Infrastructure Debt. An Evolving Opportunity

Infrastructure Debt An Evolving Opportunity Contact: Hans Holmen Senior Consultant +44 (0)20 7086 8000 [email protected] Summary Investing...
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Infrastructure Debt

An Evolving Opportunity

Contact: Hans Holmen Senior Consultant +44 (0)20 7086 8000 [email protected]

Summary Investing in infrastructure debt (investments in schools, bridges, hospitals and so on) has many attractions for pension schemes. These include:   high-quality debt linked to stable cash flows;   low volatility of returns;   low correlations to other asset classes;   a choice of seniority within the capital structure; and   fi xed, or more commonly, floating interest payments (some of which are linked to inflation). As quantitative easing tapers off and banks are faced with tighter regulations, we expect to see opportunities developing in this area for pension schemes as banks lend less. We would encourage you to consider this asset class in more detail now, and be ready to act promptly if attractive opportunities arise.

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Infrastructure debt — an evolving opportunity

More than an equity investment As a type of asset, infrastructure has long appealed to pension schemes for its potential to deliver strong real returns with low levels of ups and downs over the long term. However, while the traditional route has been through equity investments, new opportunities are developing in the debt markets. Infrastructure projects can usually produce stable cash flows, predicated on the provision of essential services, high barriers to entry and long term concessions/ contracts. For many infrastructure projects, changes in price do not have a substantive negative impact on demand.

A new opportunity for pension schemes The worldwide banking crisis and ongoing regulatory changes mean that banks need to set aside increasing amounts against what they have already lent out. This reduction in the availability of bank lending is starting to create opportunities for institutional investors, including pension schemes and insurance companies, to step in and fill the gap by directly funding the debt part of infrastructure projects.

Traditionally, companies have raised finance for infrastructure projects privately from banks and publicly via the capital markets.

As part of the move away from bank lending, new sources of finance have emerged, including infrastructure debt funds and direct private debt placements from large institutions. Pension Danmark, the US insurer Metlife, and the UK Universities Superannuation Fund are examples of institutions which have lent directly to infrastructure projects.

Chart 1 shows the various levels of infrastructure debt (from the safer ‘senior’ to the higher yielding ‘mezzanine’) and how these compare with other debt investments when looking at the risk and related return.

Governments have also been providers (and promoters) of cheap finance to infrastructure projects, for example, European governments through the European Investment Bank.

How to invest? Due to the money, skill and time needed to assess, transact and monitor individual loans, investing through an infrastructure debt fund is the most realistic option for all but the largest investors. Separate accounts are also available with some fund managers.

Expected return

Chart 1 – R  isk & Return Profile of Infrastructure Lending versus Other Asset Classes

Mezzanine infrastructure loans Senior infrastructure debt

Infrastructure equity

High yield bonds

Corporate bonds/loans

Long term government bonds

Risk Longer maturity Source: Aon Hewitt. Note: Longer maturity refers to investments that are expected to return capital to investors over a longer time period

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Infrastructure debt — an evolving opportunity

What types of debt are available?

Returns

There are quite a few differences in the debt facilities used to finance infrastructure projects. When investing in infrastructure debt, you need to understand these differences as they can have a large effect on cash flows. Some examples are shown below:

Returns from investing in infrastructure debt usually include regular interest payments. There can also be an upfront fee payable to lenders for new loans or refinancings.

  S  enior or junior debt facilities — senior debt ranks above junior debt in the capital structure and has a lower risk and return profile.

The different types of debt available mean the expected returns on offer are variable. However, as a guide, you can expect returns of Libor + 2.5% a year on senior debt, rising to Libor + 8% a year from more junior debt offerings.

  L  oans or bonds – loans are privately held and terms can be negotiated whereas bonds are publicly traded.

Whatever the choice of seniority, you will benefit from the fact that infrastructure debt has low correlations to other asset classes.

  F loating or fixed rate, or inflation-linked instruments.

Opportunities

  Short or long-term facilities — can range from short-term bridging loans to long-term loans lasting 30 years.

Security of investment 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 which allow the lender to ‘step-in’ to manage the project if this is necessary. Infrastructure projects tend to default rarely due to them being low risk with stable cash flows and have high recovery rates due to protection under the security package. Chart 2, from a credit-rating agency’s report shows that, in the past, infrastructure debt has a lower default rate than some investment-grade corporate bonds (Moody’s Baa) and the default rate reduces over time. Chart 2 – D  efault Rates on Infrastructure Loans versus Investment Grade Bonds Annual default rate from Year 5 Infrastructure

Annual default rate (%)

0.7

Moody’s Baa (or equivalent)

0.6 0.5 0.4 0.3 0.2 0.1 0.0 5

6

7 8 Years from issue

9

10

Source: Moody’s Special Report, Default and Recovery Rates for Project Finance Loans, 1983-2010, January 31, 2012. The above chart is shown for illustrative purposes only. Past outcomes are not indicative of future outcomes

We believe there are lots of opportunities for debt providers. This includes taking advantage of utility companies selling off their assets, upgrades for existing infrastructure, renewable energy projects, privatisations and new infrastructure for transporting and storing natural resources; and refinance of existing debt.

Outlook The possible opportunities available 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 still seeing banks holding onto their infrastructure loan books and they continue 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 you to gather knowledge of this sector to make sure you can react quickly when opportunities arise.

Disclaimer Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It should not be taken as financial advice and action should not be taken as a result of this document alone. Unless we provide express prior written consent, no part of this document should be reproduced, distributed or communicated. This document is based upon information available to us at the date of this document and takes no account of subsequent developments. In preparing this document we may have relied upon data supplied to us by third parties and therefore no warranty or guarantee of accuracy or completeness is provided. We cannot be held accountable for any error, omission or misrepresentation of any data provided to us by any third party. This document is not intended by us to form a basis of any decision by any third party to do or omit to do anything. Any opinion or assumption in this document is not intended to imply, nor should be interpreted as conveying, any form of guarantee or assurance by us of any future performance or compliance with legal, regulatory, administrative or accounting procedures or regulations and accordingly we make no warranty and accept no responsibility for consequences arising from relying on this document.

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