Infrastructure Debt Investment Q&A / Primer

  • Infrastructure has emerged as a clearly defined investment asset class over the last 20 years or so, as investors seek ways to diversify into instruments that have a performance profile distinct from that of more generic equities and bonds, and from other alternative investments such as real estate, private equity, venture capital or commodities.
  • With its focus on long-term assets and services which are either essential in nature with access to long-term revenue contracts or for which there is widespread and long-term end-user demand, infrastructure can offer steady income returns with low pricing volatility, and low levels of correlation to the economic cycle. Some infrastructure may be backed by regulated assets with natural monopoly characteristics being typically large in scale with high replacement costs.
  • The infrastructure debt market essentially provides capital in the form of loans or bonds for a broad range of infrastructure operating companies and projects. The borrowers range from social infrastructure such as healthcare assets, schools or government facilities to more commercial assets such as transport links, data centres or renewable energy generating assets.
  • The provision of infrastructure debt allows the infrastructure market to achieve higher volumes of asset build-out or asset refurbishment. An appropriate degree of financial leverage also facilitates higher returns for those investing in equity and this improves the overall financial viability of this sector, which is an important contributor to societal well-being and economic growth.
  • The recent growth in investor interest in infrastructure credit reflects differentiated performance from that offered by the broader corporate credit market.  The resilience of underlying infrastructure cash flows, hard asset-backing (where available) and the contractual protections afforded to a lender allow for potentially attractive risk-adjusted returns for investors in this segment.
  • Long-term studies of infrastructure credit show significantly lower levels of credit defaults and credit losses compared to generic corporate credit, at similar levels of credit rating.
  • SEQI focuses primarily on lending to “economic” segments of infrastructure:
    • These are typically investments that share one or more of the features of low-risk infrastructure (e.g. public utilities, social infrastructure) – such as operating in essential, public, communal and/or broadly available services, access to long-term cash flows and high replacement costs. 
    • While having a relatively high degree of resilience to the broader economic climate, economic infrastructure may also absorb a moderate amount of commercial risk, for example traffic flows for a toll road or train line, user demand volumes for a fibre network or healthcare asset, or reliance on there being a market for electricity off-take agreements for a renewable power asset. 
    • However, these economic infrastructure sectors are expected to avoid the higher level of cyclical risk that may be experienced in broader sectors dependent on discretionary consumer spending, financial services, real estate, or resources. A few infrastructure segments, such as container shipping or upstream oil and gas, can be very cyclical and are not suitable for a portfolio such as SEQI’s. 
  • SEQI prioritises the careful underwriting of commercial risk, with the aim of enjoying an attractive portfolio return which allows SEQI to pay shareholders a sustainable, long-term dividend.
  • Assets in the “social” infrastructure category (where SEQI has a relatively limited exposure) may either have government counterparties or availability-style revenues which reward investors for the basic provision of an infrastructure asset rather than in relation to its specific demand-based outcomes over time.  These social infrastructure assets, which may have lower levels of operating performance variability, tend to attract banks, insurance companies and other institutions investing at lower levels of return, and often using high levels of financial leverage.
  • Infrastructure debt, like other forms of credit, can be structured at a range of levels:
    • Senior debt, which has first lien rights over the borrower’s assets and cashflows if the borrower defaults on the loan) through to subordinated debt. 
    • Subordinated debt, which may be seen in a variety of forms: 
    • Mezzanine loans, with a second lien on the cash flows and assets of the borrower
    • Holding company or “holdco” loans, which may be technically senior loans but are structurally subordinated to any loans in place at any underlying operating subsidiaries. Such a loan, made directly to an operating subsidiary, would have priority security over the cash flows and assets of that subsidiary.
    • Convertible debt or preference shares which may be structured without meaningful underlying asset-based or cash flow security, but rank ahead of ordinary equity in the event of borrower default on its liabilities.  
  • SEQI focuses on a balance between senior, mezzanine loans and holdco loans, depending on the nature of the industry sector, borrower and pricing. This strategy is designed to provide a mix of good credit security and attractive income.
  • Determination of the type and the pricing appropriate for a given loan will depend on the careful assessment of a broad range of considerations, for example, the industry sector, the competitive market position of the asset, the credit rating of the borrower, the loan-to-value of the proposed instrument, the use of proceeds, the use of guarantees, the structuring of ongoing financial covenants and a host of other detailed considerations.
  • SEQI sees infrastructure investment working best as a distinct asset class – providing true diversification – where the investment is made in mature jurisdictions, offering stable legal frameworks, higher degrees of political and economic transparency and proven commercial contract law, where delivery on long-term commitments have a higher degree of certainty.
  • As infrastructure continues to evolve and deepen as an asset class, transaction volumes have been weighted more towards OECD countries.  The regions of North America, Europe and Australasia generally offer market and regulatory structures that produce a steady demand for new loans, while offering higher levels of market liquidity as they attract an expanding range of domestic and cross-border investors.
  • Even in these developed economies, infrastructure capital markets are evolving fast, and a degree of pricing inefficiency remains. This inefficiency provides opportunities to reward careful asset allocation, borrower selection and active portfolio management based on an investment team’s expertise in infrastructure and private credit markets.
  • For a broad investment portfolio, a combination of a main focus on private debt investment with a smaller allocation to public debt can be helpful, given the various features of both:
  • Private debt instruments are broadly defined as private placement bonds and loans without a syndicating bank, and the instrument is generally not traded in an open market. A lender in the private credit market may play a more active role in structuring and managing credit, with additional potential for enhanced returns derived from relative illiquidity, complexity as well as intrinsic value from the provision by the lender of a tailor-made credit solution.
  • Public debt instruments are broadly defined as public bonds or loans arranged by a syndicating bank and traded in an open market. These can increase portfolio diversification and liquidity – and allow for more active portfolio management.  Listed credit enables investors to access a higher return on surplus cash in a portfolio, and there are opportunities, as in any market, for a judicious investor to find selective value opportunities.  The analytical skills required for listed credit investment are largely the same as for private credit, and experience in the listed bond market is an essential contributor to an investment management team’s up-to-date understanding of pricing and structuring.
  • For the SEQI fund, most the portfolio is comprised of private debt. The proportion of public debt has been broadly around 5% to 10%.
  • Corporate long-term credit ratings range from very high quality with very low risk of default (AAA, Aaa or equivalent, depending on the rating agency) all the way through to D (defaulted debt) and they are commonly commissioned by borrowers, particularly in the liquid bond market where a formal rating increases the liquidity of the security.  These same ratings are applied to infrastructure credits, although where a formal external rating has not been obtained, a lender may pursue an unpublished “shadow” rating from an agency, or may assign an internal rating to loans in its portfolio.
  • Ratings in the range from AAA to BBB inclusive represent what are known as “investment grade” credits, which typically are lower risk but offer a low return on investment, with a narrow interest rate spread above “risk-free” benchmark credits, for example US treasury bonds or UK gilts.
  • SEQI focuses primarily on loans and bonds at the BB and B equivalent level, which represent the higher end of the credit quality range below “investment grade”. These credits offer a balance between higher investment yields and a moderate level of risk, which can be measured in expected default and loss rates.
  • Beyond credit ratings, the performance of the loan will depend on a range of factors, including the borrower type and management capability, the structure of the loan (including its cash flow and asset backing relative to other capital instruments associated with the borrower), as well as external factors such as the borrower’s industry, jurisdiction and regulations. The performance will also be affected by the experience of the lender in managing a credit carefully through any periods of difficulty which may arise for a borrower.
  • While BB and B credits are expected to provide a premium return over investment grade (these can range from 3% to 7% higher than investment grade credits), they are more likely to experience defaults and losses. Typically for generic corporate credits of these rating, realised losses have been in the 1% to 2% of total value per annum, while in the infrastructure segment losses have been closer to 0.5%.
  • SEQI does not focus on investing in credits at CCC or below, which represent more substantial investment risks, often requiring work-out or restructuring where these loans default.
  • SEQI’s broadly diversified portfolio, with a selective investment strategy and intensive management, to manage is designed to minimise the impact of losses, which are likely to occur over time in a credit strategy offering an attractive income margin over risk-free returns. SEQI’s average annual losses since IPO have been less than 0.5%.  
  • Infrastructure is now regarded as having “come of age” as an asset class, with strategies recognised as distinct from, and complementary to, broader private equity or private real estate strategies that make up the bulk of the private markets industry.  
  • Infrastructure credit strategies in turn have arisen as complementary to their equity equivalents. With the volumes of supply of private equity capital focused on infrastructure being significantly lower than volumes of private credit capital, there is significant potential for growth in demand for private credit such as offered by SEQI. 
  • For both equity and debt – several major infrastructure themes have become increasingly prominent, driving growth of the asset class. In particular:  
    • Energy Transition – from renewables, energy storage and networks through to more traditional gas-fired power required to bridge the global economy to a net-zero carbon future, while providing energy security and cost effectiveness. 
    • Digitalisation – from mobile towers and fibre networks to data centres, meeting economies’ demand for increasingly accessible and flexible communications, and the broader access to and use of data in all aspects of society.
    • Demographics – the changes in lifestyles and population dynamics:  we see widespread renewal of city centres and connections between cities, with a strong focus on more efficient land utilisation, sustainability and societal resource improvements. In addition to this, there is an increased focus on healthcare and medical provision, with the need for governments to partner with the private sector in financing infrastructure to address fiscal challenges posed by an ageing society. 
  • A significant proportion of infrastructure projects are aligned with these critical and increasingly well-established economic themes.
  • The headline pricing indicator of a loan is the yield-to-maturity (YTM) – this is the internal rate of return (IRR) on a credit instrument reflecting all cashflows during the life of the loan including the initial investment, all cash interest or coupon payments, loan fees and the final principal repayment.
  • The final repayment may also include payment of any rolled-up or deferred interest, often called payment-in-kind (PIK) interest, that may be structured to fit the cash flow profile of the underlying borrower, or as part of a restructuring of a loan to take into account changes in the borrower’s financial position.  
  • Yield-to-worst (YTW) refers to the lower of YTM and yield-to-call that might result from a borrower exercising a call option to redeem a loan or bond prior to its stated maturity. 
  • To determine appropriate pricing for a loan, a thorough assessment of the quality of the borrower is required (and any credit rating, if available), as well as consideration of hard asset-backing, and broader sector and jurisdiction risks.
  • In addition, the position of a new credit in the “capital stack” – i.e., what securities (if any) rank ahead of an instrument in a default scenario, as well as the amount of equity “cushion” behind it – is important in assessing credit risk and therefore determining pricing. SEQI invests in a mixture of senior credits (with a first lien on the borrower’s assets) and subordinated credits.  These subordinated instruments may be either mezzanine or “second lien” financing at the asset entity level or a holding company loan which is “structurally subordinated” to cash flow producing assets in the operating subsidiaries of the holding company; in this latter case, the loan may have security over shares in subsidiaries or over other assets of the holding company.
  • Additional structural terms are particularly important in negotiating or pricing private credit – for example, parent guarantees, financial or performance covenants, cash sweeps or mechanisms for ensuring additional equity injections to maintain credit quality.  
  • Pricing of loans can be considered as starting with a “risk-free rate” – the local government bond rate for bonds or, for loans published LIBOR, SONIA or equivalent market rates.  On top of that, there is an “credit margin” (or “spread”) representing the fundamental risk of the investment instrument.  For private debt there is also an illiquidity premium, a premium arising from complexity and normally additional “alpha” that can be attributed to the specifics of the tailored solution that is being provided by the lender. 
  • The credit spread used in the valuation of a credit moves over time with changes in borrower’s financial position as well as changes in the risk appetite and supply-demand dynamics of the financing market, which can be observed from public market data for bonds as well as prevailing pricing in private market negotiations. 
  • Additional returns may be obtained from the active management of a credit portfolio, for example by “buying low or selling high” often generated by market dislocations or the mispricing of risk, or by debt bought at a discount and then called early by the borrower.
  • Rating agencies provide regular analysis of trends in defaults and losses. Infrastructure has shown clear resilience relative to broader credit markets, with loss rates typically less than half of that of broader corporate credit of a similar credit rating.  
  • With loans at the BB/B level – the target equivalent loan rating for SEQI’s portfolio – some degree of portfolio loss is expected, with losses mitigated in particular by portfolio diversification and the establishment of strong skills and processes for sourcing, loan evaluation, structuring, portfolio management and work-out capability for non-performing loans.  
  • In an October 2022 Moody’s study of “Ba”-rated (equivalent to BB) infrastructure corporate and project finance loans from 1983 to 2021, average annualised default rates (over the first 10 years of a credit) were 0.85%, versus 1.60% for broader non-financial corporates (“NFCs”).  For B-rated loans, the equivalent default rates were 2.90% for infrastructure and 3.66% for NFCs.
  • Not all defaults result in realised loss rates, as full or partial recovery of the debt can be made through refinancing (the bringing in new equity or debt capital to replace or supplement the capital in the business), by varying the terms of the credit to allow the borrower to improve the cash flows of the business over time, or by the sale of assets to realise proceeds to repay creditors.  For infrastructure and NFCs debt recoveries represent broadly between one-third and two-thirds of the value of loans defaulting.  
  • SEQI’s long-term average annualised loss rate over nearly eight years to January 2023 was approximately 0.5% (for a blended BB/B portfolio), comfortably better than average historic realised loss rates for NFCs in this range of BB/B credits which range between 1% and 2%.
  • For a strategy like SEQI’s, the main objective is the provision of steady dividends derived from the portfolio interest income, rather than capital gains (which prioritise net asset value (“NAV”). Having said this, a degree of variability in NAV is inevitable, as it is with any diversified investment portfolio. 
  • NAV can vary with changes in interest rates or inflation:
    • Loans with floating interest rates will see variability in the interest income over time – in an era with higher prevailing rates, any surplus portfolio cash flow above the dividend paid to SEQI investors will accrue to portfolio NAV over the life of the loan. The NAV valuation of the floating rate loan itself (excluding the interest income paid out) remains relatively static as the floating interest rate reflects to a large degree the underlying market changes. 
    • Loans with fixed interest rates are affected by the mark-to-market which revalue the loan’s NAV (up or down), reflecting the yields available on equivalent investment instruments in the market.  However, for portfolios such as SEQI’s, with a short loan life (most loans being between three and five years in life), any revaluation of the loan (up or down) is limited in quantum. This is because there are relatively few interest payments remaining due prior to full principal repayment at maturity – and the principal repayment accounts for the “lion’s share” of the discounted valuation of all cash flows from the investment.  
  • In addition, unrealised revaluations are reversed over the remaining life of the loan. Whether the loan value rises above par (100% of the principal of the loan) or falls below it because of market interest rate movements at any point in the loan’s life, if the loan is held to maturity, par will be the capital repayment amount. The loan’s value will therefore adjust towards this par as the maturity date approaches (with proportionately less influence on the loan’s valuation attributable to the few remaining interest payments). This “pull-to-par” effect for a portfolio like SEQI’s has a strong anchoring effect on NAV, helping ensure that the portfolio valuation remains steadier than it would if the portfolio were comprised of longer-term fixed rate loans and bonds which would see greater volatility in their valuations.
  • With a short average portfolio life, the SEQI portfolio recycles relatively rapidly (around a quarter each year) compared to longer-dated credit or real asset equity instruments with longer holding periods. SEQI enjoys a reduced re-investment risk as it can refresh its portfolio and reset it to market conditions relatively quickly, re-investing at prevailing yields and into thematic sectors.
  • Modified duration can be calculated for a debt portfolio, to illustrate the sensitivity of the portfolio to movements in interest rates. The term “modified duration” is not technically a measure of time when used in this technical context, but it is a measure of the extent of the impact of interest rates on the value of an investment instrument (or portfolio). This will be highly influenced by remaining time that the loan is outstanding, as a short remaining loan life means the principal repayment at par value will have a proportionately greater influence over the value of the loan compared to interest income, given the limited number of interest payments due before maturity.  
  • A modified duration of 2 means that for any given percentage movement in underlying interest rates, the price of the debt instrument (or portfolio) will move approximately 2 times that percentage movement in the other direction. So, a 1% rise in interest rates would be expected to result in a 2% fall in the price of the instrument. 
  • Having a low modified duration (below 2.5 is considered low) is relevant for a portfolio designed to provide steady income combined with limited variability in portfolio value.  This also helps reduce investor exposure to interest rate fluctuations and provide a more stable, differentiated performance in the context of a broader investment strategy.
  • There are several ways for achieving this low modified duration:  
    • firstly, by having a meaningful part of the portfolio invested in floating rate interest instruments; these would not be expected to move significantly in value purely on the basis of a change in underlying interest rates, as the floating rate should closely track the underlying short-term interest rate movement.
    • secondly, by maintaining relatively short loan lives in the fixed interest rate portion of the portfolio – this reduces the extent of revaluation on the loan, given the proximity of the maturity date and the strong “pull-to-par” effect (which is further explained “How do interest rate movements impact on net asset value? above”).
  • Compared to other segments, infrastructure is expected to play an outsized role across all elements of ESG, making it an essential feature of any investment strategy in the sector:
    • Environmental:  infrastructure investment strategies impact on both the supply and demand side of energy markets – helping determine the balance between fossil and renewable generation as well the energy efficiency of power generation and distributions assets.  Infrastructure decisions also impact heavily on environment practices and outcomes in the infrastructure construction industry and in energy-intensive sectors such as transportation (roads, rail, aviation, shipping) and heating/cooling in large facilities (for example data centres, hospitals).
    • Social:  by definition, infrastructure reaches into all parts of society and can take the lead in providing benefits and safeguards for society, including promoting quality of life, economic growth, employment, equal access, healthcare, and improved levels of societal integration and community engagement.
    • Governance:  successful infrastructure investment needs to promote high levels of governance – as returns to investors depend on the long-term viability of specialised large-scale assets. These require stable legal systems, predictable regulation, and high levels of management quality, as infrastructure vehicles often have custody over assets that may play a critical role in society and involve substantial cash flows.  Successful private credit investment places emphasis on having appropriate operating and financial procedures in place at the borrower, which are monitored closely during the life of the investment.
  • For SEQI, sustainability has been an important consideration for both the Board and the Investment Adviser since IPO.  As the leading credit fund listed in London, the team seeks to “use its leverage” to incentivise and encourage high standards and improvements in all elements of ESG across its portfolio of borrowers.
    • The SEQI fund seeks to maintain an EU Sustainable Finance Disclosure Regulation (SFDR) “Article 8” categorisation, reflecting a strong commitment to the analysis of and improvement in sustainable practices including ESG performance ratings, to good governance and transparency and to the screening out of harmful investments.
    • SEQI aims to align its investments with the UN’s Sustainable Development Goals, in particular #3 Good Health, #4 Quality Education, #6 Clean Water and Sanitation, #7 Renewable Energy, #8 Good Jobs and Economic Growth, #9 Innovation and Infrastructure, #11 Sustainable Cities and Communities, #12 Responsible Consumption and #13 Climate Action. 
    • The SEQI fund and the Investment Adviser have an annual third-party validation of its ESG processes, including comprehensive evaluation of portfolio borrowers’ performance across all dimensions of ESG, in the form of an annual limited assurance assessment provided independently by KPMG.
    • The Investment Adviser, Sequoia Investment Management, is a subscriber to the Principles for Responsible Investment (PRI) and in 2023 won, largely on the back of its work with the SEQI fund, the “2022 Global Award for Best ESG Infrastructure Investment Strategy” from Capital Finance International, an influential industry media platform.