20 November 2018
What are the market and regulatory drivers impacting infrastructure investments? Participants in part two of this roundtable from Insurance Asset Risk and DWS discuss the impact of regulation, Brexit and the rise of sustainable finance on the asset class.
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: What are the market and regulatory drivers making infrastructure an attractive asset class for insurers and what are the challenges to comply with the evolving insurance regulations and capital charges?
Atanas Christev: It's very difficult to argue with the illiquidity premium. In the standard formula, you are not penalised for investing in a more illiquid asset class. When we were using the standard formula, it made sense to consider illiquid assets in addition to the credit spread risk which together with interest rate exposure makes up the bulk of our investment risk. We do not have any equities.
One thing which has been a concern for me is how different asset classes are represented in the internal model we now use. There is a lot of scope for improvement there.
In some cases, I have a feeling that we are making some approximations, and therefore losing potential diversification benefit. For example the way infrastructure loans are represented in the model do not fully reflect the nature of these loans and how they differ from simple corporate floating-rate notes. That is one thing that we are pressing our capital modelling colleagues to work on. Ultimately, it limits your ability to deploy the capital in the most efficient manner.
Hamish Mackenzie: So, you are understating the benefit to the portfolio?
Atanas Christev: In this particular case, that is my feeling. There may be other situations where actually it is the other way around. For me, it is a broader question of how accurately particular asset classes are represented in a firm's capital model. We find ourselves, on the investment side, as users of this model, without really much influence on it.
Gianluca Minella: Under the Solvency II framework, private infrastructure benefits from lower capital charges. For private infrastructure loans, from a modelling perspective, one approach can be to use the iBoxx listed infrastructure debt index that matches as closely as possible for duration, rating and sector to the loan. There are 75 indices by currency, duration, rating and infrastructure sector, so finding the appropriate index is possible. Using a listed index as a benchmark may lead to an overestimation of volatility, but this approach also supports the estimation of the complexity/ illiquidity premium offered by the private loan at entry.
The next question is, although one can estimate the illiquidity/ complexity premium at entry, what happens to it over the life of the loan? One practice we have observed in the market is to crystallise the premium at entry over the life of the loan, but this may not always be reflective of market conditions, particularly in cases of strong market volatility.
Manuel Dusina: For an insurer, illiquidity premium is an important consideration. Each player has their own benchmark. If I am investing in renewable energy, what is my benchmark to determinate illiquidity premium? Shall I use the closest listed peer? I see others using utilities as a benchmark. Who is right, who is wrong? It is an internal discussion that each player needs to have with the actuaries and credit committee because it is subjective in the end.
Another important point is the matching adjustment (MA) eligibility. I see infrastructure coming to market, being very aggressively pitched to us, but MA is not a tick-box exercise. Some are straightforward; others require a closer interpretation. You have different internal approaches. They try to put MA in one box and say, 'Okay, you go with this package,' and I say, 'No, it does not work.'
Ronan McCaughey: Will Brexit have any impact on infrastructure investment?
Gianluca Minella: Typically, the UK represents 30-35% of the European quarterly transactions reaching financial close including debt and equity. If you look at the volume of transactions from the day of the referendum, there was a dip, for about one to two quarters, to about 10–15%, but things have picked up again after that, and today the U.K. accounts for about 30% of transactions reaching financial close every quarter. Investors are delaying some of the capex [capital expenditure], waiting from more clarity around Brexit, but demand for UK assets remains relatively strong, for two reasons. Relative to other markets in Europe, the UK remains a comparatively strong and predictable market. Two, the pound depreciation has increased demand for U.K. infrastructure assets from foreign investors.
Robert Kubin: The counter argument is there has not been any Brexit yet. So, let us see once there is.
Eleanor Bucks: The thing that would concern me more is continued uncertainty for a long period of time will delay capex.
Robert Kubin: The economy is going to slow down. The question is by how much.
Manuel Dusina: More than Brexit, what I see is the potential change in government, which may affect some sectors. That may remove liquidity from certain asset classes, or drive diversification because you do not want to have all your eggs in the same box.
Hamish Mackenzie: To Gianluca's point, that has not been reflected in reduced deal activity. For high-quality core assets, people are still prepared to buy in the UK. I suspect at the more niche level, demand may have dried up a bit. However, if there is a hard Brexit, it is not just going to hurt the UK, it is going to affect the whole European economy. There is political uncertainty in pretty much every country globally. Brexit is just one of those uncertainties against a well-understood legal framework and a transparent transactional environment.
Vincent Huck: Are UK investors looking at European assets in that same mind frame of 'wait and see'?
Hamish Mackenzie: People will not take massive bets. There is a reluctance for very large transactions. However, generally we see the flow of capital in both directions as pretty strong.
Eleanor Bucks: Financing conditions seem to still be reasonably benign. That might be driving some current demand, which may fade off a little bit in Q1 next year, as you get closer to Brexit. Why would you not take out your downside now, if you can refinance cheaply?
Gianluca Minella: If we buy into the strengths of infrastructure as an asset class, including support provided by regulatory frameworks, then potentially we should be to some extent protected from that political cycle.
Hamish Mackenzie: There is a big difference between investing in an infrastructure asset, a port, a road, a water company, and investing in a car parts manufacturing plant in Sunderland. Clearly the latter sort of investments have been affected, and you have seen that in recent productivity stagnation. Infrastructure, generally speaking, does what it is meant to do, and therefore that volume of investment activity will continue.
Vincent Huck: As interest rates go up, will infrastructure remain an interesting asset class, or are insurers going to fall back on their traditional core investments?
Manuel Dusina: From a debt side, I really do not see it. We do fixed rate. Even if you took tranche with floating rate, you do due diligence normally, a good chunk of that is swapped already at the outset. When you are locked in, the rate is locked in, and there is no volatility. This is more of a question for the equity side.
Eleanor Bucks: The move into direct investments and infrastructure is a natural maturity of insurers business models that would be happening regardless of low-yield environment. Maybe it happened quicker because of the low interest rates.
Robert Kubin: Exactly. If the spreads compress too much, and the asset class is no longer going to be attractive, then no one is going to invest in it. But everyone is hungry for yield. Even if the yields go up again, you will start issuing new products, which will be priced on the new yield environment. You need the yield anyway.
Hamish Mackenzie: On the equity side, in the super-core market particularly in continental Europe, where there is a scarcity of opportunities around, for example, regulated utilities, pricing has gone into the low single digits. That has been justified by the premium to government bonds but I cannot see how that pricing can continue. I do not think that pricing has absorbed, on a long-term basis, the risk associated with those assets. So, as interest rates come up, people will look for higher returns from those assets.
Gianluca Minella: In our base case, interest rates will increase but will remain below long-term historical average. That said, an increase increased interest rates will also mean that inflation and economic growth are supportive, translating into favourable conditions for infrastructure performance.
In the case of a downturn, we believe that assets that offer long-term cash flow visibility, but also that provide flexibility to manage revenues and costs can provide long-term performance resilience.
Vincent Huck: How do you integrate environmental, social and governance (ESG) criteria in infrastructure investing?
Gianluca Minella: Already today, for us ESG factors are key when we assess investment opportunities, and when we actively manage infrastructure assets. In the future, we will see investors increasingly factoring in ESG in their investment decisions.
Atanas Christev: We have seen, mostly in listed assets, a real tsunami of activity, events dedicated to the topic, people paying closer attention to how they report on ESG matters, and changing their investment approach to reflect an ESG tilt. We are actually in the process of changing the indices on a good deal of our corporate bond investments to be ESG-weighted indices.
It is only a first step and one can be very sceptical and say, 'Well, that is not really making any difference, it is just window dressing.' But I would disagree. It will lead to real – if at first small – changes in investment decisions. The sheer fact that people are beginning to be interested in these indices will over time affect both investment and reporting behaviour.
A company which finds itself with a disappointingly low ESG score partly because it has not bothered to provide detailed information to the ESG rating providers is highly likely to take steps to change that. Further down the road, the enhanced transparency itself can be expected to influence corporate decisions in an ESG positive way. Or consider a bond issuer whose weight in some indices could be 1.5% or 3% depending on its ESG score. This already creates a link, albeit not easily quantifiable, between ESG credentials and cost of raising capital.
I do not think it ESG is a fad that will go away in a year or so.
To read part one of this round table click here