant time. Any failure to comply with such restrictions may constitute a violation of applicable securities law. While every care has been taken in preparing this article, except as required by law, none of AMP Capital Investors or their associates makes any representation or warranty as to the accuracy or completeness of any statement, including, without limitation, any forecasts, or takes any responsibility for any loss or damage suffered as a result of any omission, inadequacy or inaccuracy.
This article does not purport to be complete, does not necessarily contain all information which a prospective investor would consider material, and has been prepared without taking account of any particular person’s objectives, financial situation or needs. Accordingly, the information in this article should not form the basis of any investment decision. A person should, before making any investment decision, consider the appropriateness of the information, and seek professional advice, having regard to the person’s objectives, financial situation and needs. Past performance is not a reliable indicator of future performance and there can be no assurance that the Fund will achieve its objective or its target returns or that investors will receive a return from their capital. This article is provided to you strictly on a confidential basis and the information contained in it must be kept strictly confidential (with the exception of providing it to your professional advisors who are also contractually and/or professionally bound to keep it confidential) and may not be reproduced or redistributed (in whole or in part) or otherwise made available to any other person in any format without the express written consent of AMP Capital Investors. All information contained in this article, unless otherwise specified, is current at the date of publication and will not be updated or otherwise revised to reflect information that subsequently becomes available, or circumstances existing or changes occurring after that date. By accepting a copy of this article, you agree to be bound by the limitations, terms and conditions set out in this notice.