The UK’s new matching adjustment regime increases the attraction of infrastructure and real estate private debt markets
Highlights
- There is a wealth of companies in private markets that are not big enough to tap public debt markets, but are nevertheless fundamentally high quality and offer sizeable diversification and yield benefits.
- The outlook for private debt performance appears positive. A combination of money tightening, constrained bank lending and higher interest rates, provides private lenders with attractive loan margins.
- Solvency UK could make private debt yet more attractive to insurers. But to take advantage of the new regime will require resources to navigate an additional degree of complexity in portfolio construction.
Jonathan Stevens
Head of Private Debt, AEW Europe
Finding sufficient matching long-term assets is a familiar challenge for institutions with very long-term liabilities.
As Jonathan Stevens, head of private debt at AEW Europe, says: “There is a dearth of suitable matching assets. There are only so many publicly-traded bonds issued by water utilities and companies like Heathrow out there.”
But rather than endlessly bidding up the price of long-term bonds in public markets, institutions can look to private markets, which have a number of advantages over publicly- traded bonds.
Structural benefits of private debt
For a start, a broader range of assets is available in private markets. “There is a huge wealth of companies in private markets that are not big enough to tap public markets, but are nevertheless fundamentally high quality,” says Stevens.
These companies tend to be in the sub-$1bn range, and unable to justify the sizeable costs of listing, so borrow privately to invest in their businesses. The vast number of companies in this range enable private debt investors with deep research resources to diversify broadly across sectors and geographies.
For sophisticated investors, private offerings can be selected and structured to target liabilities with more granularity than is generally possible with listed bonds.
In addition, infrastructure debt, a large component of private debt, offers the possibility of very long-term loans – anything between one and 37 years, with an average of 17.5 years. This makes it well suited to institutions with longer liability profiles.
“Carefully selected infrastructure and real estate debt have the attractive features of real asset collateral and low economic correlation, leading to low incidence of default and high recovery rates,” says Stevens.
The default rate for infrastructure debt has historically been very similar to the default rate on investment grade bonds.
The impact of Solvency UK
The UK’s version of the EU’s Solvency II Directive, widely known as Solvency UK, could make private debt yet more attractive to insurers.
Solvency UK, which comes into force at the end of 2024, aims to increase the investment options for UK life insurers, allowing greater flexibility in the matching adjustment regime. Solvency UK will also reduce required risk margins in annuity businesses and simplify reporting requirements to reduce insurers’ costs of compliance.
Matching adjustment allows insurers to recognise the reduced exposure to short-term fluctuations in prices of assets backing long-term fixed pension payments. It is particularly relevant to insurers contracting in defined benefit pensions from pension schemes. These bulk purchase annuity contracts are increasing at a rate of £50 billion a year, according to the Bank of England.
The Solvency UK reforms will allow insurers to invest up to 10% of their UK matching asset portfolios into products classified as having “Highly Predictable” cashflows. Private debt is likely to be a key beneficiary.
Oversight required to deal with complexity
The changes to the regime may be beneficial both for insurers’ investment portfolios and for the UK economy.
Solvency UK is backed by the Association of British Insurers (ABI) which has formed a new Investment Delivery Forum for cross-sector co-operation to drive £100 billion into UK infrastructure projects over the next ten years.
But to take advantage of the new regime will require resources to navigate an additional degree of complexity in portfolio construction.
A senior manager, typically the CFO, must be appointed by insurers to attest on an annual basis that the fundamental spread reflects all risks and that the matching adjustment can be earned with “confidence”. Insurers must also publish attestation reports and develop an internal policy on how the attestation is created.
Stevens says: “In other words, as asset managers we can’t just say: buy this product. We need to show how the product works for a particular insurer, what part it plays in strategic asset allocation and portfolio construction objectives.
Growth potential is substantial
Private debt has grown fast in the past 15 years and the asset class has the potential to grow rapidly for years, probably decades, to come.
The GFC and the banking regulations which followed it, provided early momentum for private debt, and traditional bank financing further retrenched after Covid 19. As momentum grew, institutional investors recognized that private debt could reduce exposure to economic cycles and market volatility. Executed well, a private asset allocation may offer inflation protection, diversification, lower volatility, more control over ESG impacts, and illiquidity premia.
“Our strategy focuses on both real estate and infrastructure debt,” says Stevens. “There is no shortage of infrastructure debt assets, in particular, coming to market.”
Global infrastructure debt volumes reached a new record high of around $500bn in 2023, a 42% increase from the previous year, driven by growth in all of the four major global regions. Renewable infrastructure is also driving volumes and is now the single most popular sector with 32% of total debt assets in 2023*.
Part of the attraction for borrowers is that an essentially floating rate infrastructure debt market has become either fixed rate or tied to inflation, insulating investors from interest rate volatility.
The outlook for performance appears positive too. A combination of money tightening, constrained bank lending and higher interest rates, may provide private lenders with attractive loan margins.
The changing focus of infrastructure investment
The scope of infrastructure has widened, says Stevens, creating new investment opportunities. “Before the global financial crisis (GFC), the infrastructure story was about utilities, transportation, PFI and PPP. These are still around, but are now constrained assets.”
Other sectors are expanding quickly, led by energy transition. Important sub-sectors of the transition include battery storage, carbon capture and digital infrastructure.
A recent example is a €42m loan AEW provided to help finance the €2bn development of France’s first “gigafactory”. The loan was made to Verkor, a French business which was founded in 2020 and is focused on accelerating the production of low-carbon batteries for electric vehicles in Europe.
The project is expected to be operational by 2025 with the capacity to support the fit out of an estimated 300,000 electric vehicles.
Infrastructure financing requirements are changing rapidly and investors must recognise that allocating to novel sectors does create different types of risk. Stevens says: “We have to look at new areas of infrastructure in a very risk-conscious way. There is idiosyncratic project risk, so you have got to be deliberate in the assets you select and how you structure them.”
Risks must be identified and mitigated contractually, he says. “You have got to really choose to invest, not be led by the market. Great risk outcomes are out there, but let’s not pretend that all infrastructure is low-risk.”
Re-imagination of real estate
Like infrastructure, the real estate market is also evolving and providing new opportunities.
“The sector has been disrupted by Covid, online shopping and rising rates, so investors need to fundamentally reassess the asset class,” says Stevens.
Rents and prices of traditional office and commercial assets have suffered amid this shift in real estate sentiment. So called “low-risk” office development proved to be anything but, and investors are adjusting to this new reality.
In addition, private debt where payouts are linked to inflation – as it usually the case with both real estate and infrastructure debt – is more valuable amid rising rates. Stevens says: “There is a credit crunch in the real estate world, and sophisticated real estate borrowers realise that taking interest rate risk off the table is valuable.”
The more real estate debt offerings reflect this reality and replace floating rates with fixed and inflation-linked rates, the quicker volumes will catch up with infrastructure markets, he adds.
Diversity of thought adds value
AEW is organised by sector teams and has an integrated decision process which takes input from a variety of sector specialists. This cross-fertilisation of ideas has been enhanced by the joining together of AEW’s private real estate debt and private infrastructure debt teams into a single platform.
Stevens says: “The integration gives us much greater diversity of thought and analysis.” Evolving asset types such as student accommodation and data centres, need both real estate and infrastructure skills, he adds.
“We believe tying different credit segments together makes us stronger than the practice of putting equity and debt teams together.” There are few, if any investment firms, who can underwrite deals in both areas.
The depth and knowledge of this team means it can target specific portfolio construction constraints and constructs. Stevens concludes: “For insurers in particular, managing risks under Solvency UK is becoming more complicated, so they require asset managers who can partner with them to not only source and manage the assets, but structure them in a way that adds value.”
Published in October 2024
