Subordinated Infrastructure Debt is a Rising Star

Featuring Hadley Peer Marshall from Brookfield

It’s long been thought that infrastructure debt was best left to project finance banks, insurance companies, and government agencies. But the credit crisis of 2008 drastically changed the landscape — and resulted in an expansion of the asset class and sources of capital. As a result, more investors and sponsors are looking to subordinated infrastructure debt for downside protection and attractive yields.

Hadley Peer Marshall, managing partner and co-head of infrastructure debt at Brookfield and a former Goldman Sachs executive, says the reasons for the change are varied — and so are the reasons an increasing number of investors are attracted to the asset class.

Not your father’s infrastructure debt

Less than a decade ago, infrastructure debt was mostly funded by large project finance banks. That was because these deals required detailed due diligence and complex structures, and lenders had to meet sponsors’ demands for borrowing significant amounts of leverage combined with long-term financing.

Then came the credit crisis, and everything changed. Suddenly project finance banks had less appetite for these projects. For one thing, the new Basel III rules had introduced a set of reforms designed to mitigate risk within the international banking sector. At the same time, Leveraged Lending Guidance put more protections and regulations into place. And while equity should have filled the void in capital structures, that just wasn’t efficient from a cost-of-capital perspective.

Not to worry. The subordinated infrastructure debt asset class stepped in.

How does subordinated infrastructure debt work? According to Peer Marshall, it’s a lot like taking out a second mortgage on a home.

“Subordinated infrastructure works the same way,” she said. “There’s the senior debt on a project, and the subordinated debt acts just like a second mortgage, in which the senior debt must be repaid first and then the subordinated debt. Most importantly, subordinated debt should have a lower return than that expected by the equity investor, thereby lowering the overall cost of capital for a project. The debt is secured on the project and benefits from the equity risk capital, and therefore provides an attractive risk/return profile.”

A host of benefits

Infrastructure is not only a competitive asset class, Peer Marshall said, its benefits also make it compelling.

”Infrastructure debt hasn’t been around as long as infrastructure equity as an investable asset class,” she explained. “But infrastructure debt can provide returns that are potentially more attractive than what you would typically see in fixed-income portfolios, plus additional portfolio diversification.”

Those aren’t the only advantages, though.

Infrastructure is known for providing a relatively safe investment. Because of its characteristics, such as long-term predictable cash flows, essential services and high barriers to entry, historical default rates have been low and recovery rates have been high. But, from the investor perspective, it has been difficult to access this asset class unless you are a bank. While subordinated infrastructure investments provide the qualities shared by the senior debt, they also give investors a nice premium on top of that.

Still, the question remains: Is it a little riskier than the senior debt?

“It is,” Peer Marshall said. “But from a risk-adjusted perspective, it’s very attractive.”

Peer Marshall also says we shouldn’t forget the importance of sectors and geographical diversification in portfolios. Infrastructure capital is gaining popularity globally given the exorbitant amount of infrastructure buildout needed, and that provides a great investing opportunity.

As if that’s not enough, subordinated infrastructure debt just underwent its first stress test during the pandemic.

“Our portfolio did incredibly well,” Peer Marshall said. “It was quite resilient to all the gyrations that occurred during that crazy time. And that’s comforting to investors because they see that there were no impairments.”

What’s the downside?

When asked what the potential downside of subordinated debt could be to sponsors and investors, Peer Marshall had to take a moment to think.

“There’s the obvious,” she said, “that since it is subordinated debt, it will not get paid until the senior debt has been. But, in my estimation, the performance of the asset class, infrastructure’s characteristics, and the yield/risk ratio make up for that.”

Which brings us to the next point: The need for expertise when putting together these types of deals.

Don’t try this at home

Peer Marshall says that there are many different types of infrastructure assets, and the underwriting process requires a deep knowledge of each. Additionally, understanding the risk profile of individual investments is key.

“We work closely with our sector specialists to help underwrite these subordinated infrastructure investments, and that, combined with our operating expertise, really helps de-risk an opportunity,” Peer Marshall said. She added that potentially another layer of expertise is needed when the deals are structured in various regions.

To illustrate how complex these deals can be, she used US President Joe Biden’s proposed plan to install fibre to the home to improve broadband internet access.

“When talking about a deal on that scale, there are many things to consider,” Peer Marshall said. “For instance, some of the questions that must be answered are: What is the revenue source? Will the government subsidise it? Is there a cost to the consumer? What are the barriers to entry?”

What’s down the pike?

Peer Marshall says that the types of infrastructure projects that are being funded are transport, renewable power, utilities, midstream and data. She sees projects involving hydrogen and batteries as being future investment opportunities.

“These are being talked about more and more, and it’s exciting to be at the forefront of these technologies.”

This article was originally published in the Sensus Magazine. Click the image to flip through our most recent issue or browse through our previous editions of the magazine.