This article is sponsored by Ares Management
In recent years, infrastructure debt has grown to become an increasingly dominant force – filling the vacuum left by banks as they pulled back while the need for project financing surged. The asset class has captured a new host of opportunities and is now maturing, giving rise to specialisms.
Ares Management partners Roopa Murthy, head of infrastructure debt for EMEA, and Spencer Ivey, head of infrastructure debt for the Americas and APAC, discuss the current state of the asset class and its continued evolution.
How has the infrastructure debt market evolved in the past decade?
Roopa Murthy: We really saw the emergence of infrastructure debt in the period following the financial crisis. Historically, infrastructure assets had been heavily financed by the banking sector, but the global financial crisis changed everything.
First and foremost, the financial crisis put a lot of constraints on bank lending as new regulations were introduced that restricted how loans were written and how much capital had to be kept on banks’ balance sheets. That created a gap in the market, which ultimately led to the emergence of private infrastructure debt funds.
In the early days about 15 years ago, there was a focus on single strategy assets – these were designed primarily to replace banks with investment grade, senior debt. The market was relatively small – about $5 billion in assets under management across 15 funds globally – with a focus on what we would call traditional infrastructure assets, such as toll roads, airports and electricity transmission.
Fast forward to today and the market has grown enormously. Right now, there are nearly 300 funds in the market with close to $150 billion in AUM in just infrastructure debt alone.
Infrastructure debt has evolved not only in terms of size, but also the specialty and product set. Financing is no longer just focused on filling the vacuum left by banks, and we have seen greater sophistication in the kinds of strategies being brought to the market.
You will now find strategies in the market across different parts of the capital structure, including subordinated debt, unitranche and investment-grade structures. The asset class is still evolving, and there is also sector specialisation happening across strategies geared towards the increasing prevalence of opportunities in digital infrastructure and energy transition projects, as well as strategies being designed and launched that focus on specific geographies.
What is the infrastructure debt outlook today?
Spencer Ivey: The outlook for infrastructure debt is very positive. If we look across the market generally, the trend towards private capital has been growing and growing. We have seen private credit in particular play a central role, and this is especially pronounced in infrastructure.
If you boil it down to simple fundamentals, it really is a case of supply and demand. First, there is clearly a durable demand for capital to support the buildout of infrastructure, whether this is replacing ageing infrastructure, advancing digitisation or supporting decarbonisation.
When you account for initiatives focused on the energy transition and achieving net zero, there are estimates of $4 trillion-$7 trillion in capital expenditures needed each year to finance infrastructure projects over the next few decades. This underscores an obvious need for more capital.
Then there is the supply side. A lot of progress has been made by infrastructure equity funds, which are quite well capitalised in terms of dry powder, and we are seeing private equity funds deploying capital on a large scale. On the debt side, we have seen a continued retraction from banks largely due to regulation, which constrains the capital available.
Taken together, the dynamics create a pronounced supply-demand imbalance that presents an attractive opportunity for private credit to fill the void on the debt side of the capital stack with full-service financing solutions.
Overall, where sponsors need creative financing solutions, they need to diversify out of traditional bank financing sources. Where we see a lot of opportunities is being able to lend at scale while also remaining flexible.
The demand for capital is huge, and every infrastructure asset has its own requirements. You wouldn’t structure an airport deal in the same way you would for a renewable energy project. That knowledge and capacity for both scale and bespoke structuring is particularly important.
Where do you see the best relative value in the infrastructure debt market today?
RM: Generally, private infrastructure lenders want to be participating in parts of the capital structure where they see strong relative value, and we believe the subordinated junior debt opportunity in infrastructure is particularly compelling.
If you look at the risk profile of infrastructure broadly, there is a lower risk of default irrespective of where lenders sit in the capital structure, because these are typically essential assets to society and are very defensive. This creates the potential for long-term stable cashflows.
Moreover, and consistent with experienced lenders’ focus on downside protection, infrastructure debt loans in the junior space can mirror the covenants and protections investors benefit from on the senior corporate lending side. This means that, from a risk perspective, subordinated infrastructure debt positions may look very similar to what a senior corporate debt position would look like.
Finding that combination of strong relative value across the capital stack with a good amount of downside protection has always been core to Ares’ approach to private credit – whether on the corporate side or real assets side. That said, this has evolved over time. While subordinated debt often still delivers strong relative value in infrastructure, we are also seeing things like unitranche structures and first lien positions presenting compelling opportunities for lenders on the risk-return spectrum.
Lenders who have the ability to deploy capital at scale will continue to assess opportunities for more flexible capital solutions on a case-by-case basis while really retaining that relative-value focus. Beyond the capital structure, there are areas of relative value to be found across various sectors and geographies. Ultimately, a manager’s job is to attempt to offer strong portfolio diversification for investors.
How does infrastructure debt operate in a private credit portfolio?
RM: We believe increased exposure to infrastructure debt in private credit portfolios will continue to be key to the asset class’s growth over the long term. To that end, our team recently undertook an in-depth benchmarking analysis that ultimately found very little correlation between our infrastructure debt portfolio and direct lending indices. This means that for scaled private debt managers, an infrastructure debt strategy can provide enhanced platform-wide diversification with complementary exposure.
SI: Taking a step back, market data estimates that the global private credit market today – inclusive of infrastructure debt and commercial real estate debt – is more than $2.3 trillion.
US direct lending makes up roughly $1 trillion of that, reflecting the maturity and investor acceptance of the asset class.
At the same time, global investors that have had long-term exposure to direct lending more increasingly recognise the opportunity in infrastructure debt to achieve greater diversification. It is not to say one is better than the other, but what we see is similar lowly correlated risk profiles against the corporate credit environment.
Will the private infrastructure debt opportunity set continue to grow?
RM: We think so. First, you have the underlying characteristics of infrastructure assets providing a compelling foundation for investment. Whether you are looking at digital infrastructure, transportation or energy – specifically energy transition – projects, these are assets that deliver critical services to modern societies and generate consistent cashflows.
Throughout inflationary and interest rate environments, infrastructure assets generally perform well on a relative basis. Then, add the flexibility and scale that debt financing provides in filling the supply gap for project
financing.
SI: Nearly half of all infrastructure financing in 2022 originated from private lenders, and the inherent advantages of infrastructure debt ultimately give us confidence that the prevalence of this asset class in financing the critical projects of the future will only increase. And again, the diversification it provides should continue to position infrastructure debt as a core component of private credit portfolios more broadly.
How do you view the impact of interest rate environments on infrastructure debt?
Spencer Ivey: Infrastructure generally tends to be a good hedge on inflation, so there is some resilience in those assets throughout market cycles (and by extension, different levels of interest rates).
Our sector has continued to see significant dealflow across the full range of interest rate environments, and this has been driven fundamentally by a growth in capex needs. At Ares, for example, we have been very active in lending into operating portfolios where the use of proceeds has been used by the sponsor to buy new assets or expand existing assets.
Of course, over the past 18 months or so, the market has witnessed a lull in both refinancing activity and M&A driven by the higher interest rate environment. However, looking forward this could change with rate cuts being priced into the market.
We expect to see an uptick in M&A as well as a big refinancing wall to appear in the coming 12 to 18 months. These both point to increased dealflow with more opportunities for a wider pool of investor participation.