The complexity premium in infrastructure debt

A lot has been written about why and how private assets offer potentially higher returns than public or liquid investments. The difference, the alpha sought by investing in private assets, is often referred to as “illiquidity premium”, or sometimes as “complexity premium”. But most often it is a combination of the two. 

In general, illiquidity premium has been the default term used to describe private asset outperformance. While valid, we feel the term risks masking returns that are attributable to more than simply how long capital is being tied up for.

How yields have compared to credit

But where does it actually come from?

In infrastructure debt, complexity premium sources are numerous and multi-faceted. Here, we explain four of the key ways infrastructure debt managers secure complexity premium.

1. Sourcing premium

The first facet is from “sourcing premium”.

With publicly traded bonds, investors can access credit exposure immediately via an open market. For infrastructure debt investment, exposure is not so readily available. Investment opportunities are “created” by asset managers and borrowers in a private and - to an extent - inefficient market. For example, some mid market borrowers are too small to access funding through public markets, and will pay a premium to private lenders.

Some so-called “pure play” exposure can also only be obtained privately. No single public company can guarantee exposure to, say, 100% German renewable energy. Private lenders can lend to renewable projects in Germany and get pure play exposure. 

2. Speed, reliability and adjustability premium

This aspect of complexity premium could be referred to in various ways, and broadly describes the premium commanded by the reliability and adaptability of the deal terms. The bespoke nature of infrastructure debt allows borrowers to incrementally and finely adjust the terms of finance, as in many areas of private lending.  

Public markets generally offer “one size fits all” solutions for finance. Private lenders can provide tailormade products that follow idiosyncratic cash flow patterns. Borrowers will pay a premium for this.

Borrowers conducting confidential acquisitions also need reliability, speed of execution and confidentiality that they will not find in public markets. Terms can move at the last minute in public markets and are subject to market vagaries. Private borrowers are prepared to pay a premium for this too, to private lenders.

3. Risk-return adjusted premium

Infrastructure debt has historically exhibited lower default and higher recovery rates than comparable public market debt. In the simplest terms, this means infrastructure debt has exhibited a higher return, net of credit losses, than similar public debt or bonds.

Risk versus return  

Contributing to private debt’s resilience are the credit protections built into privately negotiated debt deals. These elements can be very useful if conditions become difficult for the debtor (or indeed, to prevent conditions becoming difficult).

Covenants come in several forms but are, in short, contractual aspects of a loan agreement that might limit certain activities, or ensure certain thresholds are met. Private lenders typically have protections via several different types of covenant. These protections are generally weaker or less stringently enforced in public markets.

For example, “maintenance covenants” require certain financial ratios to be reported throughout the term of the borrowing and meet a certain criterion. A common example might be for leverage ratios to stay below a set limit. While such covenants are commonplace in infrastructure debt, there are generally no financial covenants in investment grade fixed income. So-called “cove lite” instruments, with loose or quasi absent covenants, have hit the high yield market headlines in the recent past for all the wrong reasons.

The structuring efforts in infrastructure debt are also not limited to financial covenants. Strictly negotiated affirmative (what the borrower must do) and negative covenants (what they must not) are common features of infrastructure debt credit agreements.

These covenants are used to prevent risks like debt layering or “priming”. This is when a new tranche of debt is added on top of existing debt. Asset sales can be prohibited, as can the loss of collateral package (the assets against which the financing is secured). Techniques known as “value leakage” have been extensively (and to a certain extent controversially) used by private equity firms negotiating cove-lite high yield bonds. Some have been widely publicised and turned into cautionary tales in public markets.

Finally, private debt lenders can gain access to confidential information and due diligence reports as well as business plan and financial projections that are not publicly available. Better access to information and thorough due diligence enables private lenders to make more informed decisions. A private infrastructure debt investment process may last several weeks, and include several meetings and Q&A sessions, with various advisers (technical, legal, commercial, etc) and the borrower management. Public market investors often rely on a “road shows” of an hour or two and a prospectus to make investment decisions in days.

4. Engagement premium

Engagement premium is the value the borrower puts on being able to speak to engaged, clearly identified lenders. This contrasts with the “anonymity” of public markets where bonds are traded on platforms and change hands frequently.

This engagement is extremely valuable when a borrower needs to change the terms of the credit agreement. These are often needed for legitimate business purposes like undertaking value accretive M&A. Obtaining bondholders' consent in public markets is generally a time consuming and painful process. It might also be quite difficult when the success of such M&A process is conditional upon confidentiality and speed and certainty of execution. Such a process is quicker and easier with clearly identified private lenders. Borrowers are ready to pay a premium for that.

Complexity won’t go away

As we’ve seen, the complexity premium in private infrastructure stems from four different sources. To an extent, these could be found in other forms of private debt, but we believe they are exemplified in infrastructure debt.

They structurally differentiate infrastructure debt against public market investments, and are here to stay.