The cornerstone of modern society, infrastructure assets are the basic physical structures that are necessary for an economy, and its citizens, to operate. These assets, such as transport systems, schools, and the energy networks, tend to be large scale, costly and therefore capital intensive. The assets must first be built and are then used over a long period of time.
These infrastructure assets may be funded publicly, privately or through some form of public-private partnership. But in all cases, since there will be significant up-front investment required, the project must have some way of demonstrating that the asset will operate and generate revenue to provide a long-term return on investment.
The following guide will explore what infrastructure debt is, its role in the global financial landscape, and why investors should consider it as part of a balanced and growth-focused portfolio strategy.
What is infrastructure debt?
Infrastructure debt finances the development, construction, and maintenance of essential infrastructure projects. Infrastructure projects can be public or private, but usually have an essential benefit to society.
For example, infrastructure debt funds can finance renewable energy generation, social housing, community initiatives, communication centres and healthcare facilities. Infrastructure debt investments typically involve loans extended to the project companies that are responsible for long-term ownership and operation of the new infrastructure.
Significant up-front costs are usually required to build these assets. So, in order to encourage investment, the projects are often structured to have long-term visibility on revenues and costs.
For example, assets built under Private Finance Initiatives (PFI) or Public-Private Partnerships (PPP) schemes, will have long-term contracts with government or local authorities for the provision of the services of the asset, giving long-term visibility on the revenues that may be generated.
With good visibility over the revenues and costs for a project company, the equity investors in the infrastructure project often seek infrastructure debt to support the investment and increase the returns on equity. Infrastructure debt investors, in return, tend to be non-bank lenders who are interested in lending long-dated loans, often to match the interest income with long-term liabilities.
The infrastructure debt market has not always been structured this way. Prior to the global financial crisis in 2008, commercial banks provided an estimated 90% of all private infrastructure debt. However, increased legislation resulting from the financial crisis has made long-term loans less attractive for banks and has caused commercial banks to lend less to infrastructure debt instruments as a result.
This drop in funding from banks has provided opportunities for investors to lend to project companies looking to build, own and operate new infrastructure at attractive interest rates.
Five characteristics of infrastructure debt
Infrastructure debt has five key characteristics that could be attractive to investors:
1. Visible long-term cash-flows
Infrastructure debt has a long-term nature by design, making it a core holding for any investor seeking stable returns. While increased banking regulations after the global financial crisis facilitated a change in infrastructure debt instruments to shorter maturity loans (often between 5-7 years), longer dated maturities (between 15-30 years) are common for high quality assets in the infrastructure sector.
These assets are usually well regulated and have contracted revenues and costs, giving investors visibility into long-term cash flows. This reduces the risks of lending to such projects, as the ability to repay the loan should be lower risk than a commercial trading business. The interest and capital of the infrastructure debt tends to be paid before dividends, so the returns on the debt investment are more reliable than the returns on equity.
2. Consistent, long-term demand
The essential nature of the services offered by infrastructure also ensures there is consistent demand for them. The revenue may be contracted directly – for example where a local authority takes a 20 year contract for waste management services – or supported by government in other ways (such as direct government incentives like the Feed-in-Tariffs paid to the owners of new renewable energy generation). With long contracts providing revenue for the infrastructure projects they generate stable and predictable cash flows over the long-term.
3. Diversification from market risk
This long-term contractual demand helps diversify investor portfolio holdings away from market volatility. Demand for infrastructure assets is relatively inelastic, meaning it should be more resilient in a down-turn, which better diversifies traditional business cycle-sensitive holdings. As such, infrastructure debt funds are an attractive option for investors seeking diversification and risk mitigation within their portfolios. For example, even during the COVID 19 pandemic, schools and leisure facilities financed using PFI / PPP structures were paid for being available and so were able to continue servicing their debt even though the facilities were not used.
Additionally, the income generated from infrastructure debt often has embedded inflation protection. This inflation protection provides the investors in infrastructure debt with their own inflation protection.
5. Positive social and environmental impact
Last, but by no means least, as investors increase their focus on sustainable and responsible investment opportunities, infrastructure projects align with environmental, social, and governance (ESG) principles. This makes infrastructure debt an attractive option for those looking to contribute to positive societal and environmental outcomes in a relatively lower risk way than investing in the equity of the projects.
Why invest in infrastructure debt?
Investing in infrastructure debt can be a rewarding strategy for long-term investors, as it offers the potential for higher returns in exchange for lower liquidity. It gives investors the opportunity to participate in the development and maintenance of essential infrastructure project, while also enjoying stable and more predictable returns than infrastructure equity.
Find out more about GCP Infrastructure Investments Ltd here.
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