Institutional buyers jostle for position in new infrastructure debt market

Louise Bowman
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The much-vaunted institutionalization of the project finance debt market is now under way as asset managers, pension funds and insurance companies pile into infrastructure lending. However, the risks and rewards they find there might take some getting used to.

The project finance market was hit hard and fast by the banking crisis in Europe. When banks found themselves bloated with risk weight heavy assets on their balance sheets, writing new long-term loans on illiquid assets quickly became an expensive luxury. The project finance industry has been in the throes of inventing a new way to fund itself ever since.

There has been a lot of talk over the years about turning to the institutional market. Stable, long-dated cashflows from real assets should be meat and drink to these buyers but progress has been agonizingly slow. In recent months, however, there have been signs that all the talk might be turning into action.

"There is massive institutional interest in owning these assets," says Jim Barry, chief investment officer of renewable power and infrastructure at BlackRock in London. The US-based asset manager announced that it had hired a management team to focus on infrastructure debt investment at the end of November last year. "This is a total change in the market over the last three years," Barry tells Euromoney. "There has been a lot of talk, but we actually started to see movement in the second quarter of last year. The appetite is there and it is real."

BlackRock clearly means business in infrastructure: in July last year it acquired Swiss Re’s private equity fund of funds business for $7.5 billion, primarily because it specializes in investing in infrastructure funds.

The firm’s decision to focus now on infrastructure debt is the latest in a series of announcements from institutional investors declaring their intention to invest in the sector. Last summer, AllianzGI hired a team of five from MBIA subsidiary Trifinium Advisors to initiate debt investment into infrastructure, while French bank Natixis established a €2 billion joint venture with Belgian-Dutch insurer Ageas to co-invest in infrastructure loans.

In October, La Banque Postale Asset Management hired Dexia’s head of infrastructure and launched a $500 million fund to focus on real estate and infrastructure debt; in November reinsurer Swiss Re announced that it had awarded a $500 million external mandate to Macquarie Group to manage a portfolio of investments in senior secured infrastructure debt. There has also been movement on secondary sales of infrastructure loans: PensionDanmark acquired a portfolio of infrastructure loans from Bank of Ireland in June, while in the same month the Irish lender sold a £160 million ($253.8 million) portfolio of UK social infrastructure PFI loans to Aviva Investors at 81% of original face value.

The attraction of infrastructure assets to institutional investors with long-dated liabilities is strong. "Long-term investors recognize the opportunity, and want to access it," says James Wilson, chief executive of infrastructure debt investment solutions at Macquarie in London (Midis). "If you have long-dated liabilities and want to match them, the alternatives are long-dated sovereigns and corporates. Institutional investors can put part of their book in a less liquid form and get superior returns." The asset class is increasingly seen as a diversification play away from government and covered bonds in such a low interest rate environment.

But it is not just yield that is attracting such attention. "Historically, these types of assets were not available investments for us," admits Klaus Weber, managing director and head of external investment mandates at Swiss Re in Zurich. "This was mostly because the market was dominated by banks. Today, with less capital available from banks, this is changing. And infrastructure assets are an interesting fit for liability-driven investors. These are yieldy, relatively safe long-term assets."

The level of interest is not in doubt, but there are many ways to skin a cat. Little consensus has emerged among institutional buyers as to the best way to approach what can be a tricky and time-consuming asset class. "This is obviously a bespoke market where the specific terms of each deal are key," says Weber. "There is not much specialist skill out there, so there was a strong focus to look for an external partner who is in a position to attract and maintain best-in-class skills over the long run." Swiss Re’s partner, Macquarie, has a long enough track record in infrastructure equity to know where to start looking on the other side. "A number of investors are looking at the opportunity and are clearly interested," says Wilson. "But it is not an easy asset class to resource, and it is highly credit intensive."

The most straightforward approach is to hire a team, as BlackRock has done. This was also the route taken by AllianzGI when it hired its team from Trifinium Advisors last July, headed by Deborah Zurkow, formerly head of EMEA public finance at monoline guarantor MBIA. The insurer announced the launch of a £1 billion UK senior debt fund in January.

Deborah Zurkow,  managing director and head of infrastructure debt at AllianzGI
Deborah Zurkow, managing director and head of infrastructure debt at AllianzGI
"For investment managers to effectively fill the funding gap created by the retreat of banks from this area of investment, it is critical to have deep expertise in the field of infrastructure debt and the risk profiles of different projects," Andreas Utermann, global chief investment officer of AllianzGI, asserted when the team was hired. Zurkow, now managing director and head of infrastructure debt at AllianzGI, agrees. "We are trying to actualize a market that has been very much talked about but primarily theoretical," she tells Euromoney. "The infrastructure debt market is used to bank lending, and there is a notion that we are taking a huge step towards a very tricky market. AllianzGI decided to bring in a team of experts because the opportunities are large, but the devil is in the detail. Direct lending requires that you know the assets and how to structure them. The key skills are sourcing, structuring and monitoring. You can’t make a bad asset good through structuring but you can make a good asset bad."

Few would disagree with that, but some in the industry argue that this is a very expensive way to do it. "When you hire a team and lend directly, this is a very lengthy and costly exercise," reckons Benjamin Sirgue, global head of aircraft, export and infrastructure finance at Natixis. "These are different risks than those these investors are used to, so for most investors this won’t be the solution – they do not want to become a bank."

Sirgue argues that the optimal approach is for the institutional investor to partner with a bank. Natixis has done just this, forming a partnership with insurer Ageas under which infrastructure loans originated by Natixis will be sold on to the insurance company. "Teaming up with a bank is very attractive for the investor because banks have large origination teams and a continuous pipeline of transactions. Also aligning themselves with an active lead manager and advisor gives them more capacity to influence the structure of transactions," he says. Roughly €100 million-worth of loans are understood to have been transferred so far, with a further €300 million earmarked. Natixis is looking to extend the joint-venture arrangement to other investors.

There are also big attractions for the bank in being able to maintain its origination capabilities without burdening its balance sheets with long-term loans. Natixis will keep skin in the game on the loans that it originates, but the majority of each loan will be sold to Ageas.

This makes a lot of sense not only for active project finance banks but also those looking to run down their project finance books by selling in the secondary market. "This is a capital arbitrage opportunity, not a credit opportunity," explains Bob Dewing at JPMorgan Asset Management, which is busily sourcing project finance loans from banks in the secondary market. The US asset manager is managing the portfolio of infrastructure loans for PensionDanmark that it acquired from Bank of Ireland last year. "Banks don’t have to put up a huge amount of capital against these loans as the credit is generally good," Dewing says. "However, they do have to put up a huge amount of capital because of the asset liability management (ALM) mismatch. The capital charge is significant when you are funding 25-year loans with 90-day money. So banks have the choice of sitting on it and having capital drag as a result or selling it if they have a decent P&L."

Dewing says that the capital advantage that institutional investors now enjoy over the banks will be a key driver in the evolution of the market. "Institutional investors see the rationale and like the asset class," he says. "Infrastructure will be disintermediated simply because there are so many institutional investors looking at it. They have such capital advantages compared to the banks that it makes economic sense." Their capacity for this risk is not, however, boundless. In June last year the UK’s Financial Services Authority deemed Aviva Commercial Finance, a unit of Aviva Investors, to have run up against its annuity-product lending limits on PFI loans and has discouraged it from further lending.

Jim Barry, chief investment officer of renewable power and infrastructure at BlackRock in London
Jim Barry, chief investment officer of renewable power and infrastructure at BlackRock in London 
For those investors that do not want to set up on their own or partner with a bank there is the more traditional approach of investing through a debt fund. This is the path of least resistance for them, and it is of little surprise that there has been such a flurry of new debt funds announced. "We are looking for structural shifts where there is investment opportunity and it makes sense for clients," explains Barry. "We have a big alternatives division but there was an obvious gap in infrastructure. The assets make sense from an income/yield, inflation protection and correlation perspective, so we decided to go after scaleable opportunities," he says. "With infrastructure debt, it was absolutely clear to us that bank capital was pulling back, creating the opportunity." But Barry is clear that this opportunity is in debt rather than equity investing. "The general equity infrastructure business is very well served, and lots of capital has been raised. However, the weight of money has meant that the definition of infrastructure has become stretched and limited partners in some infrastructure funds have ended up with far more GDP exposure than intended from investments such as car parks and waste businesses that are not classic infrastructure. Prices and, consequently, leverage has gone up adding more financial risk on the equity side. BlackRock chose not to be in that part of the market."

Veterans of the infrastructure sector are slightly more guarded about the potential – particularly for senior debt funds. Glenn Fox, CIO at Hadrian’s Wall Capital, spent a year at asset manager Duet trying to raise a senior infrastructure debt fund, without success. "It is very difficult to raise funds for an infrastructure-based senior debt fund. The returns on offer are not sufficiently high to attract investors into what is an illiquid vehicle," he said last year. "They don’t get to select the assets, and the returns are not much higher than they would get in corporate bonds. The additional return on offer for the illiquidity of the product isn’t high enough."

Gerry Jennings, principal, infrastructure debt at asset manager AMP Capital, concurs. "Investors are targeting steady cash yield but it has to be meaningful. Yields at the senior end are typically lower than what they are looking for," he says. Jennings reckons that a high-quality regulated asset that is paying a margin of 175bp for senior debt would probably pay upwards of 400bp for subordinated lending, while a riskier investment paying 300bp to 350bp for senior could pay 600bp to 800bp and beyond at the junior level. AMP Capital raised €400 million via its IDF subordinated debt fund last year, more than half of which is invested. It recently launched a second subordinated fund, IDF 2. "We are seeing more funds looking to target the junior space," he says.

Scarcity of assets could be a concern for these funds, however, as the bid is now so strong for high-quality, regulated assets that there might not be a junior piece at all. The recent €3.2 billion Open Grid Europe transaction, for example, was very aggressively bid and did not include a junior tranche.

There are almost as many routes to infrastructure investment as there are types of investment opportunity. The lion’s share of the attraction for institutional buyers is at the lower end of the risk spectrum: refinancings and sales of existing assets. Financing greenfield projects will be a far more challenging task.

The domination of this sector by the banks for so long has meant that there is now a growing pool of new investors in the asset class that have very little experience or knowledge of the sector. "This is a tailored product," says Barry of BlackRock’s new infrastructure debt fund. "Some investors will want tenor, others will want flow and others may want index-linked. There is a huge technical dimension to this, and much of the appetite is unsophisticated in terms of infrastructure. These are conservative entities and they will take their time. General education will bring the level of sophistication up and it is important that managers really understand the asset class."

The institutionalization of the project finance market will take many forms. "There is a misconception that the capital markets and infrastructure means bonds," says Zurkow at AllianzGI. "The delivery form of the senior debt could be a bond, loan or private placement."

It is in the loan market that the changes in this market will be most keenly felt. Infrastructure projects have traditionally been financed using long-term, floating-rate bank loans. However, these – while they are still available in some quarters – are in short supply. Insurance companies and pension funds are ready and willing to lend to infrastructure, but borrowers will find the terms by which that lending takes place could change substantially.

"Borrowers are afraid of the changes taking place in the infrastructure debt market," reckons Sirgue. "They were used to dealing with the banks and are concerned at each investor being directly responsible for their own commitment. This is because they are concerned that they may lack the proper internal resources to respond to issues, and the project could be jeopardized."

Not surprisingly those working on bringing institutional money to the market would disagree. Just because there is not a bank syndicate there to negotiate with does not mean that negotiation between lender and borrower is impossible; it will just take a different form and borrowers will certainly have to get used to less flexibility than they have previously enjoyed.

"Institutions will take illiquid long-term risk," says Barry. "You have to be innovative as to how you structure and who you partner with. Every market is different."

The primary change is that institutions will offer fixed-rate rather than floating-rate lending. From the borrowers’ perspective long-term, fixed-rate money removes refinancing risk and the uncertainty built into the structure by the cost of refinancing. This is a big benefit for which they would need to pay a premium. The ALM dynamics of institutional lending that deliver this benefit to borrowers come, however, at the cost of flexibility.

Boom and bust in infrastructure bonds

Infrastructure borrowers have traditionally enjoyed the ability to repay early, but the concept of prepayment is one that institutional lenders with their very long-term liabilities will always find hard to stomach. "Institutional investors are not used to prepayment at all, and there is a high level of discomfort around it," says Dewing at JPMAM. Borrowers will therefore have to get used to much tougher call protection – lengthy non-call periods and make-whole provisions whereby any prepayment will incur payment of the present value of all future spread. "As fixed rate lenders, we seek assurances for the asset liability match in the form of a make whole," says Zurkow. "Most investors are pretty clear on this, and most borrowers understand – it is an all-in cost calculation."

For institutional lenders taking on bank loans with prepayment options as part of a partnership, or buying bank loans in secondary, prepayment is a risk they might have to accept. Dewing at JPMAM argues that the impact of this should not, however, be overstated. "The probability of early repayment is small," he insists. "Because these are floating-rate loans, the only economic loss will be if spreads have declined since an investor bought the loan. This is not a volatile asset class, and spreads have been pretty constant. The economic cost in the event of prepayment is small."

If these first few pioneers in the market can really make infrastructure debt work for institutional investors the implications for the asset class are huge. All emphasize their willingness to work with the banks in the market but the terms on which each are willing to lend might turn out to be very different.

Refinancing and asset churn are front and centre of the opportunity for institutional buyers, and that is where the majority of them will focus their attention. Whether or not many investors’ narrow focus on the very senior part of the structure will pay them enough to make the investment worthwhile is yet to be seen. Even very high-quality regulated assets do not represent a risk-free investment, and as competition in the sector intensifies investors will need to make sure they remain focused on that fact. Jennings at AMP Capital points to the recent UK government’s water white paper, which proposes greater competition in the sector, as an example of the kind of risk that regulated assets still embody. "There is a misconception that just because something is regulated it means that it is safe," he warns. "The changes that [regulator] Ofwat have proposed potentially have a huge impact on how assets are priced and operated, and there has been a huge pushback from equity sponsors as a result." A report published by House of Commons Environment, Food and Rural Affairs (EFRA) Committee on February 1 concluded that further analysis of the likely impact of the draft Water Bill is needed and the case for upstream reform has not yet been fully made - so the situation remains fluid.

Much of the infrastructure expertise now being applied to the debt markets has come from the equity side. Equity fund managers that decide to launch debt funds might face the types of conflicts of interest that private equity firms launching CLO and debt funds before 2007 did. That is something that the industry will have to address as the market changes. It is just one dynamic in the fast-moving evolution of this bank-dominated market into something that will be very different. The potential is enormous, but there will very likely be challenges along the way.

"A number of investors are setting themselves up with expensive fixed costs that need to be covered," says one infrastructure specialist. "These sorts of situations always lead to them stretching themselves to justify their existence. It is a fair expectation that as new players come in they will probably gain market share by pushing the envelope, as has been the case in so many other asset classes."