Investment Actions

Erik Savi on infrastructure debt

Aug 24, 2016

The global need for infrastructure financing is no less acute than the need institutional investors have for alternative sources of income. And with tighter bank regulations and fiscal constraints on governments limiting the ability of these traditional capital providers to finance infrastructure projects, institutional investors have been eager to fill the gap.

The attraction is clear: Private infrastructure debt can add both income and diversification to a portfolio, via access to long-term cash flows generated by essential real assets in sectors ranging from transportation to renewable energy to student housing and water treatment. But if the global need for infrastructure finance is measured in the trillions of dollars, the portion addressable by investors remains much smaller. In the U.S., President-elect Donald Trump released a 100-day action plan in October that includes a goal of stimulating $1 trillion in infrastructure investment over the next 10 years, partly via public-private partnerships. If the goal is realized, it may help expand the opportunity set over time.  For now, though, the market for infrastructure debt is a competitive one, putting a premium on origination.

Erik Savi, BlackRock’s Global Head of Infrastructure Debt, describes the state of the market and explains how investors should approach it.


Q. What’s the current opportunity set? What trends are you seeing?

A. Rising target allocations to infrastructure make this an increasingly competitive asset class. Today’s climate of low rates and uncertainty makes the income and diversification potential especially attractive, so there’s a boom in the formation of investment platforms, both internal and external. We’re starting to see everything from insurance companies starting their own internal investment teams to an increase in the number of dedicated infrastructure debt funds to new third-party asset managers entering the space.

With this influx of capital comes a concern that there may not be enough deals in the market that can generate the type of premiums to which private debt investors have grown accustomed. The increased competition has also led to ratings shopping on certain transactions. This is something we saw before the global financial crisis, and it has recently reemerged as a trend. Many investors are participating in transactions that have borrower-friendly terms and conditions and aggressive pricing.

We believe a fiduciary origination strategy is best positioned to provide investors access to transactions that meet their risk-return criteria. It’s important to partner with banks and sponsors to ensure the covenants reflect the rating of the transaction and that the relative value is attractive enough to justify the lower liquidity. What this means for us as investors is we need to supplement origination via broadly agented transactions with an increased focus on partnering with banks, financial advisors and sponsors early in the transaction process. Investors need to get involved early and be prepared to offer committed financing support—and a significant portion of the financing—during the M&A phase if it’s an acquisition, or the bidding phase if it’s a public-private-partnership.

While this new way of sourcing deals requires considerable effort and a unique skill set on the part of investors, it can also lead to opportunities to generate alpha and better secure allocations. Private transactions are best positioned with a few select investors that have an in-depth understanding of the projects and their inherent risks. Banks and sponsors are more willing to partner with an investment manager who can help structure the investment and ensure certainty of execution through its ability to act as an anchor investor or provide the entirety of the capital in the institutional tranche of a project financing.

So the bottom line is that while infrastructure debt investing has certainly become more competitive, there are still attractive deals in the marketplace. However, the process of originating those transactions has shifted and become more challenging. We think this trend is going to continue and that institutional investors will become increasingly important capital providers in the future.

Q. How do you expect this asset class will perform as the cycle turns?

A. While there are no guarantees as to how any asset class will perform when the current cycle ends, infrastructure investors may have a big potential advantage in turbulent markets: their cash flows are secured by essential real assets. That’s one of the defining characteristics of the asset class. So there’s a margin of safety that doesn’t exist in debt that is backed by, say, corporate cash flows. Because of that fundamental difference between infrastructure debt and debt that is backed by a corporate balance sheet, there are important differences in what can happen to infrastructure debt holders versus corporate debt holders when companies do run into distress.

Let’s say you’re looking at a utility company that offers both corporate bonds and project bonds. If that company ends up in severe financial distress, it may file for bankruptcy. But it still has to provide essential services to the public, so there will be mechanisms in place to ensure the project continues to operate and service its debt. For instance, in the U.S., a utility can affirm a contract in bankruptcy court and continue to service it, despite having defaulted on its corporate debt. This kind of dynamic has helped the asset class experience lower default and higher recovery rates than similarly rated corporate debt.

Default and recovery rates for corporate and infrastructure debt

Lower Defaults Higher Recovery Rates

Sources: Moody’s Default and Recovery Rates for Project Finance Bank Loans, 1983-2013 Addendum, as of September 2015;
Moody’s Annual Default Study: Corporate Default and Recovery Rates, 1920-2013, as of February 2014.

 

The other thing to keep in mind when thinking about the end of a credit cycle is that it can be an attractive time to buy into infrastructure debt. Because we are talking about assets that provide essential services, states or municipalities can only defer those types of investments for so long. So if the economy hits a rough spot and banks withdraw further from the sector, institutional investors may be looking at a less-competitive landscape that could provide increased yield and more attractive pricing.

Q. What is required for success in this asset class?


A. First and foremost, investors have to be clear about what they are hoping to achieve. Because of its lower defaults and higher recoveries, and its low payment default correlation to corporates, infrastructure debt is a corporate credit diversifier, and there are opportunities that span the capital spectrum. Understanding how you are already taking credit exposure and deciding how you want to diversify that exposure is critical.

In terms of analyzing the opportunity set, it really helps to be part of a broad platform with experience investing globally across the entire capital structure. Although we’ve been talking about debt here, I think that having expertise investing in infrastructure equity as well can bring additional insight and diligence to the debt-investing process.

Finally, infrastructure is a truly global asset class. There are opportunities to invest in everything from early-stage projects in developed countries with a long history of partnering with private investors to projects in emerging markets with less stable environments. In order to harness the full spectrum of opportunities, it is invaluable to have locally based experts to help source opportunities and navigate the often complex regulatory environment.

Erik Savi
Managing Director, Global Head of Infrastructure Debt
Erik V. Savi, Managing Director, is the Global Head of Infrastructure Debt and Head of the North American Infrastructure Debt business within BlackRock ...