Private market: Investing in infrastructure debt with a positive impact for the climate

March 14, 2022

Infrastructure such energy production, waste treatment center, hospital, public transport, telecommunication are essential services and central to a well-functioning society. Looking forward as we are well into the new year, we believe that investments in sustainable infrastructure are at the heart of this secular transition that shall enable long term sustainable economic development. Indeed, addressing climate change is the most pressing requirement for the planet and the society. It is at the forefront of government policies in Europe and around the world. Particularly, due to the impact of the Covid-19 pandemic on governments’ budgets, private capital will play a critical role in supporting governments meet the objectives implied by the Paris agreement. This immediate opportunity is massive and here to stay for the long term. It is the biggest and most attractive private market opportunity that we currently see.

Historically seen as the remit of governments, the role of the private sector in infrastructure assets increased over the last two decades. Privatizations also drove the increasing need for private capital alongside constraint public spending. This favorable regulatory environment led to the growth of the unlisted infrastructure funds. The latter allocation stands currently at $640 billion and is forecasted to reach $1.87 trillion by 2026 . The long-term, diversified, and resilient nature of infrastructure assets as well as their strong return profile attracted the interest of an increasing number of asset managers and pension funds. In Europe only, in order to achieve the EU’s stated objectives, up to €7 trillion in infrastructure spending will be required over the next 30 years; of which around €3 trillion will come from private sources.

The growth of the infrastructure private debt market

Once considered as a sub-set of alternative investments, infrastructure is now fully recognized as a separate and attractive asset class in its own right. This is acknowledged in Switzerland with the recent pension fund regulation (OPP2) change. Instead of being included into the alternative asset allocation, the new regulation allows Swiss pension funds to invest up to 10% in infrastructure assets. Infrastructure investing assets are financed through a mixture of equity and debt. The debt market segment of this asset class is predominant in volume. This is because it represents 70% to 80% of the financing package needed to build and operate the infrastructure asset. Private infrastructure debt investment volume is indeed massive and stable with around USD250-300bn private infra debt originated per annum since 2007 .

Historically, in Europe it was the banks providing the financing to this attractive infrastructure sector. However, at the outset of the Great Financial Crisis of 2008, the banking sector hardly hit by the blow of their subprime mortgage exposures has been progressively constrained by the capital requirement enforced by banking Basel regulation. Following this unfavorable banking regulatory environment, many banks retreated from long-term lending, or are collaborating with asset managers so that they can access the asset class and play a growing role.

Despite the impact of the Covid-19 pandemic, the state of the European infrastructure debt market gained momentum during the second half of 2020, returning to pre-Covid levels. 251 transactions were completed representing a healthy €105bn in volume. Approximately 70% of this volume were financed through debt . The remaining 30% (€31.5m) represents the European infrastructure private equity transaction volume, which weight evidently on the private equity dry powder deployment.

Despite the impact of the Covid-19 pandemic, the state of the European infrastructure debt market gained momentum during the second half of 2020, returning to pre-Covid levels. 251 transactions were completed representing a healthy €105bn in volume. Approximately 70% of this volume were financed through debt . The remaining 30% (€31.5m) represents the European infrastructure private equity transaction volume, which weight evidently on the private equity dry powder deployment.

Secondly, similar to real estate, the underlying real estate? asset offers long term cash flow income and inflation protection through inflation indexed long term contracted revenues. The distinction is that it can benefit, when accessed through floating rate debt, from interest rate increases. Importantly, the Infrastructure asset class has low correlation to business cycle with inelastic consumer demand, strong pricing power, and limited over-supply especially seen in the Swiss real estate market.

Finally, it is a good diversification tool for private equity investors. There are higher volumes, which fastens capital deployment. These higher volumes are mainly related to the above-mentioned asset capital structure, which consists of 70-80% of private debt and 20-30% of private equity. It also offers recuring attractive cash-flows during the life of the loan while most of the private equity capital returns materialize at a long horizon often with the sale of the asset. The latter success being a function of the current high valuation and ability to generate and crystalize future value growth from the asset. Lastly, infrastructure debt is safer than private equity as it benefits from downside protections via robust security structuring, priority ranking, and specific covenant packages. To give some context, if an asset is facing difficulties in repaying its debt, debt investors are able to trigger certain rights. They can draw on specific reserve accounts, drawstop further borrowing, or cease paying dividends to the private equity investor. In this instance the private equity investor has limited protection. It faces dividend collection delays, reduction in returns or potentially face losses. The strength of these infrastructure private debt protections is demonstrated during the Covid-19 impacted year 2020 with the very limited credit rating downgrades (-0.3% of issuers) while preserving the coupon and principal repayments. On the other end, the internal rate of return of private equity infrastructure was nil at -0.1% for that same year .

Overall, in this low yield environment, investors are more than ever hunting for yield. It is becoming clear to many investors that significant allocations to zero-yielding government bonds will not enable them to meet their liabilities. In this situation, infrastructure private debt can be considered as a viable higher yielding alternative to listed government and non-financial corporate bonds as it offers an attractive illiquidity premium. Furthermore, the coupon reflects a complexity premium that the borrower is ready to pay to identified investors who have the in-house expertise to due diligence, originate, execute, and monitor bespoke debt instrument tailored to the idiosyncratic cashflows of an infrastructure asset.

How does infrastructure debt deliver a positive environmental impact?

This asset class is very attractive for institutional investors from a credit risk adjusted return perspective. For asset owners interested by sustainability and willing to dodge greenwashing exposure to sustainable infrastructure debt investment strategy can be designed to meet impact objective. For example, to finance infrastructure assets and infrastructure companies that have a measurable, intentional, and positive impact on the planet. Impact framework can enable to identify assets contributing positively to a number of environmental challenges underlined by some of the United Nations Sustainable Development Goals (“SDGs”). From these identified SDGs, impact targets can translate into actionable investable themes and establish impact measurements for each invested asset. The investable impact themes can be namely:
1. Clean & Smart Energy (e.g renewable energy generation, storage, and energy efficiency),
2. Clean & Smart Water (e.g waste-water treatment plant),
3. Decarbonization (e.g EV charging stations roll-out, electric trains),
4. Pollution Reduction (e.g waste treatment and recycling plants).

Offering diversification in a portfolio, decorrelation to other asset classes, stability through economic downturns, protection against inflation and rising rates, selective infrastructure debt opportunities can offer stable attractive coupon income, and so makes capital allocation sense on top of offering a positive climate impact.

Sources:
Preqin’s ‘2022 Global Infrastructure Report’
Goldman Sachs Equity Research: The EU Green Deal, July 2020
Dealogic, excluding refinancing & oils, gas &mining sectors.
Inframation, January 2021.
Moody's "Infrastructure Default and Recovery Rates 1983–2017“
Moody’s Default and recoveries: COVID-19 one year on – infrastructure proves its resilience, May 2021
Preqin’s ‘2022 Global Infrastructure Report’. Past performance is not a guarantee for future results.


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