Keynote Interview: What the future holds for infrastructure debt

Higher interest rates have reshaped investment paradigms across private markets, including infrastructure, but there are other factors driving change – such as the energy transition and innovative technologies transforming our economies. Schroders Capital’s head of infrastructure debt, Jerome Neyroud, explores the risks and opportunities.

At the end of an aggressive cycle of interest rate rises, and growing unease over geopolitical events creating further uncertainty, investors are now focused on what comes next for the infrastructure debt asset class against this macroeconomic and global backdrop.

The return of a more normal rate cycle, albeit with a lag, will have implications for infrastructure debt along with all assets. The good news is that the resilience of the asset class in the face of higher rates has generally held up well relative to some other private assets.

Further, there are many sector-specific issues at play, including investors’ increased interest in sustainability and the energy transition, along with the risks and opportunities these entail. Neyroud also highlights the imperative for managers to assess assets on their individual characteristics.

How has dealflow and the M&A market changed?

There has been a reduction in M&A activity, which has had a direct impact on the infrastructure equity side of the business. Infrastructure debt dealflow, however, is less reliant on the M&A engine. Dealflow in infrastructure debt remains strong with no slowdown in overall activity.

Although we have seen a decline in M&A related financing, re-financing and capex financing have taken up the mantle, with equity investors focusing more on asset management or growth and less on asset sales.

We are seeing less deal volume in the digital sector after a few years of very strong activity where high demand was underpinned by the post-covid dynamic. For example, fibre for remote working and data centres for streaming. But this reduction is more than compensated for by the increase in energy transition financing. There is generally little activity in social infrastructure, in part due to reduced state budgets.

Within the traditional infrastructure segments such as transportation, certain subsectors that suffered from the effects of the pandemic have generally recovered to pre-covid levels. The space is evolving rapidly with more emphasis on green transportation like rail and emerging trends like EV charging infrastructure.

How is the asset class addressing the subject of ESG today?

On the face of it, everyone wants to finance the energy transition. But rewiring the entire world’s energy supply is fraught with complexity. For infrastructure debt investors, ESG factors add a new dimension of risk that needs to be taken into account.

Take renewables as an example. Wind turbines and solar panels are relatively safe investments, so everyone wants to invest in them, given that the gap between supply and demand still exists. If one wants higher returns on the energy transition theme, they will need to take more risk, which requires considering additional sectors such as hydrogen or EV charging.

While these sectors are clearly promising, they are in nascent stages of development and therefore have less history from a track record perspective. This is why we remain selective. We note, however, that infrastructure equity funds, which have a higher risk appetite than debt, are embracing these sectors.

How will higher rates impact returns, and how resilient to risk is infrastructure debt as an asset class?

Infrastructure is one of the most capital- intensive asset classes and therefore requires, everything being equal, more debt than traditional corporates. It is therefore not unexposed to changes in interest rates. This is why, rather than lending on an unhedged floating rate basis as opposed to traditional bank lending, infrastructure lenders are adamant on mitigating interest rate risk from day one at the borrower level. This is affected either via fixed-rate financing or interest rate swaps.

Therefore, interest cover ratios have been relatively immune to interest rate risk. This is a distinguishing feature of infrastructure debt relative to corporate direct lending and is another illustration of the asset class’s stability.

Infrastructure assets generally continue to produce stable, positively linked to inflation and predictable operating cashflows. Debt is heavily structured and covenanted, which allows risk to further be mitigated and therefore investors view this area of private debt as a beacon of stability.

There are, however, a few acid tests that one needs to consider. As an illustration, we tend to shy away from construction risk and focus on mature brownfield assets. Construction risk has increased recently due to supply chain bottle necks.

Another topical issue is the risk of stranded assets, for example financing assets that are relevant today but may become irrelevant tomorrow. Probably nobody would consider refinancing a coal-fired power plant today. What would be the economic utility of a gasfired power plant or a gas pipeline in 20 years in a net-zero economy? We are taking a very long-term view when analysing these risks. We also include protective structuring features like amortization or cash sweeps where necessary to mitigate or remove refinancing risk.

Therefore, one of the key risks is related to financing the assets of today that will no longer be the essential assets of tomorrow.

How are clients viewing the asset class at the start of 2024?

Investors’ sentiment varies as to whether they are looking at infrastructure debt from a macro or micro viewpoint. In recent years, with respect to broad private asset allocations, investors focused heavily on private equity, venture capital and corporate direct lending.

However, this is changing. We are seeing interest from both existing and new investors, created by the increased need for diversification and achieving varied risk/return profiles.

Examining infrastructure debt in particular, we observe its unique position at the intersection of two notable trends: a sustained need for infrastructure investment that is highly scalable; and it's potential to offer attractive risk-adjusted returns that can deliver resilient income, yield enhancement, as well as the ability to achieve ESG/impact objectives.

How will the infra debt market evolve over the next three to five years?

Infrastructure has historically featured investment mainly by real money institutional players, notably insurance and pension funds.

The institutional space alone has significant room for allocation expansion given the debt financing needs of the infrastructure asset class in the context of private assets, as well as the fact that most investors are under-allocated to infrastructure debt vis-à-vis their private debt portfolios. This is changing, and we expect that the expansion of risk/return profiles will attract a broader spectrum of institutional investors.

What is developing in parallel as ‘the next frontier’ is opening of access to affluent and retail investors through the broader democratisation of private assets. We also note lawmakers and regulators are favourably considering supportive legislation in Europe and the UK through the creation of new investment vehicles and other initiatives to support this democratisation theme.

From a product perspective, infrastructure debt will continue to mature. About 12 years ago, when we started investing in infrastructure debt as one of the first movers, the market had a one-size-fits-all product offer: longterm, fixed-rate, investment-grade debt, which insurance companies would use as a proxy to fixed-income to diversify their asset allocation. Then the market segmented with the advent of sub investment grade infrastructure debt. We were also a pioneer in this space eight years ago and are very pleased to see it has become more and more mainstream as an institutional product offering.

We expect this trend to continue with further segmentation occurring in the market, by providing borrowers and sponsors a suite of innovative debt solutions in the years ahead, for instance with hybrid debt products.