Investor appetite for infrastructure debt is proving to be robust in the face of a challenging fundraising environment for private markets. Vincent Guillaume and Stephanie Passet, Co-heads of Infrastructure Debt, argue for a disciplined approach to risk tolerance.
Investors should watch for portfolio managers who are increasing their risk profile by going further up in the debt structure1.
Other risks to watch include technology risk, for example, regarding newer sectors in the energy transition, and market risk. Finally, instead of being financed at the ready-to-build stage, there is now a push to finance renewables earlier in the project process. We believe these developments justify a conservative approach to risk appetite.
Within the broader infrastructure debt market, the sub-investment grade segment2 in particular is booming as it allows investors to extract a net yield close to that of core infrastructure equity, but with the added benefit of the downside protection that a debt product provides.
However, we are also seeing greater appetite in the investment-grade segment, particularly as it relates to sustainability and impact strategies.
Resilience in the face of intense volatility
One appealing aspect of infrastructure debt is that it is resilient across different economic cycles as it finances assets that provide essential services such as power and transport.
The asset class has performed well through different environments: the Covid pandemic, the surge in energy prices post Russia’s invasion of Ukraine, rising inflation and interest-rate hikes.
As the asset class’s defensive features have been tested in multiple downturns, investors have come to appreciate its ability to act as a portfolio diversifier in volatile periods. Its defensive features also include low default rates, high recovery rates and low loss levels.
Managing infrastructure debt
Key characteristics of successful asset managers include expertise and track record. An asset manager ideally should also have:
- Strong relationships with all the key infrastructure players including sponsors, banks and financial advisers
- The ability to deliver proprietary transactions and the capacity to deploy capital efficiently
- The ability to assess highly complex projects and structure bespoke financing solutions.
Attractive areas
We see new renewable energy production as well as clean energy solutions for the transport and industrial sectors as areas in need of significant financing.
There are opportunities related to power grid stabilisation – reinforcing the grid so it can accommodate more flexible sources of generation such as solar. We are also seeing more battery storage projects in our pipeline. Other opportunities exist around electric vehicle (EV) charging, energy demand response3, and energy efficiency.
Around the circular economy, there are financing opportunities in waste management, waste-to-energy and recycling. We expect to see opportunities in nascent areas such as carbon capture and green hydrogen, but for now those represent more equity risk than debt risk.
Another key theme driving the market is the digital transition. This is fuelling data consumption and thus the need for digital infrastructure. Last year, we saw significant refinancing activity in fibre connectivity in Europe. This year has so far been dominated by datacentre financing, driven by the continued migration to the cloud and the additional demands of artificial intelligence (AI).
How the structuring of deals is evolving
Sponsors are increasingly developing projects located in many countries and spanning multiple sub-sectors. Because of this diversification, a more corporate approach to how deals are being structured is emerging.
We are seeing greater demand for platform lending and holdco financing, as well as corporate-style infrastructure financing with leveraged finance features and a push to implement unitranche financing for infrastructure assets.
Investors need to remain selective as equity-like risks are increasingly appearing in infrastructure debt. This includes riskier products that involve moving higher up in the capital structure. The products can also involve greater technology risk, for example, in newer sectors of the energy transition, as well as more exposure to market risk with fully merchant projects.
Finally, while it used to be the norm that renewables were financed at the ready-to-build stage, there is now a push for this to happen earlier in the process.
Infrastructure debt – A competitive market
Infrastructure debt is becoming more competitive, notably in the sub-investment grade segment. However, we should note size matters in this market to be able to handle mid-market transactions as well as larger ones. That is why we are seeing consolidation in the asset management industry, and in particular in private markets.
While scale is an attribute, it is also important to retain sufficient flexibility to be able to tap into the attractive risk-return profile of those mid-market opportunities.
In this environment, managers can differentiate themselves by being part of a sizeable private markets platform.
Finally, internal expertise can allow managers to consider less obvious transactions that may otherwise be difficult to analyse.
Looking ahead, the main challenges and opportunities
Strong fundamentals are supporting the European infrastructure debt market, including two powerful megatrends: the energy transition and digitalisation.
Energy supply security is critical as last year renewables overtook coal production in the EU for the first time.
We anticipate opportunities in other aspects of the energy transition including energy efficiency, battery storage and perhaps carbon capture. In addition, we foresee a need for greater investment in grid improvements.
On digitalisation, there are huge capital spending needs around datacentres. Europe is lagging in this area.
Admittedly, geopolitics and global trade tensions are a challenge. However, the asset class has proved its resilience through numerous macroeconomic shocks, and we anticipate that will continue.
[1] The most secured part of a company’s capital structure is composed of senior secured bonds. Next are senior unsecured bonds, then convertible and subordinated debt. More here: https://www.antiquesage.com/bondholders-capital-structure-coming-stock-market-crisis/
[2] With credit ratings indicating a higher risk of default and weaker creditworthiness. Issuers typically offer higher interest rates to compensate investors for the increased risk
[3] Demand response: balancing the demand on power grids by encouraging customers to shift demand to times when power is more plentiful or other demand is lower, typically through prices or monetary incentives
