IN THIS ISSUE pg. 1 Spotlight pg. 8 Characteristics and Data

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1 CALLAN INSTITUTE Real Assets Reporter IN THIS ISSUE pg. 1 Spotlight pg. 8 Characteristics and Data Summer/Fall 2017 A New Development The Rise of Infrastructure Debt as an Investment Opportunity Unlisted infrastructure debt may offer consistent and competitive risk-adjusted returns in today s low-interest-rate environment, with potentially low correlations to other asset classes. Manager research data show higher recovery rates for infrastructure assets compared to non-financial corporate bonds. But competition from new debt providers has increased demand for good assets, putting upward pressure on pricing and leading managers to expand their definition of targeted assets and acceptable financing structures. It is important to work with experienced lenders that can conduct detailed diligence and build a diversified portfolio. Investors building out an infrastructure allocation should consider the role of infrastructure in their portfolio, primarily target returns, and select the type of investment that best fits their risk/return targets. Jan Mende Senior Vice President, Callan s group Knowledge. Experience. Integrity.

2 What Is Infrastructure? Infrastructure can be broadly described as facilitating the movement of people, goods, and ideas, and it is essential for the economic productivity of a society. Infrastructure assets include: Regulated utilities: Electricity, natural gas, and water distribution Transportation assets: Airports, seaports, rail lines, toll roads, bridges Energy assets: Electricity generation and transmission; pipelines Communication assets: Radio and television broadcast towers; wireless communications facilities; cable and satellite networks Social infrastructure: Government buildings, schools, hospitals, courthouses, detention centers Exhibit 1: Types of Investors That Target Unlisted Infrastructure Debt Other 10% Corporate DB Plan* 2% Foundation 2% Investment Company 5% Government Agency 7% Asset Manager 9% Private Sector Pension Fund 11% 27% 12% *Also known as Superannuation Scheme Source: Preqin, data as of September 2016 Bank/ Investment Bank 19% Insurance Company 16% Public Pension Fund 14% Infrastructure Categories Core: Existing asset, with established cashflow Brownfield: Expansion of an existing asset, with a cashflow profile to be augmented by this additional investment; akin to a value added strategy in real estate Greenfield: Development of a new asset, without existing cashflow; similar to an opportunistic strategy in real estate Evolution of Infrastructure Debt Before the Global Financial Crisis (GFC), traditional banks were responsible for nearly 90% of infrastructure debt finance.^ But regulations issued in the wake of the crisis limited the ability of banks to provide these loans, notably for longer-term financings. Private placements or municipal bonds have also played an important role in financing infrastructure investments in the United States, but they have focused on investment-grade assets. After the GFC, managers began offering a variety of options for investors to access both investment-grade and noninvestment grade unlisted infrastructure debt with the potential for attractive returns. From 2009 to 2016, 89 unlisted infrastructure debt funds reached final close, with over $43 billion of capital raised from a wide array of investors (Exhibit 1).^ During that period, debt funds ranged from 6% of all unlisted infrastructure fundraising in 2009 to 26% in 2013 (Exhibit 2), which shows the relatively recent rise of infrastructure debt as an investment opportunity. The variety of infrastructure debt opportunities continues to grow as the sector matures. ^ Preqin Special Report: Infrastructure Debt, September

3 Exhibit 2: Unlisted Infrastructure Fundraising Trends Debt s Share of All Unlisted Infrastructure Fundraising Annual Debt Funds Closed and Total Capital Raised 6% 16% 25% 22% 26% 19% 24% 19% No. of funds closed Aggregate capital raised ($bn) Source: Preqin; 2016 data as of Aug. 5. How Is Infrastructure Financed? U.S. state and local governments secure financing for infrastructure through municipal bonds. This has been an efficient way to raise capital, and attractive since municipal bond interest is often tax-exempt. And Callan research indicates it is a sizable market, representing approximately $82.6 billion annually, based on a 10-year average. Private infrastructure investment owners may seek debt across a wider range of options, including senior debt, mezzanine loans, and preferred equity. Infrastructure owners typically use project finance loans secured by the underlying asset, and lenders have limited if any recourse to the owner s other assets. This debt is typically serviced solely by the cash flows from the financed asset. Infrastructure owners sometimes arrange debt at the corporate level for expansion projects, and those loans may be serviced by the corporation s income rather than a specific asset. Investors need to understand the type of collateral risk an infrastructure debt manager will consider to deliver its target return and evaluate whether the return is commensurate with the risk (Exhibit 3). Exhibit 3: Risk-Return Profile of Infrastructure Return Brownfield Infrastructure Mature Brownfield Infrastructure HY Infrastructure Debt IG Infrastructure Debt Greenfield Infrastructure Opportunistic investment Value added investment Core investment Risk Income-oriented Total return/ growth-oriented Source: Callan Knowledge. Experience. Integrity. 3

4 There are no set rules about which type of debt is used for a specific kind of infrastructure asset. Mature asset owners typically employ fixed-rate financing, as they seek longer-term debt and want to avoid pre-payment scenarios to better match their liabilities over lengthy periods of time. Greenfield investment projects more often use floating-rate debt, with shorter maturity schedules that match business plans. Brownfield investments may use a mix of both, with floating-rate entity-level financing used for expansion or growth plans. Loans can be tailored to meet duration objectives, and rates are often set as a function of a base rate, e.g., LIBOR plus a fixed spread. Sector Performance Seems Attractive Research from infrastructure debt managers, largely based on the performance of lending by banks, shows higher recovery rates on average for infrastructure assets compared with nonfinancial corporates, for both senior secured and unsecured debt (Exhibit 4). Recovery rates for project finance loans are even higher, even though they tend to be more highly levered and have a longer tenor compared with other infrastructure debt. Research suggests that these higher recovery rates are largely driven by the relatively stable demand for assets, such as water and electric utilities, leading to more consistent revenue to service their debt. Exhibit 4: Average Default Rates Total infrastructure debt securities Corporate infrastructure debt securities Non-financial corporate issuers 0.1% 0.5% 2.2% 0.3% 1.0% 4.5% 0.4% 1.5% 0.6% 1.9% 0.7% 2.2% 0.8% 2.5% 0.8% 2.7% 0.9% 3.0% 1.0% 3.2% 1.1% 3.4% 6.6% 8.4% 9.8% 11.1% 12.1% 13.0% 13.8% 14.5% Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Source: Moody s Investors Service The table below details the recovery rates for defaulted corporate infrastructure and project finance debt securities. Unsurprisingly, senior financings had higher rates of recovery than unsecured and subordinated financings. Average Recovery Rates for Defaulted Securities Type of Issuer Senior secured Senior unsecured Subordinated Utilities 74% 55% 33% Regulated electric and gas (E&G) utilities and networks 81% 60% n/a Unregulated E&G utilities and power 80% 52% 20% Energy-related projects 64% n/a n/a Transportation 74% n/a n/a Corporate infrastructure and project finance debt securities 73% 54% 32% Non-financial corporate issues 53% 37% 33% Source: Moody s Investors Service 4

5 Benchmarking Benchmarking is handled in many different ways, depending on the role of infrastructure debt in an investor s portfolio (Exhibit 5). Investors have tended to use an absolute return benchmark, or spread over a defined interest rate, such as LIBOR. Infrastructure debt in particular does not have a longestablished benchmark; the iboxx Infrastructure Debt Index was only developed in Infrastructure debt investors seem to prefer the absolute return or spread-over-definedrate method. Exhibit 5: Limited Benchmarks for Infrastructure Debt Investors Handle It in Several Different Ways Absolute Return Target Spread iboxx Infrastructure Debt Index Similar to infrastructure equity, a CPI + method may be used Can be customized based on the expectations for the portfolio Investors may opt to take an arbitrary or measured spread of infrastructure bonds over U.S. Treasuries, LIBOR, or a bond index Produced by IHS Markit. Launched in July 2016 Measures the performance of senior investment grade infrastructure bonds in U.S. dollars, British pounds, and euros, and high yield debt in dollars The indices include companies in the energy, telecommunications, transportation, and utilities sectors Source: Callan Vehicles to Access Infrastructure Debt Investors can access infrastructure debt via separate accounts, or by participating in commingled funds. The table below lays out the variety of options available. Strategy Separate Accounts Core plus Brownfield Greenfield Closed-End Funds Core plus Brownfield Investor Control Moderate high Limited Liquidity Moderate Little to no liquidity Fund terms can reach up to years with hard and soft locks Diversification by Property Type and Geography Diversification by Number of Loans Moderate high depending on manager s capabilities Moderate; varies based on tenor of investment vehicle Varies based on size of fund and investment strategy Varies based on size of fund and investment strategy Monitoring by Investor Moderate Moderate Fees Moderate Varies based on return objectives of fund, investment markets, and deal types Diversification Benefit to Overall Portfolio Moderate Moderate Investment Grade Yes, possible Yes, possible Minimum Capital Required to Invest $50 million $5 million Source: Callan Knowledge. Experience. Integrity. 5

6 How It Measures Up Infrastructure debt has the potential to diversify a portfolio and may deliver strong risk-adjusted returns. It does share some of the same benefits and risks as infrastructure equity investments. Array of benefits: Potential for liability- and duration-matching characteristics with stable, long-dated cash flows that compare favorably with current yields for traditional fixed income Diversification from a traditional stock and bond portfolio, as well as from equity real estate and other alternatives Potentially low-risk asset class combined with favorable lending structures in the current environment Downside protection compared to equity infrastructure interests Growing opportunity, as capital adequacy requirements resulting from regulations such as Basel III have driven traditional lenders out of the space and created a gap in the market for non-traditional lenders Potential for attractive risk/reward characteristics, from senior investment-grade debt to mezzanine loans or financing for projects with construction risk Need for fresh capital for both new projects and to refinance existing debt Lower historical volatility and narrower dispersion of outcomes at the investment level compared to other asset classes; underlying asset values have also shown lower volatility Variety of risks: Managing and operating infrastructure assets is complex and varies between sectors and in different markets, requiring an experienced team Some infrastructure sectors, such as toll roads, may be subject to fluctuations of market-based demand, and this may decrease the certainty of revenue Other assets may take on commodity-price risk, which can reduce revenues if those costs cannot be passed on While some infrastructure assets have a government as the counterparty and generally greater certainty that the payment contracts will be honored, other assets have a private entity as the counterparty that may be unable to meet its obligation to pay revenues stipulated in a service contract Greenfield investments may be subject to completion delays or cost overruns; brownfield projects are also subject to some level of construction risk The borrower s ability to repay debt early may lead to reduced ultimate interest payments if the capital cannot be redeployed within the reinvestment time frame, and infrastructure debt investors may not collect yield for as long as initially anticipated Potentially subject to high levels of scrutiny by end-users on cost and quality of service, which may lead to smaller profit margins for operators and reductions in investor returns Exchange rate risk is also a consideration; hedging can manage this risk but comes at a cost to ultimate investor returns Infrastructure debt has been seen as an increasingly attractive asset class with its promises of relatively safe, steady returns based on inflation-protected assets. As a result, the competition from an increasing number of debt providers has created demand for good assets, which has put upward pressure on pricing and led managers to expand their definition of targeted infrastructure assets and acceptable financing structures (Exhibit 6). Exhibit 6: Infrastructure Managers Views on Competition for Deals Core/Core Plus Value Added Opportunistic Distressed Debt More competition than a year ago No change Less competition than a year ago 33% 31% 74% 67% 69% 26% 31% 69% 14% 54% 46% Source: Preqin, data as of June

7 Evaluating Infrastructure Debt for a Portfolio Despite the risks, investors may consider infrastructure debt as an appropriate strategy for their portfolio and should bear in mind the following considerations. First, an investor should establish a target return profile, considering the associated risk, and select the appropriate part of the capital stack for that exposure. Next, investors should work with experienced infrastructure lenders that are able to conduct detailed diligence. Portfolios should be diversified, with limitations to avoid concentrating risk in a single investment, sector, geography, or borrower to name a few considerations. On an individual loan level, seasoned infrastructure debt practitioners will look to mitigate risk by strong financing terms, such as restricting certain business activities, implementing robust lending covenants, and ensuring they can replace operators. Not all infrastructure debt investments are alike, so it is important for investors to select the type of risk and exposure that best fits their strategy. Exhibit 7: Infrastructure Investor Interest in Fund Strategies Core Brownfield 48% 39% 13% Value-Added Greenfield Opportunistic Open-End Infrastructure Debt Infrastructure Separate Accounts Actively targeting Invest opportunistically Do not invest 19% Source: Probitas Partners, data as of mid % 29% 10% 32% 42% 26% 42% 39% 8% 38% 34% 3% 36% 61% 7% 20% 73% Investors still perceive infrastructure debt as a new asset class, based on data from industry sources. Only 3% of investors surveyed were actively targeting infrastructure debt opportunities (Exhibit 7), with 36% having an opportunistic view on infrastructure debt investing. Some investors may not consider infrastructure debt for their real assets portfolio since it may have lower return targets than required for that portion of their portfolio. Certain investors, such as insurance companies, may target infrastructure debt for their portfolio as it may be structured in such a way that it is beneficial for their regulatory capital requirements. Conclusion Infrastructure debt is becoming easier for institutional investors to access. The number of infrastructure debt fund sponsors is growing and there is potential to access it through separate accounts. Infrastructure debt has the potential to deliver bond-like yields for core assets, or higher levels of return along with more risk as part of brownfield and greenfield infrastructure debt investment. Investors building out an infrastructure allocation should consider the role of infrastructure in their portfolio, primarily target returns, and select the type of investment that best fits their risk/return targets. The rise of infrastructure debt as an asset class has created opportunity for investors, but also competition for good investment assets, which may put pressure on future investor returns in this sector. As with any investment strategy, past performance is no guarantee of future returns. Therefore, it is important to select a manager that has an experienced team to underwrite the potential risks, avoid investments with higher risk characteristics, and appropriately structure the debt investment to minimize risk. Infrastructure debt is not a one size fits all investment, and with its relatively recent debut as a new asset class, it must be carefully scrutinized and considered as an addition to an investment portfolio. Knowledge. Experience. Integrity. 7

8 Real Asset Characteristics and Data Eugene Podkaminer, CFA Real assets play a key role within institutional portfolios as diversifiers, sources of income, sources of manager value-add, and potential hedges against inflation (Exhibit 8). In addition to core real estate, real assets encompass investments with exposure to the real economy (as opposed to the financial economy) such as timber, infrastructure, and commodities, as well as inflation-linked. Each of these sub-asset classes provides a different exposure to inflation and economic growth, leading to a range of correlations with public equity and fixed income markets. In high or rising inflation scenarios, real assets can provide a hedge against losses from short- or intermediate-term underperformance by equities and bonds. In low-inflation environments, real assets provide diversification benefits. Some, like commodities, are well-suited to play the diversification role while contributing only modestly to total portfolio return; others, such as core real estate, can both diversify risk and augment returns. Because real assets include a wide spectrum of and approaches, we expect an equally wide distribution of returns (and risk) over time. Their use of leverage, and the inherent illiquidity of some real asset classes, also drives the expected returns demanded by investors while increasing risk. Investors need a thorough understanding of the risks of real assets. For instance, the hazard of investing in real estate is poorly represented by the volatility of return streams generated by an annual valuation process. The actual volatility of real estate returns in 2008, 2009, and 2010 was not represented in the smoothed return history available prior to 2008, suggesting it could never happen. And the artificially low correlation of those smoothed returns with stocks and bonds suggested greater diversification than real estate actually offered. Diversification works only when investors can rebalance, and they can only do so when they can sell the investment that has run up to buy the investment that has declined. Because of all these factors, investors need to set realistic expectations for real assets given the framework of a generally low return environment across the capital markets. Exhibit 8: Real Assets Primary Strategies and Key Characteristics Real Asset Strategy Private Markets Peripheral Strategy Inflation Protection Diversifier Growth Illiquid High Fees Real Estate X X X X X High Implementation Risk Timberland X X X X X X X Farmland X X X X X X X Infrastructure X X X X X X X Energy X X X X X X X Public Markets REITs X X X X Natural Resource Equities X X X X Commodities X X X Listed Infrastructure X X X X X MLPs X X X X X Investable Index Source: Callan 8

9 Real Assets Research Team Barbara Bernard Real estate debt, office and retail sectors, U.S. opportunistic Kevin Nagy Real estate, real estate securities, Latin America Michael Bise Private Equity Research Private energy, minerals/mining Eugene Podkaminer, CFA Capital Markets Research Strategic investment planning, asset allocation Jonathan Gould, CAIA Real estate, infrastructure Gary Robertson Manager, Private Equity Research Private energy, minerals/mining Sally Haskins Real estate, Asia Avery Robinson, CAIA Real estate, emerging managers, minority-, women-, and disabled-owned firms Jay Kloepfer Capital Markets Research Strategic investment planning, asset allocation Lauren Sertich Real estate, real estate securities, timber Jan Mende Infrastructure, Asian real estate, U.S. value-added Knowledge. Experience. Integrity. 9

10 The Real Assets Reporter newsletter offers Callan s data and insights on real estate and other real asset investment topics. Callan s real assets consulting practice offers extensive manager research; a dedicated and experienced team; and a solutions-focused, customized approach. For real assets inquiries, please contact your Callan consultant or the appropriate member of the research team at Editor Stephen R. Trousdale Designer Jacki Hoagland If you have any questions or comments, please institute@callan.com. About Callan Callan was founded as an employee-owned investment consulting firm in Ever since, we have empowered institutional clients with creative, customized investment solutions that are backed by proprietary research, exclusive data, and ongoing education. Today, Callan advises on more than $2 trillion in total fund sponsor assets, which makes it among the largest independently owned investment consulting firms in the U.S. Callan uses a client-focused consulting model to serve pension and defined contribution plan sponsors, endowments, foundations, independent investment advisors, investment managers, and other asset owners. Callan has five offices throughout the U.S. For more information, please visit About the Callan Institute The Callan Institute, established in 1980, is a source of continuing education for those in the institutional investment community. The Institute conducts conferences and workshops and provides published research, surveys and newsletters. The Institute strives to present the most timely and relevant research and education available so our clients and our associates stay abreast of important trends in the investments industry Callan LLC Certain information herein has been compiled by Callan and is based on information provided by a variety of sources believed to be reliable for which Callan has not necessarily verified the accuracy or completeness of or updated. This report is for informational purposes only and should not be construed as legal or tax advice on any matter. Any investment decision you make on the basis of this report is your sole responsibility. You should consult with legal and tax advisers before applying any of this information to your particular situation. Reference in this report to any product, service or entity should not be construed as a recommendation, approval, affiliation or endorsement of such product, service or entity by Callan. Past performance is no guarantee of future results. This report may consist of statements of opinion, which are made as of the date they are expressed and are not statements of fact. The Callan Institute (the Institute ) is, and will be, the sole owner and copyright holder of all material prepared or developed by the Institute. No party has the right to reproduce, revise, resell, disseminate externally, disseminate to subsidiaries or parents, or post on internal web sites any part of any material prepared or developed by the Institute, without the Institute s permission. Institute clients only have the right to utilize such material internally in their business. 10

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