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The times they are a-changin

Infrastructure debt is moving from a lending asset class to an investment asset class

Autumn 2014

23 September 2014

As infrastructure debt moves gradually from being substantially a banking monopoly to an established institutional asset class, many people have given consideration to the likely consequences for lending structures and terms for example, fixed rate, bond versus loan format, fully drawn day one, higher credit quality, less prepayment flexibility, etc. These structures are driven by investor requirements and in particular ALM matching and regulatory capital. However they are not a perfect fit for the typical infrastructure deal. For instance, a debt instrument that is fully drawn day one will result in a material interest cost to a project with a lengthy construction profile. Attempting to resolve this mismatch between investor and borrower requirements has resulted in a range of novel structures such as the EIB's Project Bond, PEBBLE, Commute and the late Hadrian's Wall. Some of these structures have even resulted in transactions such as Project Castor.

These new structures have been motivated not just by the structural considerations mentioned above, but also by a perception that banks are "good" at origination and managing risk (especially hedging and construction risk) but "bad" at holding long-term debt. Given that the former attract fees whilst the latter consumes capital and funding, it is not surprising that many of the initiatives have been developed by banks. The dialogue between banks and institutional investors to date can thus be categorised as banks saying "We like this bit but not that bit – why don't you take that?"

Clearly in the longer term this is not a very satisfactory arrangement, so larger investors such as Allianz have hired in-house teams to disintermediate the banks. Sequoia provides a similar, independent role for institutions, giving direct access to projects and borrowers, as well as to banks which currently remain an important source of deal flow and are the only source for secondary market loans.

One important factor that will drive change is the profound difference between a lending bank and an institutional investor, not just in terms of product but, equally importantly, in terms of objectives and strategy. These differences are often overlooked by banks that develop an "originate and distribute" model or especially a "co-investment" model. For example, for most banks, fee income is highly valued not just by the bank but also by the individual banker, whose bonus may be linked to it. Therefore a high fee loan with a moderate margin can be just as, if not more, attractive than a high margin loan with a low upfront fee. For an institutional investor, of course, the opposite is true. In fact, this point goes much further since for a bank an early prepayment of the loan is to be encouraged since it frees up capital which can then generate further fee income – a refinancing is even better as the fee income is immediate. Paradoxically banks are often happy to refinance a loan they have made with another to the same borrower at a lower margin, provided it generates valuable fee income. Again, this is the opposite of what most institutional investors want.

Fee income is earned by banks not just on loans but also on a range of ancillary services and products including advisory and arrangement fees, hedging, equity bridges and revolving facilities. Typically when a bank considers whether or not to make a loan, it may look at its total economics across all its services and products but under an originate-and-distribute or co-investment model these economics are not shared with investors, who therefore inevitably have a worse risk/reward ratio than the bank. On competitive transactions, banks have an incentive to use ancillary revenues to subsidise lending margins. If several banks do this then the subsidised lending margins are the "market rate" and again institutions lose out.

The differences go further when considering not just individual loans but a portfolio of loans. Each bank is naturally strong in certain jurisdictions and industries. Sometimes this is the result of a strategic decision, but equally it may be simply a historical legacy. Within these sectors banks often target market share – to be a "leading player" – and individual bankers tasked with covering the sectors will be personally remunerated based on their origination volumes. Market share is, in reality, the opposite of the diversification that an institutional investor ought to target. Such an investor would prefer to spread his risk across a wide range of sectors and jurisdictions without being overly "strong" in any of them, since this strength is actually a potential weakness.

For these reasons, Sequoia's belief is that, over time, investors and independent asset managers will develop institutional debt products which, in parallel with a higher level of institutional experience and risk appetite, will reduce the need for bank intermediation.
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