The fundamentals of Infrastructure Debt

The fundamentals of infrastructure debt

Debt is an important source of financing for infrastructure businesses, and we believe infrastructure debt can present attractive risk-adjusted returns for investors. Its resilient fundamentals make it diversifying to other forms of private credit.

What is critical infrastructure?

We focus on lending to critical infrastructure assets that underpin the functioning of the economies in which they operate.

Essential assets: We look for businesses with proven technologies, in strategic locations, that have long lives and a low risk of obsolescence

Stable cashflows/revenues: Infrastructure businesses tend to have inelastic demand for their services which contributes to more stability in cashflows than corporate private credit.

Inflation resilience: Often infrastructure projects have contracts or regulatory provisions that allow for inflation adjusted pricing. The availability of floating rate debt can further insulate investors against the forces of inflation.

Competitive advantage: Infrastructure assets tend to exhibit monopolistic features with high barriers to entry given the asset-heavy nature of the business.

We focus predominantly on core infrastructure businesses which benefit from these characteristics over long-term horizons. These are typically in one of five sectors: transportation, utilities, power and energy, social and digital infrastructure, allowing investors to gain exposure to a range of asset types.

Exposure to crucial trends

We believe an allocation to infrastructure debt can allow investors to build exposure to some crucial economic trends – from digitisation to the energy transition, or the provision and improvement of social infrastructure.

The nexus of increasing energy demand, technological innovation and climate change is creating a growing potential investment opportunity as new infrastructure needs to be built and existing infrastructure enhanced. We expect to see outsized opportunities in the coming years in the digital sector, in transportation, and in power and energy.

How are infrastructure businesses financed?

Many infrastructure businesses can rely on debt financing given the stability of the business through the economic cycle. Debt typically accounts for 60-90% of the capital structure, and there can often be different levels of seniority that offer investors different levels of risk and return. Senior debt ranks first in the capital structure. These lenders have priority access to borrower cashflows and greater ability to control decisions in downside scenarios.

We see opportunities to enhance returns by investing lower in the capital structure of infrastructure businesses – e.g. by taking a subordinated or junior position – where we thoroughly understand and are comfortable with the credit fundamentals and transaction structuring.

We aim to look for infrastructure businesses that display fundamentals similar to investment grade, but where we can seek to enhance the return potential by accepting structural subordination in the way that cashflow is available for debt service.

Use of loan proceeds

When extending a loan, it is crucial to understand what the borrower plans to do with the proceeds. This can be for general corporate purposes, M&A, or for refinancing existing debt at prevailing market rates.

We may make project finance loans, which are related to the construction or completion of a specific project, secured by assets specific to that project. The yield should account for the construction being underway on a brownfield or greenfield site, although IFM Investors tends to limit itself to more de-risked brownfield opportunities.

Credit risk of debt investments

Like corporate credit, infrastructure debt will have a rating to reflect the credit risk of the business or project on a consistent framework. Much of the infrastructure debt market is private and unrated by any of the major ratings organisations. However, investment organisations will typically apply their own ratings methodologies consistent with the frameworks used by major ratings agencies to allow for comparison.

Infrastructure debt’s risk-adjusted characteristics

We believe infrastructure debt’s risk/return profile distinguishes it from other asset classes, including other types of private credit. The key reasons for this include:

• Cycle resilient cashflows which have led to historically lower default rates

• Higher recovery rates based on the real asset-backed, and strategic nature of the businesses

Committing to infrastructure debt, as with any private capital allocation, requires an understanding that any investment will have less liquidity than a listed asset due to the privately negotiated and often complex nature of the loan. However, with this, investors can also reap the associated illiquidity premium.

The case for infrastructure debt

Population growth, and changing economic dynamics like digitisation, and the reshoring of manufacturing create the need for more power generation and infrastructure to move goods and people around the world. Infrastructure also addresses societal needs like affordable housing and the creation of next generation industries as the world undergoes an energy transition. We believe infrastructure debt provides an opportunity to invest in these solutions and generate stable income and attractive risk adjusted returns. We believe the asset class can serve as a resilient, diversifying part of a private debt allocation with historical evidence of reducing default risk.