06 November 2018
Infrastructure can mean different things to different investors, insurers therefore have to be savvy in fitting the asset class into their broader investment strategy, as participants discuss in part one of this two-part roundtable from Insurance Asset Risk and DWS.
Manuel Dusina, director, infrastructure & energy, Scottish Widows
Eleanor Bucks, direct investments & real assets, Legal & General
Atanas Christev, head of investment, Direct Line
Robert Kubin, chief investment officer, PZU
Ronan McCaughey, deputy editor, InsuranceERM
Gianluca Minella, infrastructure research, DWS
Hamish Mackenzie, head of infrastructure Europe & infrastructure debt, DWS
Chaired by: Vincent Huck, editor, Insurance Asset Risk
Vincent Huck: How should investors categorise infrastructure assets, and what investment frameworks are needed?
Hamish Mackenzie: Looking back to when we launched our first fund in 2005, infrastructure was just this loosely defined and fairly amorphous asset class that was supposed to offer diversification, duration, yield, and so on. Over the past 12/13 years, we have seen a significant evolution of the asset class, with much better understanding, both on the side of the managers and investors. In response, the types of infrastructure fund strategies and structures as well as the range of entry points in the capital structure have changed.
The understanding of the asset class in terms of performance has also evolved significantly. Back in 2005, a port was a port, an airport was an airport. Whereas now, there is much greater sophistication about how you position things, and moving away from labelling to actually understanding what the underlying risks and revenue drivers of each asset are.
That evolution has also been supported by the availability of data allowing investors to tailor their approach to investing in infrastructure, selecting different strategies and different entry points, in order to fulfil different objectives within their allocations and their portfolios.
Gianluca Minella: When you look at infrastructure as an asset class, the same name will mean different things to different investors. That said, over time, we have seen more clarity of what the key characteristics are.
Solvency II is relatively precise in defining what is infrastructure. Often infrastructure investors think that only regulated assets are 'real' infrastructure – and for example contracted infrastructure is potentially not. However, beyond fully regulated assets, the Solvency II definition of infrastructure can include also assets that have a large number of users and a diversified business profile. Infrastructure needs to have those contractual characteristics that underpin long-term cash flows visibility, which is ultimately what investors want.
Robert Kubin: Hamish, when you talk about stratification, is that how the market really behaves or are we evolving to such a thing?
Hamish Mackenzie: I think it is an evolution. The industry as a whole is starting to look behind the labelling and understand the contractual position. An investment banker selling an asset will now create a story that supports the contractual position of it and the market positioning. Whether that is real or not is a question. However, the framework for understanding is certainly there.
Vincent Huck: Robert, as a CIO, what are the most helpful ways to categorise the asset class? By country, by yield...?
Robert Kubin: I would say 95% of our infrastructure assets are local. Within that we just see what infrastructure deals are out there: if we like the name and/or the credit, we go for it, if we do not like it, then we abstain.
We are trying to look outside of Poland as well. We are not really specialising in infrastructure. It is just one of the asset classes, a small portion of our balance sheet. However, if we were bigger, and if this asset class was more important, then stratifying, what Hamish was describing, would make a lot of sense.
Eleanor Bucks: In terms of allocation to infrastructure, I think part of that comes down to definition of Infrastructure. We think of infrastructure as being the built environment.
In addition to considerations around sectors when considering allocations within infrastructure, the phase of the project is important, whether we are in the construction phase or non-construction phase in the project.
Robert Kubin: Exactly. If you want to do this stratification, by definition, you have to look globally. The country is too small to do that, I would say.
Atanas Christev: In terms of size, we are in a similar position to PZU, with a single-digit percentage weight in the overall portfolio. We started investing in UK infrastructure four years ago, because we considered it a good asset class to back our long-term liabilities.
After the separation from RBS, there was a clear message to the market: "we are going to be a relatively low-risk investor". In my view, it made a lot of sense to use the fact that we are a long-term investor to add a social element to our investment in this illiquid asset class. More than 80% of that portfolio is in social infrastructure, mostly hospitals, schools, police stations.
Manuel Dusina: The current market, in particular in the UK, is overcrowded. You do not realise the premium that you are supposed to realise. If you do a road now in the UK, do not expect to generate a premium: you will get duration but forget the premium.
To attract a premium, you need to push yourself to invest in something new/not standard. There is a push to grow the definition of infrastructure: the 'core plus', the 'core plus plus'. That is subjective, there is no real definition.
Vincent Huck: What are you investing in at the moment, or what are you looking to invest in?
Atanas Christev: Outside of the social infrastructure, it will be ports, airports, roads.
Eleanor Bucks: We have invested in renewable energy, social infrastructure, rolling stock financing, ports. In terms of new projects if you look at the National Infrastructure and Construction Pipeline you can see that 40% is going to be energy, and 40% is going to be transport/mobility so it is important to understand these sectors.
Hamish Mackenzie: Manual's point is an important one. On the one hand, it is a push, trying to define something as infrastructure when it is not, in order to broaden the investible universe.
The flip side of that is identifying an asset with a contractual position that offers the returns and benefits of infrastructure.
Rolling stock financing is a good example of that, which up until 2009/10 was firmly in the private equity category. Looking under the hood and really trying to understand the contractual basis of the business allows investors to access opportunities that they would not have historically met from a more top-down definition.
Vincent Huck: How do you address infrastructure supply constraints? How do you go about originating deals and finding the right assets?
Manuel Dusina: The supply is there, because we can go and buy back-books/secondary from other banks or other investors, but is that the right formula? Does it have the protection that as an insurer I require? Of course, by insisting on that, you reduce the pool.
New green field opportunities are on the agenda of each government. There are a lot of rolling stock opportunities coming to market, or franchises to be retendered. We are in the renewable energy era now: every year there is a bigger offshore wind farm coming to market in the UK. Then you have consolidation of solar and onshore wind portfolios. Other asset classes growing at the moment are energy efficiency, storage, batteries. Technology is advancing fast, so it carries the risk of becoming obsolete.
The opportunities are there, but maybe not in the right format. You need to make them suitable for you.
Vincent Huck: You said earlier the space is overcrowded. How do you compete with your peers and other players like the government and banks that have recapitalised after the crisis?
Manuel Dusina: If possible I try to avoid tenders or auctions, because you know they will squeeze you down to the bone in terms of pricing.
You need to find some market or structure where not everybody is looking. So, you can have a little bit of competition but not as fierce as when you go price shopping around everyone in the market.
Ronan McCaughey: Can you give us any example of a market where you find real value, where it has not been so crowded?
Manuel Dusina: There is some premium in large greenfield opportunities, where you need liquidity from both bank and institutional investor. There is no value for me, at the moment, in refinancing of private finance initiatives in the UK; maybe it provides duration, which is an important feature for my balance sheet. But I have three key parameters; credit quality, duration and pricing. If I need to compromise one of them, at least two out of the three should be okay.
Gianluca Minella: A lot of diligence is needed today to spot the right market opportunities. The equity market is a bit split in two. On one side, we see large investors targeting large trophy deals in auction processes. If you look at smaller transactions, particularly in the mid-market, we believe that there are still more opportunities there.
On the private debt side, we have tight margins, but there are opportunities there too. Spotting transaction opportunities that offer an illiquidity/ complexity premium requires constant monitoring of where the spreads for listed infrastructure debt are, as well as diligence in assessing the credit risk correctly for private transactions. That said, when looking at infrastructure debt, investors should consider that even though the illiquidity premium can be tight, from a risk-adjusted perspective for buy-and-hold strategies, the premium is wider, because infrastructure assets default less and recover more compared with corporate debt.
Hamish Mackenzie: The UK has always suffered to some extent, because it is such an easy market to invest in. If a non-UK investor is going to speak one language, it is going to be English. If they are going to be familiar with one regulatory legal framework, it is going to be a UK framework. That has driven returns down for the highest-quality, safest assets. Today, the supply of new assets continues to be pretty strong. But as the market matures, it becomes harder and harder to avoid the auction processes and find those pockets of value.
Vincent Huck: What are the arguments for and against doing it in-house or using a third-party asset manager? Is it easy for an insurer to originate infrastructure deals in-house?
Robert Kubin: If you are big enough, then you just do it yourself. It also depends on the geography that you are focused on. If you are big in the UK, then you do it in-house for the UK market. If you want to do something in Italy or in Japan without having the presence there, then probably you'll go through a third-party asset manager.
Hamish Mackenzie: It is a trade-off between what your aspirations are in terms of capital deployment and what that capital's role is within the portfolio, whether it is pure duration, whether you are looking for alpha or diversification, and the extent to which you can achieve all of those directly with your team. How important is that incremental return, and are you prepared to trade away some of that to use a third party to access that greater diversification or those niche markets that offer alpha, in order to achieve that broader portfolio ambition?
Robert Kubin: And ultimately seeing how much it is going to cost you. You need to build a team of people, which costs something. If you have the size then you do it, if you do not have the size, you rely on external.
Hamish Mackenzie: Because the market is more granular now, and there is more data to benchmark, the ability to frame a strategy and to assess how that has been delivered in the past, allows investors to pick and choose which part of the strategy is delivered in-house and which is better serviced externally.
Vincent Huck: How do you pick the best strategy to match what you want to do? What are the considerations in entering the asset class through debt versus equity or direct lending?
Gianluca Minella: Both asset classes are attractive. Private infrastructure equity can maximise returns while still providing a strong annual yield component. Ultimately, it is a question of what the investor return and cash-flow needs are. Private infrastructure equity can provide a 10%-12% internal rate of return (IRR), but an annual yield of 6%. The IRR for private infrastructure debt is around 3.5%, but if you also consider annual loan amortization, it can meet investors' cash-flow needs.
Hamish Mackenzie: A linked question is, if given Solvency II capital charges for infrastructure, does your double-digit equity strategy deliver better return for the capital usage than your senior debt strategy? How as an investor do you weigh up the two? If equity offers the better relative capital returns, is that something appealing, or is it the duration of the senior debt, and so returns do not really matter?
Eleanor Bucks: There is an element to do with the shape of your balance sheet. Specifically, within annuity funds there is a strong regulatory incentive to be in senior investment grade debt.
We increasingly think about when you would want to be in the equity, and when you would want to be in the debt. I use the word 'when' advisedly, because it might be a timeframe rather than a project point.
Robert Kubin: We are now trying to go down the grade scale. We touched some BBs and some B deals. Once you do that, and something goes sour, then you have to be ready to become an equity holder. You need to have the infrastructure to do so, which is quite important.
Part two of this roundtable will be published on 20 November.