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

March 14, 2022

Infrastructure are essential services and central to a well-functioning society. Looking forward, 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. The new geopolitical and energy market realities require to drastically accelerate Europe’s energy independence from Russia’s volatile fossil fuels. Massive scale-up of renewable energy generation being the cheapest and cleanest energy, which can be produced domestically will reduce need for energy import. Electrification of the transport system and improved water access are critical in the face of global warming. 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 environment led to the growth of the unlisted infrastructure funds. The latter allocation will reach a record high of $950 billion in 2022, with planned steady increase to infrastructure over the next three to five years . 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 assets are financed through a mixture of equity and debt. This financing principle inherently splits the infrastructure private market between the private equity segment and the private debt segment. The latter is predominant in volume. This is because debt represents 70% to 80% of the financing package needed to build and operate an asset. The remaining 20%-30% is the private equity capital. Massive and stable the infrastructure private debt volumes originated is around $250-300 billion per annum since 2007.

Historically, in Europe it was the banks providing the financing to this attractive infrastructure market. However, at the outset of the Great Financial Crisis of 2008, the banking sector hardly hit by the blow of the subprime mortgage market, 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 infrastructure lending, or are collaborating with asset managers so that they can access the asset class and play a growing role.

The attractiveness of infrastructure private debt for portfolio diversification

Credit interest rate for infrastructure private debt transactions in developed economies are ranging between 1.5% and 3% for investments grade Solvency II credit profile and up to 8% for higher yielding assets. Infrastructure private debt, hence, can be considered as a viable higher yielding alternative to listed government and 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 asset managers. This premium reflects mainly the in-house expertise to originate, due diligence, execute, and monitor bespoke debt instrument tailored to the idiosyncratic cashflow nature of each infrastructure asset. It is also a good source of diversification from real estate and private equity allocations.

It offers to investors a different exposure than private equity infrastructure. Firstly, there are higher volumes, which fastens capital deployment. It also offers recuring attractive risk adjusted coupon income during the life of the loan. Private equity dividend stream can be extracted from the assets but only after servicing the debt first that often contains a dividend lock-up covenant. Most of the private equity capital returns materialize at a long horizon, often with the sale of the asset. The latter future successes are a function of the current high valuation entry point, ability to generate value growth and to successfully crystalize the return. 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, draw stop 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 has been demonstrated during the Covid-19 impacted year 2020 with the very limited credit rating downgrades (-0.3% of issuers) while generally preserving coupon and principal repayments. On the other end, private equity infrastructure internal rate of return was nil at -0.1% for that same year , albeit rebounding since but to varying degrees based on the business model of the asset and its sub-sector. Looking ahead, in an increasing interest rate environment capital gain of infrastructure private equity strategies is likely to be reduced. The multiple expansion due to the last decade of low interest rates, were the key driver for private equity returns . EDHEC Infrastructure research finds that a 1% increase in the discount rate would reduce the fair value of unlisted infrastructure equity by 10%.

Similar to real estate, infrastructure is a real asset. It offers long term cashflow income and inflation protection through inflation indexed long term contracted revenues. The distinction is that infrastructure debt can benefit, when accessed through floating rate debt, from interest rate increases. Importantly, the Infrastructure asset class has lower correlation to business cycle with inelastic consumer demand, strong pricing power, and limited over-supply especially seen in the Swiss real estate market.

Infrastructure debt exhibits favorable recovery rates compared to listed corporate credit. Moody’s research shows an average 80% recovery rate in the case of default with a 100% recovery in almost two thirds of cases. At a similar BB credit rating the 10-years probability of default is 8% and 18% for European infrastructure debt transactions and listed non-financial corporate (“NFC”) bonds respectively. Average recoveries amount to 55% and 38% for unsecured European infrastructure debt and unsecured NFC bonds respectively.

How can infrastructure debt deliver a positive environmental impact?

For asset owners interested by sustainability, 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).
For institutional investors, selective investments in direct private debt infrastructure transactions in the above impact themes can deliver superior risk adjusted returns underpinned by cashflow visibility and strong collateral. This way investors can be exposed to a diversified infrastructure debt asset class that offers decorrelation to other asset classes, stability through economic downturns, protection against inflation and rising rates. The icing on the cake, such approach offers a positive climate impact.

Sources:
RePower EU : affordable, secure and sustainable energy for Europe
ESGinvestor: Asset Owners and Managers to Target Renewable and Social Infrastructure
Goldman Sachs Equity Research: The EU Green Deal, July 2020
Dealogic, excluding refinancing & oils, gas &mining sectors.
Moody’s Default and recoveries: COVID-19 one year on – infrastructure proves its resilience, May 2021
Preqin’s ‘2022 Global Infrastructure Report’. s.
Bain&Company “Private Equity’s Inflation Challenge”, 2022
EDHECinfra
Moody's "Infrastructure Default and Recovery Rates 1983–2020“,
Past performance is not a guarantee for future result.


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