Building new bridges – are insurers the new banks for infrastructure investments?
We analyse the opportunities and options for insurers to ramp up their large-scale infrastructure project investments, as banks and governments scale back theirs
The dynamics of the infrastructure investment landscape in Europe are fundamentally changing. As banks increasingly feel the pinch of capital constraints and tightening regulations such as Basel III, governments are drastically cutting infrastructure funding. Both are now increasingly reticent about providing financing for long-term infrastructure projects.
The result is a potential funding gap across the European infrastructure sector. Amongst other institutional investors, insurance companies have expressed an interest in filling the void – potentially becoming asset managers in their own right and triggering a massive flow of capital into the European infrastructure market.
Could insurers rescue the market of infrastructure investment? Based on a comprehensive survey and extensive interviews, this paper looks at options open to insurers and how they can make the most of the opportunity that infrastructure investment presents.
London bridges are falling down
Completed in 1961 at a cost of GBP 1.3 million (note 1), the Hammersmith flyover – a road bridge in West London – was one of the first examples of its design type in the UK (note 2). Its features were state of the art for the time, including a single concrete central beam (note 3) and under-road heating cables, enabling it to stay open in the winter months. The then transport minister, Ernest Marples, said it was, ‘Quite the nicest flyover I have ever seen.’
Some 50 years later, the flyover was in a very different state, however. Problems with funding the electricity bill for the bridge resulted in the eventual failure of the under-road heating (note 4), meaning that for years the flyover was gritted instead. Salt from the grit was a significant factor in the later corrosion of the reinforced steel cables, shutting this vital infrastructure for months.
The Hammersmith flyover is by no means an isolated example. Bridge failures take place for numerous reasons, including corrosion, ground movements, resonant frequencies, increased weight of traffic, or even poor design. In May 2013, a road bridge crossing the river Skagit in Washington State collapsed, following an oversized vehicle hitting a number of girders as it attempted to cross (note 5).
Whatever the causes, the consequences of bridge failure are invariably very expensive. Repair costs to the Hammersmith flyover were initially estimated at GBP 10 million, but more recent figures suggest a GBP 60 million bill to extend its life for a further 15–20 years. A spokesman from the Hammersmith and Fulham Council said this needed to be the last time taxpayers’ money was spent on ‘maintaining this monstrosity.’
Total investment across transport, energy and ICT infrastructure required to achieve Europe’s 2020 objectives
Examples such as this affect both public and privately funded infrastructure across Europe. According to the European Commission, total investment across transport, energy and ICT infrastructure has been set at EUR 2 trillion (note 6) to achieve Europe’s 2020 objectives. The OECD, too, estimates that global infrastructure investment needs across the land transport (road, rail), telecoms, electricity and water sectors would amount to around USD 53 trillion over 2010–30 (note 7). Meanwhile however, the purse strings are pulled tighter than ever. Austerity remains a key element of national policy, which translates into a restricted supply of capital.
Infrastructure loans in 2012 were at their lowest level for eight years
While government rhetoric suggests this is changing – for example, in May 2013 Angela Merkel and Francois Hollande talked of a ‘growth pact’ to increase European market liquidity (note 8) – the infrastructure finance market remains at a very low level. Indeed, infrastructure loan levels in 2012 are even lower than eight years ago.
Even as European infrastructure crumbles, investment pressure is coming from another direction – banks, the traditional provider of loans to infrastructure projects, are reconsidering their role in the game. This paper is based on panEuropean research and 55 interviews with a range of financial institutions conducted by BearingPoint, in partnership with the Infrastructure Journal. In this paper we consider the changing dynamics of the infrastructure investment landscape and the potential role for other investor types – notably institutional investors such as insurers. Before we do so, however, let us look at the factors driving the banks’ fundamental change of heart.
The growing gap in infrastructure financing
In the days of post-World War II public ownership, infrastructure investment was dominated by government institutions. Over more recent decades (notably through the rise of public–private partnerships in the 1990s), the private sector has played an increasingly active part in infrastructure financing, with equity and loans offered on a projectby-project basis. Private lending looks set to continue – cash-strapped governments simply do not have the money to invest in the range of infrastructure required.
In lending terms, banks have traditionally taken the lion’s share of the risk and, therefore, the majority of any resulting reward across both the higher-risk construction phase and lower-risk operational phases of privately financed projects. One explanation for this quasi-monopoly of banks in infrastructure lending, put forward by Dr Frédéric Blanc-Brude, Research Director at the EDHEC Risk Institute – Asia, is that it represents ‘too good business to let it go to the bond market’. Equally however, banks bring expertise that cannot be found elsewhere. ‘Without project finance bankers there simply are no projects: banks play an essential role in structuring and mitigating credit risk, which makes project financing unique,’ he continues.
This being said, recent capital market crises have caused banks to review where and how they allocate their resources. Not least, banks recognise that longterm debt, such as that involved in infrastructure projects, is more difficult to finance than short-term debt. While much attention has been placed on capital in recent years, liquidity is even more important – illustrated by the fact that Lehman Brothers’ 11% capital/asset ratio was insufficient to prevent the firm from collapsing in September 2008 (note 9). The investment banking model of ‘taking short-term debt, repackaging it as long-term debt and selling it on’ has also been exposed as a flawed model that does not work in an illiquid market.
'Policy makers – for understandable (future crisis avoidance) reasons – are effectively constraining the activities of many project finance banks' - Nicholas Bliss, Freshfields Bruckhaus Deringer
The liquidity situation is exacerbated by the introduction of stricter regulation, such as Basel III, itself brought in to prevent similar situations from happening again. As Nicholas Bliss from Freshfields Bruckhaus Deringer wrote in the Infrastructure Journal (note 10), ‘Policy makers – for understandable (future crisis avoidance) reasons – are effectively constraining the activities of many project finance banks. The implementation of Basel III requires banks to hold greater levels of (expensive) capital against long-dated and less liquid project finance loans.’
With Basel III, banks are required to hold sufficient capital assets to match any liabilities they incur. The main impact is to further increased costs that banks can ill afford to underwrite, which is forcing a review of existing asset portfolios. ‘It is difficult to see how banks will be able to match-fund for a 25–30 year maturity,’ remarked infrastructure industry analyst firm, Inspiratia. ‘The most immediate impact of Basel III – once it comes into effect – will be a significant reduction in the length of loan maturity’ (note 11).
The result is that the fundamental economics of infrastructure investment are changing. While banks are still prepared to invest up front in infrastructure projects, they require a faster return on their loans and expect higher rates of interest from borrowers, explains Trusha Pillay, Director of Structured Finance Solutions, EMEA, for the Bank of TokyoMitsubishi UFJ. ‘There may be more competitive alternatives for certain deals – depending on the size of deal and sector, etc. Had there been projects coming to market last year that had larger funding requirements, it would have been entirely possible that the bank-funding market may not have been able to fund these larger projects, irrespective of the price – but that did not happen.’
While banks are continuing to invest, certain projects are looking less attractive than they might have done in the past. The result is of a potential funding gap as infrastructure projects continue to emerge, but as traditional bank investors no longer wish – or are no longer able – to support them to the same extent. This may not be the case for all projects across all banks, but new projects are being subjected to increasing scrutiny – particularly given the increasing price of debt. ‘Focusing on the price of debt does not imply that there is a gap, it simply means that it may be considered to be less economic to fund projects at that cost, but the financing could still be available,’ continues Trusha Pillay. So, does a financing gap exist in reality, and how might it be filled?
The top-line picture is stark: banks are reducing their exposure to long-term financing in infrastructure projects
To answer these questions and understand the broader state of infrastructure lending, we surveyed a total of 55 banks, asset managers, institutional investors (mainly insurers and pension funds note 12) and holders of other investment vehicles, such as infrastructure funds. We then interviewed a number of people in strategic positions in banks, insurers and other financial institutions, to obtain a view of how the future landscape might evolve.
The top-line picture we have built is stark. While Infrastructure Journal market data shows that infrastructure projects are still currently mainly financed by bank loans, respondents confirmed that banks are reducing their exposure to long-term financing in infrastructure projects. In our survey, 86% of investors agreed that banks are offering significantly less long-term project financing today than in the past (figures 1 and 2).
What of the regulatory view? About 83% of banks and asset managers confirmed that Basel III is indeed a constraint for banks. So, if regulation pushes banks as a group to provide shorter-term loans for long-term infrastructure projects, who will come to the rescue? The answer, agree the majority, is to look for alternative arrangements and partnership opportunities. Chris Manser, Head of Infrastructure Investments at Swiss Life, says: ‘While banks used to provide all the loans for infrastructure investments, they are now looking for partners for long-dated loans.’
In other words, while banks have been dealing with the situation on a case-by-case basis, the market is opening up to new players. As we shall see, this presents a highly appealing opportunity for insurance firms.
Insurers Step up to the mark
In another part of the financial sector, insurance companies have also been faced with their own investment challenges. Not least that traditional asset classes are resulting in lower yields for insurers, impacting their bottom lines. Government bonds, for example, are yielding 1%–2%: one fund buyer in Investment Week commented, ‘We’ll need to get more than that to do our job’ (note 13).
As they manage the assets of their clients, life insurers and pension funds constantly need to invest and reinvest in attractive assets. Sometimes they give guarantees on minimal interest rates, further driving the need to assure appropriate levels of yield from their investments. For assets currently reaching maturity, these investors are looking for new investment types that fit with their requirements, to deliver appropriate yields over the next 10–20 years – for example, the infrastructure asset class.
The main benefits of infrastructure investment are that the asset class yields reasonable returns while offering comparably low risk, high resilience, stable cash flow and a better match of the duration of the liabilities of the insurer. ‘This market makes so much sense – long-dated assets, long-dated liabilities, it’s almost a no-brainer for insurers,’ remarked Deborah Zurkow, Head of Infrastructure Debt at Allianz Global Investors. Matching institutional investors’ long-dated liabilities with long-dated assets becomes possible through the inherent cash-flow stability of infrastructure investments. 90% of survey respondents highlighted stable cash flow as the most important positive characteristic of infrastructure investment, seen as more important than diversification, or indeed lower absolute risk, by a wide margin.
This market makes so much sense – long-dated assets, long-dated liabilities, it’s almost a no-brainer for insurers - DEBORAH ZURKOW, ALLIANZ GLOBAL INVESTORS
The attractive returns and stability of infrastructure investments are complemented by low risk levels. Ian Berry, Fund Manager for Infrastructure and Renewable Energy at Aviva Investors, commented: ‘The European infrastructure debt market […] has low default rates and high recovery rates throughout the economic cycle. This makes it an attractive potential proposition for institutional investors, specifically as a liability matching solution’ (note 14).
As a result, insurers are becoming increasingly interested in this market. ‘Infrastructure debt opportunities are likely to be sought after investments in the coming months and years,’ (note 15) states Prequin Senior Analyst, Paul Bishop. Chris Manser from Swiss Life concurs: ‘The limited appetite for the equity market makes institutional investors look for alternatives. Insurers’ focus on asset liability management makes infrastructure an attractive asset class. Investments are backed by real assets and are therefore often naturally linked to inflation.’
These views were confirmed when an increasing number of (re)insurers announced plans to get into the infrastructure debt businesses in 2012 (note 16), including Allianz, Swiss Re and Ageas. Our survey data further corroborates how insurers and pension funds are looking for opportunities to invest in lowerrisk infrastructure projects with sustainable returns across longer periods. Indeed 84% of all survey respondents confirmed that insurers and pension funds are currently ‘extremely interested’ in such investments (figure 3).
When we drill down into how such interest can be turned into action, we learn that fund holders face a number of choices based on their own market focus, their competences and attitudes. We look at the different options that have emerged and how insurers are choosing between them.
WHERE IS THE INVESTMENT? FINDINGS FROM OUR SURVEY
It is interesting to compare the risk perceptions of banks and asset managers with insurers and pension funds, with regard to specific industry sectors.
The top choices for the banks are ‘renewables’ in first place (a new and riskier sector), ‘power’ and ‘transport’ in equal second position, and ‘social infrastructure’, such as hospitals and schools, in third.
Whereas for the insurers, ‘social infrastructure’ (an established and well-known sector) is the first choice, followed by ‘transport’ and ‘water’ in equal second, and then ‘power’.
This seems to indicate that the type of investments that attract institutional investors concern visibility and stability (liability hedging/matching), whereas banks have a preference for larger, more complex projects.
Insurers are a natural holder of infrastructure assets because they have long-term capital - CHRIS MANSER, SWISS LIFE
A closer look at infrastructure investments
What drives infrastructure investment? The country where the project is being built or is in operation and the regulatory regime in place on a specific industry are both very important driving factors for infrastructure project financing, and have been extensively researched. For instance, very generous subsidies in the last decade have enabled massive investments in renewable energy infrastructures in Germany, Spain and Italy. In 2012 however, Spain and Italy cut subsidies to reduce government expenditure, dramatically slowing their investments in ‘green’ infrastructure.
When considering the relationship between banks and other investors in terms of how investments are financed, a number of additional dimensions emerge (note 17). These include:
• Whether the investment is short term or long term;
• Whether the project is in a construction or operating phase;
• Whether financing is made through debt or equity.
We can differentiate between short-term and longterm financing based on the time horizon of the investor invested in the infrastructure. The difference tends to refer to an order of magnitude – short-term investments tend to be measured in years, whereas long-term investments are discussed in terms of decades.
As shown earlier, banks remain the dominant debt financiers of infrastructure projects and will continue to deliver short-term infrastructure funding. However, as documented by insurance mediator Trifinum Advisors, ‘Institutional investors increasingly recognise the value of long-dated assets to match their long-dated liabilities. Investment in long-dated infrastructure debt can improve the asset/liability duration matching, resulting in a lower interest rate [for] risk capital charge, […] and it offers yield enhancement over sovereign debt’ (note 18).
Casualty, life and pension insurers have much longer-term liabilities than banks and are thus more interested in longer-term investments. As Chris Manser of Swiss Life notes, ‘Insurers are a natural holder of infrastructure assets because they have long-term capital.’
In conclusion, as we have already seen, insurers will tend to have a deepening role in proportion to the length of investment involved.
Long-term infrastructure projects roughly divide in two phases: construction and operation. The construction phase is perceived to be the riskiest, particularly when compared to the operational phase of an infrastructure. The latter is perceived less risky after the infrastructure is built and has a proven track record of at least 12–24 months of operation.
The top-line picture is stark: banks are reducing their exposure to long-term financing in infrastructure projects
Our survey found that 74% of bank and asset managers ‘agreed’ or ‘agreed strongly’ that – currently – insurers and pension funds are uncomfortable when it comes to investing directly into the construction phase, whereas only 56% of insurers and pension funds shared this opinion.
Construction risk in infrastructure project finance is, on average, zero, in that cost overruns happen but they are limited and they average out because cost under-runs also exist - DR FRÉDÉRIC BLANC-BRUDE, EDHEC RISK INSTITUTE – ASIA
A further finding was about the perception of the future role of banks and insurers in the financing of an infrastructure. A majority of banks and asset managers (about 70%) felt that, for future projects banks will mostly provide short-term financing for the construction phase of an asset, selling the debt to institutional investors after the asset has established a track record in the operational phase. A comparable share was found for insurers and pension funds: nearly 60% concurred with the statement (see figure 5).
To illustrate this position, we can look at the recent case of PensionDanmark, which in 2012 acquired USD 750 million (EUR 603m) of loans for infrastructure projects, taking advantage of forced selling by European banks having to shrink their balance sheets. In the first deal, PensionDanmark acquired a portfolio of UK infrastructure project finance loans from the Bank of Ireland for around USD 292 million (note 19).
This is not a black-and-white market however, as Deborah Zurkow from Allianz Global Investors points out. ‘It’s not like one part of the market is reserved for insurance and the other is for banks.’ Insurers may choose to invest in the construction phase if they have the expertise, thinks Georg Grodzki, Global Head of Credit Research at Legal & General Investment Management. ‘If you invest early in the construction phase, you can expect higher yields. We are comfortable to invest in that phase because we have the infrastructure expertise in-house and we have the knowledge of the sector (e.g. toll roads, airports, hospitals).’
Dr Frédéric Blanc-Brude at EDHEC Risk Institute – Asia, takes things one step further when he suggests that construction risk might not be the challenge many consider it to be. ‘Construction risk in infrastructure project finance is, on average, zero, in that cost overruns happen but they are limited and they average out because cost underruns also exist,’ he said. ‘It follows that institutional [investors] should invest in greenfield debt because it is (a) better remunerated and (b) defaults are not correlated with defaults in post-construction periods. Hence they complement each other nicely in a debt portfolio.’
Despite these views, in the immediate future insurers see the main opportunity as being in the lowerreturn operating phase, which offers a foothold in the market for organisations with less expertise, without incurring the perceived risks of construction.
To understand the infrastructure investment market, it is essential to understand which actors are financing infrastructure projects from both the equity and the debt side of the equation (figure 6). The vast majority of infrastructure equity is financed by industrial investors, followed by a range of actors such as banks, governments, funds, and some institutional investors.
Equity represents usually 20%–30% of infrastructure investments, which are highly leveraged (i.e. the money is made to work as hard as possible). The risks of infrastructure equity are higher than debt investments, but so are the returns. Ironically, for a long time, investing in infrastructure equity has been better established among institutional investors.
Meanwhile, because historically infrastructure debt was issued most often in the form of bank loans, institutional investors did not have the skills and access to the debt market. Today, debt makes up 70%–80% of infrastructure financing in a field that is traditionally dominated by banks. This is changing, however. As we can see, the debt from project finance banks took a fall due to the Basel III regulation.
The group of debt providers closest to – but still running far behind – banks includes governments and sovereign wealth funds. These actors finance infrastructures with concessional financing, a type of loan with an interest rate below the market rate.
The investor category that has shown the most growth in debt transactions is institutional investors – transaction volumes have more than doubled since 2009.
Investing in infrastructure debt – many roads lead to Rome
As infrastructure debt is the newest and least explored space with highest growth, we will focus on this area and indicate a few investment options from the perspective of an insurance company in particular, and an institutional investor in general. As shown in figure 7, an insurer may invest in the infrastructure asset class through one of five major channels, namely:
1. Joint venture;
2. Bank as asset manager;
3. Insurance as asset manager; (note 20)
4. Independent asset manager;
5. Direct investment from insurer.
Firstly, we and Natixis will share the risk. Secondly it involves only doing new business – we are not taking on older deals. And there will be complete transparency between the partners so that all our decisions are taken on an equal footing - WIM VERMEIR, AGEAS
We evaluate each approach below – in terms of requirements on investors and banks, alignment of stakeholders’ interests, and current track records of all the players – according to the following criteria, which we have graded in terms of terms of high (★★★), medium (★★) and low (★):
• Resource effectiveness;
• Alignment of interests;
• Track record. Note that these evaluations should be understood as a broad summary of typical actors in each category – exceptions and specific situations will always exist
In the joint venture scenario, an insurance company and a bank choose to invest in the infrastructure market in a close partnership. The joint venture between French corporate and investment bank Natixis and Belgo–Dutch insurer Ageas, in 2012, is an example of an innovative and pioneering collaborative model operating in the infrastructure space.
While Natixis structures the loans, Ageas takes a majority stake in the resulting investments. The intention is to create a portfolio of EUR 2 billion over the next three years, focusing on the power, transport and public–private partnership sectors. The first three deals alone were worth EUR 134 million (note 21). According to Wim Vermeir, Chief Investment Officer at Ageas, writing in Infrastructure Journal, three principles provide the foundation of the relationship: 'Firstly, we and Natixis will share the risk. Secondly it involves only doing new business – we are not taking on older deals. And there will be complete transparency between the partners so that all our decisions are taken on an equal footing’ (note 22).
A number of additional factors come into play, not least the need to respond to the evolving regulatory landscape. Wim Vermeir continues: ‘Ageas is looking to get around the stringent regulatory capital requirements of Basel III by creating their own internal risk model, rather than relying on the unfavourable modelling drawn up by regulators.’
To ensure the scalability of such cooperation, Ashley Blows – Head of Infrastructure Strategic Development at Natixis – felt that it is important to set clear boundaries: ‘The infrastructure platform set up by Natixis is highly scalable, although individual initiatives will be restricted to a limited number of partners and will also be focused on USD denominated debt to expand the global reach of the platform.’
How attractive is a joint venture for an institutional investor?
• Investor’s resource effectiveness: The institutional investor that enters into a joint venture will not need to build up a full-scale team capable of doing sourcing and origination. However, the institutional investor needs to build up sufficient capabilities to review and evaluate investment proposals.
Banks have been investing insurer money in various vehicles for decades. What is new about it [now] is that insurers ask the banks or independent asset managers to invest their money increasingly in infrastructure, to the point that you have an oversupply of capital [...] for a very limited pipeline - CHARLES JUNIPER, OVUM
• Bank’s expertise: A bank such as Natixis has long-standing experience in the project finance market. In-house teams at banks have extensive experience in the different sectors and segments of infrastructure financing, whereas an insurer is lacking the required skillset.
• Alignment of interests: As banks are specialised in the origination and structuring of deals, they typically hold their positions for short time periods. Insurers have a buy-and-hold strategy (unlike banks) and depend entirely on the longterm success of their investments. Therefore, banks will co-invest – alongside their insurer partners – and hold a minority stake of the loans of each deal to ensure the alignment of interests.
• Bank’s track record: Traditionally banks have been the dominant player in infrastructure debt provision. They present strong and long track records in investing in infrastructures. Having such an actor as a partner increases the access and visibility to the infrastructure market for nonmarket participants, especially when investing in the construction phase of complex projects.
The joint venture model is not suitable for all kinds of institutional investor. ‘Would a joint venture make sense with a bank? In my opinion, no,’ says Georg Grodzki at Legal & General Investment Management. ‘We don’t want to be tied to an institution for the deal sourcing. We prefer to source our deals project-by-project by approaching various institutions.’
Insurers can take advantage of the significant experience of infrastructure teams in large, renowned banks
A second option is for a bank to continue in its traditional role as manager of infrastructure assets, with insurers providing the funding. This model is probably the most logical from an evolutionary sense, in that it builds on how things have been done in the past. Charles Juniper, from analyst firm Ovum, says: ‘Banks have been investing insurer money in various vehicles for decades. What is new about it [now] is that insurers ask the banks or independent asset managers to invest their money increasingly in infrastructure, to the point that you have an oversupply of capital [...] for a very limited pipeline.’
For example, in a drive to invest into tailored infrastructure debt solutions, Swiss Re recently awarded a USD 500 million mandate to Macquarie Infrastructure Debt Investment Solutions (MIDIS), an investment platform set up by the Macquarie Bank. MIDIS formulates debt investments for longterm institutional investors and specialises in senior secured debt of assets located predominantly in northern Europe (note 23).
How attractive is an investment with an asset manager at a bank, from the perspective of an institutional investor such as an insurer?
• Investor’s resource effectiveness: As the asset manager takes care of most investment-related activities, the infrastructure investment team needed at the institutional investor is more limited.
• Asset manager’s team expertise: As in a joint venture with a bank, insurers can take advantage of the significant experience of infrastructure teams in large, renowned banks. As the asset manager sources the investments, the amount of resources needed by the investor is less significant than for other options.
• Alignment of interests: Conflicts of interest can arise if banks are only involved in short-term lending and hand over loans after construction. This is the opinion of Trusha Pillay at the Bank of Tokyo-Mitsubishi UFJ when she says. ‘In the case of having a bank as an asset manager for an institutional investor, there may well be an inherent propensity for conflict of interest to arise if that bank is only doing short-term lending and then having an institutional investor [taking] on risk after the construction phase on a longerterm basis. However, if the bank is doing longterm lending and is exposed on the full period of the loan, then there is a great alignment of interests with an institutional investor lending for the same or similar period.’
• Track record of asset manager: Banks present a strong and historically long track record at investing in infrastructure. The insurance company can take advantage of knowledge transfer from the asset manager.
Banks have long had the role of asset management, representing the interests of institutional investors and injecting essential domain expertise. As the market evolves, new collaboration models are founded largely on the location of this expertise, which is the view of Ian Berry, at Aviva Investors when he says: ‘One of the key rationales is that insurers don’t have the in-house capabilities – be it manpower, market contacts, experience, etc. – to source and execute large infrastructure investment strategies.’
However, given the direction of the market, it is increasingly uncertain that banks will retain high levels of exposure for very long-term assets over, say, 20–30 years. So, in this scenario, one way to assure aligned interests is to have the bank to commit for the full cycle of the project, for example by prohibiting the premature sale of infrastructure debt assets. However, Ian Berry continues, ‘The certainty of a bank retaining actual economic exposure to such assets for such long periods should be considered with a great deal of scepticism.’
Insurer as asset manager
Insurers are increasingly interested in acting as asset managers themselves in the infrastructure debt asset class, particularly if they feel they have sufficient expertise in-house. For example, in 2012 Allianz Global Investors was one of the first asset managers to set up a platform in 2012 for institutional investors, anticipating ‘significant demand from insurers, pension schemes and other institutional investors with long-term liabilities seeking investments with stable cash flows and riskadjusted returns, according to Financial News (note 24).
Insurers are increasingly interested in acting as asset managers themselves in the infrastructure debt asset class
How attractive do institutional investors see investments managed by an asset management function at an insurer?
• Investor’s resource effectiveness: As the asset manager takes care of most investment-related activities, the team needed at the institutional investor is more limited.
• Asset manager’s expertise: To establish infrastructure debt platforms with sufficient levels of expertise, many insurance companies have started to hire project finance professionals with infrastructure investment backgrounds. While their expertise is less significant than for established project finance banks, it is rapidly strengthening.
• Alignment of interests: This is seen as strong, as the risk profile is similar between insurers and the institutional investors they represent, particularly smaller investors who lack the resource or expertise to invest directly in infrastructure themselves. ‘This approach should give substantial comfort that their interests are aligned with their manager’s interests and their manager’s other investors interests for the long term,’ says Ian Berry at Aviva Investors. However, this strong alignment can be weakened in the case of an insurer placing an investment with a direct competitor.
• Track record of asset manager: Most insurers are still starting out in the infrastructure debt space. ‘Their ability to come into the market is subject to their having the expertise,’ points out Deborah Zurkow at Allianz Global Investors.
It is worth noting the importance of individual expertise, as illustrated by Industry Funds Management’s recruitment of a senior expert from the banking sector to run its own infrastructure investment growth (note 25).
Independent asset managers typically have less capital to invest but have the advantage of not being tied to a given banking or insurance institution
Independent asset manager (note 26)
In another move, independent asset management companies are also starting to look at infrastructure investments. While such firms do not typically have as much capital to invest, they have the additional advantage of not being tied to a given banking or insurance institution. As they operate directly on behalf of their investors, they are less likely than banks to take risks that may result in write-offs later on.
In November 2012 for example, asset management company BlackRock established a European Infrastructure Debt investment unit focusing on Germany, France, Benelux and the UK. The aim of the new unit is to focus on secondary loans from banks and refinancing of existing transactions (note 27). However, as Dr Frédéric Blanc-Brude notes: ‘Institutional investors generally prefer dedicated accounts to pooled funds offering a pre-packaged product, as every insurer’s liabilities is different. This is one reason why the infrastructure debt fund is taking time to emerge.’ While dedicated accounts might not be an option for smaller institutional investors, most large investors will avoid investing in pooled funds.
How attractive is an investment with an independent asset manager, for an institutional investor?
• Investor’s resource effectiveness: As the asset manager takes care of most investment-related activities, the team needed at the institutional investor is more limited.
• Asset manager’s expertise: This can be seen as limited, simply due to the scale of knowledge required. Trusha Pillay says: ‘Investing in the construction phase requires greater dedicated resource for more extensive due diligence than investing in the operations phase. This isn’t always feasible if you have only a small team. Independent asset managers may focus more on the operation phase because it is easier to invest in and provides an immediate return – or [they] may be more willing to cooperate with banks to get deals over the line.’
• Alignment of interests: This has to be evaluated case by case, but it is typically strong, as there are few conflicting interests. However, this depends on the fee structure built into the incentive scheme.
• Track record of asset manager: Most independent asset managers (including BlackRock) are still developing their brand for infrastructure debt investments by hiring out whole teams from project finance banks or funds linked with higher risks (e.g. mezzanine funds).
Insurers who buy the debt of a couple of toll roads and a few Scottish schools may find that they are not diversified and that they are exposed to something that is very good or very bad, but not the ‘average’ that they had in mind - DR FRÉDÉRIC BLANC-BRUDE, EDHEC RISK INSTITUTE — ASIA
Direct investment from insurer
A final option is for insurers to use their own capital and make investments directly into long-term infrastructure projects. An important example is the announcement made by AXA in June 2013 that they will invest EUR 10 billion in infrastructure over the next five years, to diversify and identify long-term investment opportunities. For such a sizeable investment, ‘going direct’ appears a sensible option (note 28).
When going direct, an obvious challenge that institutional investors face is that the benefits of investing in the infrastructure class only become apparent once they have invested in a sufficient number of different infrastructure projects. Dr Frédéric Blanc-Brude says: ‘Insurers who buy the debt of a couple of toll roads and a few Scottish schools may find that they are not diversified and that they are exposed to something that is very good or very bad, but not the ‘average’ that they had in mind.’
How attractive is a direct investment in infrastructure for an institutional investor?
• Investor’s resource effectiveness: The downside of the direct model is that it requires significant upfront cost and long-term commitment, for example in terms of hiring of experienced professionals from banks.
• Insurer’s expertise: Setting up a team is resource intensive and can be risky – particularly given that transparency in the market is still quite low, so visibility on deal flow might not be good. Nonetheless, survey findings confirmed that insurers are working on their team expertise – 75% of insurers and pension funds will significantly develop their own internal infrastructure teams to manage infrastructure investments (see figure 8). ‘Over time, institutional investors will upskill, and they may develop the knowledge and the asset management skills required to directly invest in all phases of an infrastructure project. However, banks have a long track record in the infrastructure financing market,’ explains David Cooper, Investment Director of Europe at Industry Funds Management.
• Alignment of interests: As there is no intermediation in direct investment, there are no conflicts of interest. According to Chris Manser at Swiss Life, as a direct investor, one can better control the risk profile of the investment (provided that a strong team is in place with relevant industrial expertise in mergers and acquisitions [M&A] and project finance). Also, direct investments may allow for longer holding positions – they give complete control over deal selection and can prevent the payment of any fees to an asset manager, so reducing costs and increasing efficiency.
• Track record of insurer: In most cases, institutional investors do not have a track record in investing directly into infrastructure debt.
Tune in the right channel – or blend them
The wide range of options makes it possible for specific investors to choose an approach that fits most closely with their needs. While it remains to be seen which of these approaches – or which combination – will become most popular, a bigger question is, ‘What will be the overall impact on the future of the market and, indeed, the economy at large?’
Insurers as the white knights?
Given the changing landscape for investment, banks appear very open to the opportunity to work with insurers on longer-term infrastructure investments. ‘The void left by banks in the long-term infrastructure debt market can be ideally filled by insurance companies,’ says Sundeep Vyas, Director of Alternatives and Real Assets at Deutsche Asset & Wealth Management, the asset management arm of Deutsche Bank.
In practical terms, this is likely to play out as major shifts across the infrastructure debt market. As we saw from the market data earlier (see opening infographic), this is much larger than equity. ‘About 80% of all invested capital is debt – an area which used to be dominated by banks,’ reminds Deborah Zurkow at Allianz Global Investors. While banks will continue to have a major role, new players look set to change the dynamics of infrastructure investment across Europe.
The impact of infrastructure investment evolution
Trusha Pillay believes this will appear as a largescale, ‘push-down, pop-up’ phenomenon, as models such as the five major channels offer both direct and indirect investment opportunities to institutional investors (see figure 9). ‘Within Western Europe, with a small pipeline you could see banks and other new entrants, such as insurers, becoming competitors in the long run. If the pipeline becomes bigger, then it is entirely possible that the pipeline is actually big enough for everyone to have a role in it in some shape or form.’
Institutional investors will become the backbone financiers of infrastructure projects, but more for the operation phase of long-term infrastructures. This could happen in a 3–4 year time horizon! - DAVID COOPER, INDUSTRY FUND MANAGEMENT
Infrastructure investment is at a crossroads. While banks are financing ever fewer long-term infrastructure projects, insurers and asset managers are proving highly active in this sector, as they act on behalf of institutional investors (commonly insurers and pension funds). These offer a source of new capital that will grease the market significantly, compensating for the exit of banks from this particular financing segment.
Banks will continue to be involved: ‘The need for private infrastructure funding is so huge that the insurers and pension funds are not going to be able to fulfil the financing needs,’ says Deborah Zurkow, at Allianz Global Investors. The increased role of insurers allows banks to stay active in the part of the market in which they are most interested – the construction phase – and enables them to originate loans and rotate their balance sheet.’
Above all, a more liquid infrastructure debt market is good news for a continent that desperately needs an infrastructure upgrade. In 2010, the former President of the European Investment Bank, Philippe Maystadt, stated, ‘Well-functioning infrastructure networks are the backbone of prospering economies. The European Union is facing large infrastructure investment needs over the coming decade: in the ‘old’ member states, a significant part of the existing capital stock comes up for renewal; in the ‘new’ member states, there is still need for raising their infrastructure capital stock’ (note 29).
However, EU governments remain paralysed by their austerity programmes, which prevent the financing of large-scale infrastructure projects, leaving them unable to jumpstart economic growth. Indeed, nearly 80% of respondents to our survey consider that governments will increasingly rely on private infrastructure funding (see figure 10).
Many experts are convinced that the pouring in of institutional investors’ capital is about to become a reality in the near future. This opinion is reflected by David Cooper at Industry Fund Management, saying: ‘Institutional investors will become the backbone financiers of infrastructure projects, but more for the operation phase of long-term infrastructures. This could happen in a 3–4 year time horizon!’ Lord Deighton, the UK Infrastructure Minister, concurred recently by saying, ‘It’s encouraging to see companies developing new products [that] match institutional investors’ requirements with the need for long-term debt to finance infrastructure projects’ (note 30).
Insurers may well become the white knight of the infrastructure market and the impact of their funding would would be beneficial to the economy as a whole
In financial circles, ‘white knights’ are investors acting in the interests of an investment, even while hostile investors lurk in the wings. Insurers may well become the white knight of the infrastructure market and, if the commitment of investors gets significant, the impact of their funding would go beyond the immediate benefits, as solid investments in infrastructure would be beneficial to the economy as a whole.
Catalysing the involvement of institutional investors
How can more institutional investors be encouraged to participate in infrastructure investment space? One challenge is the opacity of both past performance and future projects, largely because institutional investors investing in debt is a relatively new phenomenon.
‘[There is a need to] enhance the transparency of data on the historical performance of the infrastructure debt asset class, so as to educate both regulators and other investors,’ says Ashley Blows, at Natixis, which has set up a research chair on the investment characteristics and governance of infrastructure debt instruments, in partnership with the EDHEC-Risk Institute (note 31).
Meanwhile, nearly 60% of all survey respondents felt they lacked a healthy and visible pipeline of projects (figure 11). It is most likely this is a symptom of what is still a relatively young and immature market; the deregulation of various infrastructure sectors (e.g. telecommunication, water, transport, energy) has only happened within the last two decades.
Another issue comes from the still-challenging area of market liquidity. There is a limited supply of large infrastructure projects. In response, the European Investment Bank Project Bond Initiative was set up with, as main objective, ‘to stimulate capital market financing for large-scale infrastructure projects in the areas of trans-European networks in transport and energy, as well as broadband telecommunications’ (note 32). The initiative was designed to encourage institutional investors such as insurance companies and pension funds to pour more capital into infrastructure projects.
Initiatives such as this confirm the increasing importance that institutional investors are seen to have. We believe that the large-scale investments of institutional investors into the infrastructure market will not just provide a significant lift to the infrastructure market, but may also benefit the European economy as a whole. Insurers may, in other words, become the white knights for the infrastructure market, and by extension for the European economy.
Solvency II is a moving target, has created some uncertainty and has been one factor in holding back insurers from making clear investment commitments - SUNDEEP VYAS, DEUTSCHE ASSET & WEALTH MANAGEMENT
HOW SOLVENCY II REGULATION TREATS INFRASTRUCTURE INVESTMENTS
The draft EU Solvency II Directive 2009/138/EC aims to harmonise insurance regulation across Europe. Currently planned for 2016 (though the schedule is likely to be delayed), its main focus is on capital reserves held by European insurers to minimise the risk of insolvency. The increase in capital requirements and uncertainty over how future regulations will unfold pose a dual challenge to insurers.
Infrastructure investments fall broadly into two categories, each treated very differently under the Solvency II:
• debt, bond and loan-type investments are treated under the spread risk sub-module;
• equity-type investments treated under the equity risk sub-module, based on a stress test.
Debt, bond and loan-type investments are treated under the spread risk sub-module, with risk charges varying according to duration and external ratings or proxies for unrated loans and bonds. In general, according to the OECD, this equates to ‘25% for real estate and infrastructure debt’ (note 33 25 Euros in reserve capital for each 100 invested). When it comes to infrastructure though, bonds tend to be rated BBB or lower and a 25-year BBB bond, for example, could incur a 32.5% capital charge. The standard equity stress under Solvency II is also set at 25%, but equity in infrastructure projects are classed as ‘other equity risk’ and could mandate reserves up to 49%.
Hence there is concern among insurers that such capital charges do not correctly match the investments. The European Insurance and Occupational Pensions Authority (EIOPA) recently launched a consultation on the standard formula design for certain long-term investments including infrastructure investments and voices are calling to ease the looming burden on infrastructure investments. ‘The framework clearly does not recognise the underlying economics,’ says Ingo Bofinger at Gothaer (a German life insurer/asset manager). ‘In our case, infrastructure is the part of our portfolio with the lowest volatility and most stable cash flows’ (note 34). The capital discrepancy between debt and equity might also influence the dynamics of the market. According to Risk.net, ‘Solvency II could also push investors towards the debt markets’ (note 35) given the potential equity charges.
Infrastructure investments are clearly worth fighting for and given their significant economic importance, perhaps the regulators may reconsider their stance. Jean-Christophe Gaury, Partner in charge of Solvency II at BearingPoint, highlights this: ‘The regulator will be hard pushed to justify a different treatment of capital charge between corporate bonds and debt investment in infrastructure projects. But, given the burden placed on public funding of infrastructures and the overall withdrawal of banks for long-dated loans, insurance companies could become a crucial source of funding for the European infrastructure market. Regulators should provide them with the necessary flexibility.’
Sundeep Vyas, at Deutsche Asset & Wealth Management, describes Solvency II as ‘a moving target’, as the uncertainty it creates limits insurers ability to make clear long-term decisions. As long as Solvency II remains in this state of flux it will ultimately be unhelpful
Insurers should step into the breach and define their role in the market
As a main cause of the financial crisis was capital resources being spread too thinly across an increasingly illiquid market, regulators are looking to ensure (through Basel III) that such a crisis never happens again. Inevitably this means that banks’ resources cannot stretch as far as they did – particularly in infrastructure investments, whose risks and returns take place over decades.
While investments in infrastructure debt and equity share many characteristics, insurers have historically only invested on the equity side and barely made forays into infrastructure debt. This situation arose because the banks had the traditional role of originating these complex arrangements and because, historically, they wanted to keep the deals for themselves. As regulatory changes cause banks to pull back from infrastructure investment, an attractive space is opening for a third party – and institutional investors such as insurers appear ready to seize the opportunity.
The arrival of insurers into the market is more than a short-term response, not least because infrastructure debt is less risky than equity, which makes it a better match for insurers’ investment needs. Insurers and pension funds are under constant pressure to invest in assets to fulfill their commitments on returns to clients and shareholders. Our study shows how infrastructure debt offers a way out, as it comes with very attractive margins and allows insurers to shape the duration so that they can reduce capital costs.
Whilst insurers should clearly start building up expertise and step into the breach, they need to decide which approach to take, based on their own risk attitude, business model and existing skill set. Direct investment is an attractive option for organisations with high levels of experience in the sector, but we believe that most insurers will work with an asset manager at a bank or insurance company instead, leveraging the experience and track record of these institutions, rather than developing the considerable resources it takes to go direct.
INSURERS SHOULD CHOOSE THEIR INVESTMENT APPROACH CAREFULLY
The choice of investment approach is critical and complex, and should not be made lightly. As an overview:
• Insurers (or institutional investors) with strong infrastructure sector experience and internal teams in place can access the infrastructure debt market directly.
• Insurers can invest with an asset manager at a large bank to take advantage of the latter’s highly regarded experience, expertise and track record, while sparing internal resources.
• Insurers with concerns about conflicts of interest with asset managers at a bank should consider investing with an asset manager at another large institutional investor.
• Insurers can choose to enter a joint venture with a bank if they are looking for opportunities for tighter collaboration and knowledge transfer.
Insurers looking for alignment of interest will invest their funds with an asset manager at another large institutional investor, yet others will turn to independent asset managers. As a final option, the joint venture channel offers opportunities for collaboration and knowledge transfer. This model combines the experience of banks with insurers’ ability to fund large projects, while restricting the ability of partners to make independent ad-hoc decisions. As the joint venture model has only emerged over the last year, it will be interesting to see how it evolves. Figure 12 summarises our comparison of the five approaches to investing in infrastructure debt.
Overall, our research strongly indicates that the market will grow, leaving room for everyone – which is positive news for banks, insurers and other stakeholders. A more diversified market is a better market overall, particularly as it becomes more resilient in the face of ongoing change. The ultimate beneficiary of a healthy, dynamic market is infrastructure, as the range of funding sources both reduces risk and enables a broader range of projects to be funded.
Faced with the need to increase yields, many insurers have no choice but to pursue infrastructure as an investment option. By doing so, will they become be the white knights of the market, deploying their substantial assets to help catalyse liquidity across Europe? One thing is for certain – they will gain a substantially greater role across the years and even decades to come, ensuring that infrastructure of all kinds across Europe, including London bridges, won’t fall down.
• Infrastructure debt investments offer an attractive risk/return profile for insurers, coupled with an illiquidity premium and diversification advantages.
• The current market offers an unprecedented opportunity for insurers to benefit from investing in long-term infrastructure.
• Many banks have decided to reduce their exposure, thereby creating the opportunity for insurers to access the market.
• However, a market entry in this complex environment needs to be carefully planned and typically takes about 1–2 years of preparation.
• Insurers need to consider their entire go-to-market model, including the choice of which channel to invest through and which investment vehicle and which project phase to invest in (see figure 7).
About the Research
This article provides insights and shows trends in the domain of infrastructure investment. It discusses innovative investment and cooperation models, explains the regulatory constraints banks and insurances are facing, and shares the views and expectations of key opinion leaders in the area. The report was developed in close collaboration with the Infrastructure Journal (IJ), an online intelligence service focusing on the global infrastructure market. The numbers given on deals and transactions within the infrastructure sector stem from data gathered and maintained by IJ.
The findings of the article are based on a survey with respondents covering 55 organisations in Europe relevant for the infrastructure sector. Among those are 26 banks and asset managers, 11 insurance companies and 18 pension or other funds. Effectively the surveyed organisations were involved in 36% of all transactions in the global infrastructure market from January 2012 to April 2013 (based on IJ’s data), therefore representing a substantial market share. The survey was conducted between April and June 2013.
Notes and Bibliography
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