Infrastructure has become a key area of focus for institutional investors as they look to diversify their fixed income portfolios to access longer term, resilient credit opportunities for income-like returns. Within this asset class, infrastructure debt is on the rise as investment managers look to construct new debt vehicles: either to provide direct lending to infrastructure operators, to access well-established municipal bond markets, or to structure their own private lending programmes by issuing tranches of unlisted bonds.
Last September, Schroders established a new infrastructure finance capability designed specifically to help institutional investors access the asset class.
Commenting on infrastructure finance as an asset class, Philippe Lespinard, Co-Head of Fixed Income at Schroders, said he believed it was set for future growth: “We believe it is currently benefitting from increasing demand from long-term institutional investors due to the increasing supply of projects, partly attributable to macro-economic factors and changing regulations.”
Listed or unlisted?
From a structuring perspective, typically an infrastructure fund will look to enter into some kind of loan arrangement rather than making a direct equity investment.
With respect to a listed fund, what investors tend to find difficult to understand is that there’s a re-characterisation, in terms of what the fund does with the debt that it is buying and selling and turning it into an equity instrument, which can then be bought and sold as shares on an exchange. More popular is the private, unlisted fund.
“A private infrastructure fund will often be structured as a limited partnership. If investors wanted to hold equity you could use a limited company in place of a partnership or put a limited company on top of a limited partnership to enable some investors to hold equity and some a partnership interest – there really are multiple possibilities for bespoke structures depending on investor needs,” explains Craig Cordle, investment funds Group Partner at Ogier in Guernsey.
Those thinking of structuring infrastructure funds will need to consider where the assets will be located, as well as the target investors, before determining where best to domicile the vehicle. The investment manager’s location will also be an important factor.
“The manager will have to consider the position under AIFMD and how the fund may be marketed. Are any EU investors likely to be targeted? Could they take advantage of National Private Placement Regimes, which we see frequently utilised successfully by funds domiciled in Guernsey, as the Channel Islands are not part of the EU, or does the manager require full passporting rights?
“Also, think about what advisers will need to be appointed and how exactly investments will be made. Will this require other entities as part of the overall structure? If seed investments have been identified, this will impact the disclosures which will need to be made to investors and the level of verification of that information required,” explains Cordle.
A USD4.6 trillion hole
Doubtless there will be plenty of infrastructure opportunities in Europe but right now, it is the US infrastructure market that appears particularly ripe for investment.
The municipal market supplies 80 per cent of the capital for US infrastructure projects, which could grow substantially if Congress approves President Trump’s USD1 trillion spending plan. As FTSE Global Markets reported on 21st April 2017, an estimated minimum USD4.6 trillion of public spending on US infrastructure is needed by 2025.
“In general, President Trump has indicated that he is in favour of projects such as the Alaska Pipeline and LNG Project. He wants US-built pipelines using US suppliers, US steel, etc. Previously, there was demonstrable opposition to pipelines but under Trump it is a much friendlier environment in terms of trying to push these projects through,” remarks Michael McCabe, Sales Director, MUFG Investor Services. “The energy infrastructure sector seems particularly deal rich. Our clients are buying into existing pipelines, they are building wind farms. We see interest both in brownfield sites and greenfield investments, depending on the risk appetite of the end investor.”
Approximately USD150 billion in dry powder was ready to invest in US infrastructure at the end of last year and another USD50 billion or more was raised in Q1 2017. From a supply/demand perspective, infrastructure managers are scrambling to keep up with investors and put their capital to work. It is a nice problem to have.
“Unless the global economy collapses, then I do believe there will be continued demand to invest in these assets, not just in renewable energy but core infrastructure assets: roads, bridges, ports, tunnels. A lot of these were built more than 50 years ago in the US and need upgrading,” says McCabe.
Grande Prairie Wind project
Some asset managers are investing directly into global infrastructure on behalf of their clients by issuing unlisted bonds, as opposed to locking investors into quasi-PE fund structures.
This was evidenced recently by Allianz Global Investors, which made an investment of over USD400 million into the Grande Prairie Wind Project; a 400-megawatt wind farm in Holt County, Nebraska – the largest wind energy project in the state’s history.
The financing consisted of unlisted bonds with a 20-year term that were privately placed with US and European investors via AllianzGI’s established infrastructure debt platform. The operator in this instance is BHE Renewables, a subsidiary of Berkshire Hathaway Energy, which owns one of the largest renewable energy portfolios in the US. The subsidiary was specifically created to support BHE’s expansion into the unregulated renewables market, including wind, solar, hydro and geothermal projects.
Jorge Camiña is Director, Infrastructure Debt, Allianz Global Investors. He confirms that after first establishing an infrastructure debt team in Europe in 2012 (first investment took place in 2013), where it initially focused on P3 and transportation assets, AllianzGI expanded its reach by targeting the US infrastructure space in 2015.
“Our first US transaction was the Indiana Toll Road. We made a USD700 million long-term investment and that quickly put us on the map in the US,” says Camiña.
“Since then, we have a had a good run in transportation and have made three transactions in total: the Indiana Toll Road, Chicago Skyway, and most recently (Q4 2016) the Pocahontas Parkway in Virginia.”
He says that from a deal flow perspective, a large number of P3 and transportation assets are covered by tax-exempt financing, which means the actual number of transportation deals is quite limited.
“We realised that most of the infrastructure investing opportunity in the US lay in the power and energy space. That’s where we’ve been increasing our focus over the last 12 to 18 months. Since then we’ve closed two transactions in the power space; the first of which was the Grand Prairie Wind Project in December,” says Camiña.
A lot of power assets, in the renewable energy space, are also able to enjoy tax incentives that require more complex structuring to monetise such benefits, meaning there aren’t many that are suitable for an institutional investment grade profile.
There are some cases, like the Grande Prairie Wind, where the sponsor (in this case BHE Renewables) has its own tax capacity and that facilitates the access to institutional investors to such deals. “They monetised the tax incentives and that helped to create a straightforward debt structure,” confirms Camiña.
“The second transaction we recently closed in February was also in the wind space: the Balko Wind Project based in Beaver County, Oklahoma. We are confident we’ll be able to close a few more deals in our pipeline by the end of the year. That said, tax reforms could possibly push back on the timing of some of these transactions, when there is more clarity on what those tax reforms look like.”
Affiliates of DE Shaw Renewable Investments LLC (DESRI) own Balko Wind. The way the deal was structured, AllianzGI agreed to provide the necessary funding to refinance Balko Wind’s existing bank financing. The transaction was executed as a “back-leverage” loan in order to tailor the solution to the structure that DESRI had in place.
Both of these investments differ slightly in composition. With respect to Grand Prairie, this was becoming operational close to the same time that AllianzGI was making the investment. BHE financed the transaction with its own internal resources and then opened it up to institutional financing, close to completion.
“Balko is slightly different. Several banks were providing the trade finance and we stepped in to take over the refinancing of that debt. Balko has been operational for a little over a year now,” says Camiña.
The credit profile of these renewable energy deals is the operational asset itself. These projects usually have a highly rated creditworthy counterparty (typically a utility) that buys the power and green energy certificates from the project under a long-term contract (PPA – Power Purchase Agreement).
“Since the Borrower is a special purpose vehicle that actually owns the Project, the credit profile of these transactions is typically ring fenced from the Sponsor. We finance specific assets so it’s just project risk that we are taking. Our financing is specifically tailored to the capacity of the cash flows of a particular project,” adds Camiña.
Archmore infrastructure debt platform
In Europe, UBS Asset Management has established the Archmore Infrastructure Debt Platform to cater to institutional demand, specifically targeting private lending opportunities in the mid-market sector.
“This is a part of the market that we identified as lacking the necessary capital,” explains Tommaso Albanese, Global Head of Infrastructure, Real Estate & Private Markets, UBS Asset Management. “We thought there was an opportunity to focus on the private side of the market rather than the public market, to provide debt financing and build investments for our clients with attractive risk return profiles.
“Infrastructure represents the most conservative, but equally a very attractive area of private debt. Investors are looking for alternatives to fixed income investments and infra debt offers them a yield pick-up thanks to the illiquidity premium. These are assets with long-term, stable cash flows, typically secured with a pledge on the underlying physical assets. This is the `real asset’ aspect to the asset class and that gives institutions a lot of comfort.”
To date, Albanase says that the team has invested in a ferry and port transportation company in Scandinavia, a solar company in Spain and an energy company in France, to name but a few. He says the plan is to be fully deployed in Archmore by the year-end, “so that we are in position to prepare for the launch of our next fund”. The platform has raised USD630 million from 17 institutional investors across Europe and Japan and as Albanese states: “There is plenty of demand and we think it is a trend that is here to stay. Infrastructure companies appreciate the benefits of working with long-term investors and, equally, investors are interested in keeping capital invested over a longer time horizon. So there is a strong alignment of interests.”
Also, infrastructure operators like the idea that they can borrow at a fixed rate, long term, as it gives them certainty of funding costs and avoids having to use swaps.
“Beyond solar and wind, I think there is growing activity in other areas of energy such as biomass and new energy efficiency technologies – smart grids for example. These require more in-depth analysis before structuring deals but they provide an interesting opportunity for future fund investing. I think this more interesting area of energy infrastructure will continue to grow,” suggests Albanese.
The third way
As UBS and AllianzGI have demonstrated, investors have the option of investing in dedicated debt fund vehicles such as Archmore, which provide a co-investment-type opportunity, or by taking direct exposure to the operational assets by holding long-term private bonds.
These solutions are not always the most optimal for institutional investors. They might not necessarily want to be in a fund but at the same time they might not have the in-house expertise to source deals directly. Secondly, a number of investors require advice before allocating: the asset class is incredibly complex and offers many different risk/ performance mix to investors that may be difficult to differentiate and assess. Pedagogy should be a cornerstone of infrastructure investment.
“Thirdly, risk monitoring is top of their agenda and they want a close relation with their asset manager to understand how the risks change following the initial investment, and reporting that is as bespoke as possible,” comments Charles Dupont, Head of Infrastructure Finance, Schroders.
Dupont joined the firm in 2015 to set up its infrastructure finance division, since when it has gone on to raise more than EUR1.1 billion of AUM.
What Schroders has done, says Dupont, is develop a third way of investing by creating tailormade solutions by combining the benefit of investing in a closed-end fund and keeping the proximity with the fund management team as if it were in-house.
As Dupont explains: “That EUR1.1 billion in AUM has been sourced from 12 investors, with whom we have developed five distinct funds, ranging from senior secured debt to junior debt and equity solutions. Every time we structure a dedicated investment mandate, it is based on the investors’ specific demand in terms of absolute return, on average maturities, on geographic diversification, sector diversification, etc. All of these criteria are taken into account to build a mandate that is unique to the investor.”
Each fund is for one investor or group of investors. Once each of the funds is closed, no other outside investors can come in. They are, in very simple terms, funds-of-one that are made available just to the investor club; in this case, 12 institutions. Dupont says that most of the allocation has gone into the senior secured loan infrastructure fund, specifically because most of the investors are European insurance groups.
“Under Solvency II regulation, the rules offer a discount on the Solvency Capital Ratio to those insurers who allocate to infrastructure debt, provided investments meet a number of criteria; they can gain a 30% discount on capital requirements, compared to corporate bonds of similar rating.
“If you also consider that the premium for holding infrastructure debt, compared to corporate bonds, is 150 basis points or so – we have actually generated 200 basis points over comparable listed bonds – then it creates a very attractive relative value opportunity,” explains Dupont.
The pick-up premium
This ties in with Camiña’s assessment of the return potential in infrastructure debt.
As mentioned, the deals that AllianzGI put together involve a single tranche of bonds, which are amortised over the life of the deal contract.
While returns are very much deal-specific, the common denominator is that most institutions are looking to get a pick-up (a spread) premium over the price of the equivalent bond of the PPA off-taker; that is, the utility company taking the power being generated. This involves looking at how that utility’s bonds are trading in the capital markets and applying a premium for the operational risk and more limited liquidity of the project financing.
“Let’s say that the bond of the utility off-taker for a similar average life as the project is trading at 4% yield. If one then prices in wind risk, operational risk, liquidity premium and so on, this will lead to adding a pick-up premium to that coupon. This pick-up varies a lot depending on the deal and the sponsor.
“Ultimately, there are three ways for institutions to invest in long-term resilient credit: sovereign debt, utility bonds, and infra debt. If you want a pick-up over sovereigns you buy utilities, and if you want a pick-up over utilities you buy infra debt, which is where we come in,” explains Camiña.
Within the senior secured debt arena, Dupont points out that there are a number of sub-segments that offer differing relative value opportunities to investors. There are, he says, four different sub-segments: long duration credit, short duration credit, brownfield sites and greenfield sites. Brownfields are existing operational assets, greenfields are new projects with significant construction risk and no proven track record in terms of operational performance.
“Let’s first consider lower RV opportunities in the market. For example, long duration greenfield projects have seen evident demand from investors looking for asset liability matching instruments. But with a lack of pipeline investments, and significant investor capital to deploy, this is supporting low rates relative to corporate credit.
“By contrast, in short duration brownfields, where companies are offering loans of five to seven years, they have consistently offered 200 basis points above Euribor over the last five years. The team at Schroders is very focused on brownfield projects rather than greenfields in the senior secured fund,” explains Dupont.
In total, Schroders has made 19 individual transactions across the five funds over the last 12 months including offshore wind, energy grids, oil pipelines and storage facilities.
There are many risks to investing in infrastructure of which investors will need to be mindful – although these are applicable in varying degrees to any investment. Regulatory risks, political risks, economic risks – these could all potentially play a role in affecting the performance of operational assets and the future cash flows they generate.
By way of example, Cordle says that a risk to the economics of a fund can be introduced if additional infrastructure projects are envisaged. He cites the Dartford Crossing, just outside London, which faces a second tunnel being built under the Thames, reducing the volume of traffic. Infrastructure investors would look to see how their investment is safeguarded in this scenario.
“No infrastructure asset is fully protected. Regulations can change. Economics can change. There’s no guarantee that an electricity producer with a fixed contract for a certain number of years will be able to negotiate a similar deal in the future. That’s part of the cost of setting these funds up – there is often an awful lot of due diligence involved and a critical assessment of the intended investments,” says Cordle.
The UK is arguably Europe’s most important infrastructure having first privatised its airports, water companies and rail line operators 30 years ago.
But last year, a curveball in the form of Brexit occurred, instantly changing the optics of its infrastructure market.
“As these projects are denominated in Sterling, it becomes more difficult for non-UK investors because of the currency risk and the lower price of Sterling, which has fallen significantly since last June. In turn, there is also more political uncertainty. At Schroders, our client base is Euro-denominated and we are recommending them to invest in Sterling-denominated infrastructure at a later stage when the impact of Brexit will become clearer,” explains Dupont.
Strength of partnership
For all of the excitement surrounding infrastructure investing, be it in the US or Europe, investors and managers alike have to take confidence in those servicing the assets. In that respect, fund administrators play a vital role in terms of validating assets and providing a much needed layer of independence to ensure that the fund is doing exactly what it should be doing.
“One of the areas we can support infrastructure managers is by providing finance for subscription lines to minimise capital calls,” says McCabe.
“Investors want the assurance that someone other than the investment manager has looked at the calculations related to the fund, looked at the management fees and that their returns have been verified and calculated by a third party.”
In addition, MUFG Investor Services will do independent reconciliations and from a cash flow and investor perspective, perform all the necessary AML/KYC checks to make sure everything is in order.
“Factor in that there’s also an annual audit and it gives the investor the assurance that fraud risk has been minimised.
“Look through reporting is another key strength of ours. We work with some of the largest pension funds in the US who want to pierce through the fund down to the portfolio company or investment level to understand their exposures in those portfolios. We are a clear market leader in the industry with respect to the accuracy, depth and breadth of reporting available to our clients,” concludes McCabe.
Regardless of how institutions choose to invest in infrastructure, it is clear that the dynamics continue to look favourable. It’ll be interesting to see if total inflows for 2017 break the record books.