Bridge & Tunnel
Guelda Voien Oct. 6, 2014, 6:30 a.m.
While bridges and roads have been in vogue for centuries, debt funds for building them are still taking shape at barely 10 years old.
Major infrastructure projects have typically been financed publicly or by large banks. That’s because building an airport, or tunneling through a mountain, is not only a long-term project, it has historically been perceived as a high-risk undertaking. Now, a variety of factors have converged, making infrastructure debt and equity investments attractive to a broader scope of players, such as sovereign wealth funds and pension funds.
Those players could invest directly, but often go through debt funds with international financial services firms, to forgo the hassle.
And as the sector expands, some are even calling for a reclassification of infrastructure debt that would allow it to be securitized, sources told Mortgage Observer.
Enter the Debt Fund
A major factor driving demand from investors and fund managers is the fact that the lending and investor communities have discovered that in OECD countries, and in some emerging markets, the risk involved in financing infrastructure projects is not actually very high at all—contrary to previous thinking.
“Infrastructure as an industry is very young,” said Elliott Bradbrook of London-based investment data provider Preqin. “The vast majority [of investment] is on the equity side, but we have some infrastructure debt funds, which is kind of a new strategy.”
When infrastructure funds first surfaced, around 2003 or 2004, they were associated closely with private equity investments, Mr. Bradbrook said. As a result there was a sort of guilt by association, and many investors assumed that infrastructure deals were as high risk as a private equity leveraged buy-out. But this was an unfair stigma. And as it has been lifted, interest in infrastructure has grown prodigiously.
A total of $43.9 billion in debt and equity for infrastructure projects was raised in 2013, up from $31.8 billion in 2010, according to numbers provided by Preqin.
The affiliation with private equity also meant that the most popular mode of private infrastructure finance was equity investment. But that, too, is changing.
“Traditionally, these debt funds have made both equity and debt/mezzanine investments,” a late 2013 report on infrastructure finance from the firm reads. “However, with changing investor demand fund managers are increasingly launching vehicles focused solely on debt investments as well as separate accounts and mandated arrangements to satisfy investor appetite.”
Infrastructure debt and equity, as asset classes, have also filled a hole for investors looking to park money on a very long-term basis but still receive relatively high yields, sources told Mortgage Observer.
Now, long-term holders of fixed-income and other yield-driven assets, such as pension funds, some endowments and even some family offices, are looking to infrastructure debt, instead of ABS, CLOs or private equity, a source said.
“Only recently have people begun to realize that [infrastructure debt is] not comparable to private equity—there is less risk,” Mr. Bradbrook said.
Indeed, in 2013 infrastructure debt fund-raising, from unlisted fund managers, was $11.3 billion, up nearly eight-fold from $1.5 billion in 2010. The amount of fund-raising in debt funds grew more than four times faster than that of the sector as a whole, the numbers show.
Mr. Bradbrook said of the 600 funds geared towards infrastructure, “about 50 or 60” invest in debt.
While sovereign wealth funds and the like could invest directly in infrastructure debt—and some do, to be sure—such investments often go through managers both because of the size of deals and the complexities of individual relevant markets.
“It typically behooves theses investors to access the right manager, particularly if they don’t have the, no pun intended, infrastructure in place,” said one banker who deals invests in infrastructure debt on behalf of institutional clients for a multinational bank.
And it makes perfect sense, given the potential returns. Yields on debt investments through Deutsche Asset & Wealth Management “range from 4 to 5 percent for straight investment grade, to low to mid teens for structured debt products,” Jorge Rodriguez, head of debt for Deutsche Asset, told Mortgage Observer. (Deutsche Asset is a part of Deutsche Bank Group that services institutional clients as well as ultra-high net worth individuals and family offices and trusts).
Decline of Bank Lending
The reasons for the emergence of debt and equity funds targeting infrastructure are myriad. First, banking regulations, in particular Basel III, have made it more difficult for banks to properly serve the sector, leaving an opening.
“Because it got labeled as a high-risk asset class, it made it kind of difficult for banks or insurance companies,” to participate in the infrastructure space, said Mr. Bradbrook.
“Banks have a changed appetite in terms of leveraged ratios and tenders after the credit crunch,” said Boe Pahari of Chicago-based AMP Capital Investors in a report from Preqin. His firm invests in infrastructure through unlisted debt and equity funds and directly. “As a result, there is a space where pension funds can participate on the debt side, particularly in mezzanine,” he said.
New capital constraints overall limit a bank’s ability to lend on these projects, but also, the long terms for infrastructure loans, and the flexibility in terms they sometimes require, present an additional challenge for banks. The result has been an ebb in banks’ participation in infrastructure debt and the rise of institutional funds, with the exception of hedge funds, as the primary players in the market, sources said.
“The bank market [for infrastructure debt] is essentially capped at five to seven years,” Mr. Rodriguez said. Infrastructure lending, on the other hand, generally needs a term between 10 and 50 years, sources said.
In addition to institutional players, the space has also recently seen growth in the number of unlisted fund managers, which can also pool funds from institutional investors.
The most active unlisted fund managers are from Japan and Europe, and include Sumitomo, Bank of Tokyo, KfW Banking Group and Credit Agricole, according to Preqin. The biggest American player, with 19 infrastructure transactions so far, is International Finance Corporation, a Washington, D.C.-based affiliate of the World Bank.
A Sleep-Well Investment
The investors most interested in infrastructure— ironically perhaps, given its prior reputation—are those looking for relatively safe investments.
“What differentiates this sector is the predictability of cash flow, and [the lack of] high barriers to substitution,” said Mr. Rodriguez. “It’s a ‘sleep well’ investment.”
And as turmoil has spread around the globe—from the Middle East, to Ukraine, to Thailand—in recent months, infrastructure projects in OECD countries remain calm waters, investment-wise. This is largely because they are highly regulated and the borrowers— with a few exceptions, like, ahem, Greece—are creditworthy.
The one notable exception has been hedge funds, which have avoided investments in infrastructure debt because they generally avoid long-term commitments, sources said.
In addition to offering low risk in combination with high yield, infrastructure debt is very well hedged against inflation, Mr. Rodriguez explained. There is a “strong correlation between growth in revenue and GDP,” for this type of investment. And as volatility has reached some markets amid political turmoil, an investment position that can wither inflation becomes increasingly important.
The Right Risk Profile
Infrastructure lending, of course, requires extensive research into which countries are politically stable and treat debt as recourse.
For the moment, investor interest is in projects mainly in OECD countries and parts of Asia and South America, sources said.
In Asia, the Philippines is the market du jour, a source said, while in China there has been almost no investment in infrastructure debt, because “the government has too much money of it’s own.”
“In the Philippines we’ve seen a lot more deal activity; their government has become more comfortable” with foreign investment, said Mr. Bradbrook.
In India, “absurd” levels of corruption have typically dissuaded investors. But a source said international investors with local partners have done well.
Of course, no matter where an institution or trust invests, the reason the asset class excites investors and managers alike, is that it is undeniably growing.
“About 41 trillion U.S. dollars need to be spent on infrastructure worldwide by 2030,” Hamish Mackenzie, Deutsche’s head of infrastructure for Europe, said in a recent report for the bank. Increasingly, that money is being sourced from the private market, even for infrastructure projects in the West.
“If you’ve ever driven on the roads in the United States or you know anything about the United Kingdom’s creaking Victorian sewage system, you’ll be aware the industrialized world also needs to spend heavily on infrastructure,” Mr. Mackenzie said.
In North and South America, Mr. Bradbrook said Latin America is a particularly attractive space at the moment, even beyond Brazil, which has long been seen as a sort of classic emerging market for foreign investment, including for infrastructure debt. “Colombia—there is a lot of movement there,” he said, echoing the perspective of a banking executive who asked not to be identified. Other parts of South America are less attractive. “Argentina is a mess,” the executive said.
Where will no investors go? Besides parts of Asia and South America that are unstable or in turmoil, the loudest answer: Russia.
“There really isn’t any interest from outside of Russia to invest in Russia,” said Mr. Bradbrook.
So far, while infrastructure bonds are sold in many parts of the world, similar to municipal bonds, securitized debt is not available. But some groups are working to make CMBS a new financing tool for infrastructure transactions.
Just last month, India Ratings & Research, a Mumbai-based rating agency, issued a report that said “certain structural adjustments, improved investor’s risk appetite and the availability of active secondary bond market could create an enabling environment for infrastructure debt funds.” Locally, the ratings agency encourages that because of the banks’ “over-exposure to the infrastructure sector.”
Not everyone believes a secondary bond market is the answer, though.
“I understand some folks out there have been trying to expand the mortgage pool definition to include infrastructure assets,” said our unidentified banker, “but its unclear who.”
And the absence of CMBS in infrastructure debt is not a bad thing, he said. “It’s putting a square peg in a round hole.”