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Infrastructure Debt: The Growing Attraction

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Greg Campion: Infrastructure debt continues to grow in its appeal for investors, ranging from insurance companies to pension funds. But can the asset class deliver attractive returns while also protecting investors from volatility?

Orhan Sarayli: I would say with all the opportunities across all the various sub- sectors, and all the tailwinds that we're seeing, I've never been as excited as I am about the opportunity set and infrastructure debt as I am today.

Greg Campion: That was Orhan Sarayli, Head of North America with Barings Global Infrastructure debt team. And this is Streaming Income, a podcast from Barings. I'm your host, Greg Campion. Coming up on today's show, the evolving opportunity in infrastructure debt. All right. Orhan Sarayli, welcome to Streaming Income.

Orhan Sarayli: Thank you, Greg. Pleasure to be here.

Greg Campion: Excited to have you here. I think it's a very timely time to be discussing what we're here to discuss today, which is infrastructure debt, the opportunity that you see, and a lot of the dynamics that are going on in this market. But before we get into all those specifics, let's define our terms upfront if you don't mind. So can you help me just understand when you and the Barings team talk about infrastructure debt, what are the asset types that you're actually referring to, and is there any common or unifying characteristic among them?

Orhan Sarayli: I think it's a great start to the conversation, Greg, because it's an exciting time in general for infrastructure and we have seen infrastructure grow and evolve, and there are a lot of trends supporting that evolution. Having said that though, we do believe there are some core aspects that make an asset an infrastructure asset. Starting with... We sort of break infrastructure, and we think we're relatively consistent with the rest of the industry, into six broad categories. There's economic infrastructure, for example, airports, toll roads. There is social infrastructure. These are things like courthouses or hospitals that a state or municipality will look to build in partnership with a private operator. There's power and renewables. There is utilities and pipelines. There is midstream and storage, for natural gas and oil products. And then finally digital infra. But just because an asset fits within those six categories, that doesn't necessarily make it an infrastructure asset the way we would like to look at it. For us, the additional aspect is an essentiality aspect, which is a critical and core component of what makes an asset infrastructure. For example, there are airports out there that might be core to the location, but nobody flies in and out of the towns. So we look at very much how important is the asset, not just to the equity and the lender, but also to the core customer base. And fortunately, a lot of these assets have decades of history where we can gain comfort around that. But it's that essentiality aspect that we look to for generations of usage, and or contracts that align well with the ultimate customer.

Greg Campion: Okay, interesting. Yeah, it's quite a diverse group of assets that you just described. And I'm curious, as you and the team think about sourcing these assets, I'm sure that's really an interesting part of the business. So let's talk about how that works. This is obviously quite different than some of the public market asset classes that we might discuss on this podcast from time to time. This is a much more privately negotiated market, et cetera. So tell me a little bit about just how sourcing generally works in this market.

Orhan Sarayli: Yeah, historically infrastructure has not been readily available for most institutional or individual investors. Perhaps you could buy utility stocks on the stock exchange and bonds, but generally most of infrastructure is privately negotiated.

Greg Campion: Mm- hmm.

Orhan Sarayli: And historically, I'd say anywhere about around 90% of all debt financings have been done in the bank market where an institutional or individual investor would rarely see those kind of financing opportunities come to them. So yes, it is a private market and it relies heavily on having relationships. And the three main channels where we source our deals, I would say are directly with the sponsors. And that has been a fast growing segment of the infrastructure universe, almost all private equity driven. On top of that, there's the traditional bank market, both from bank deals that they themselves lend to and then look to distribute to investors like ourselves, or where they're working on behalf of a sponsor to arrange a debt financing. And we have great relationships with the banks. And then finally, advisors. Infrastructure, as it's growing, we're seeing an increasing number of advisors who are focusing on the segment, and there's a lot of bid activity around public private partnerships where these advisors add a lot of value.

Greg Campion: Hmm. So I'm curious how that landscape might have changed recently. Obviously we've had a lot of different changing dynamics in the broader economy. Interest rates have obviously moved up quite a bit. We've had worries about a recession now, it seems like those worries are evaporating before our eyes given some of the most recent economic data. And obviously inflation's been a big recent concern. Is any of that affecting the sourcing environment right now? And I guess the other thought there is, when I have conversations with our real estate team, with our direct lending team, given the kind of more I would say volatile economic backdrop, there's been a lot less activity in those transaction pipelines. I don't want to say they've slowed to a stop, but it seems like there's more of a price discovery in those asset classes going on where you're seeing a lot of assets not change hands because buyer and seller need to figure out a price to agree on. Is that the case in infra debt today?

Orhan Sarayli: I definitely think we've seen an impact from what you're talking about, particularly the interest rate environment. Like a lot of sectors, particularly around long- term fixed assets such as infrastructure, interest rates are a critical component as fixed capital costs are a big driver of the value for investors. And we definitely saw a slow- down in M& A sometime around the third quarter of last year, and the M& A activity had kept sort of dormant through I'd say as recently as a couple of months ago. What is interesting though is right now we're as busy as I've ever seen our team be here in the US. What has helped infrastructure ride some of that volatility, I think, is right now we are seeing a very good confluence of organic trends that have been driving growth and have almost been cycle resistant in many ways tied together with sort of a reemergence of M& A. Right now we're working on three direct M& A finance opportunities directly with the sponsors. These are small and middle market type deals and around assets that I think represent everything about infrastructure that we like, not tied to the broader economy and demonstrating good resilience to both inflation and recession risk. And the appetite from the sponsors continues to be strong there. But will we see the big M& A deals in the near future? Possibly, but right now that spot still continues to be a little quiet.

Greg Campion: Okay. Yeah, that's fascinating to hear just how busy you are. Because I think that is, based on my perception, I feel like that's an outlier versus some of the other private asset classes that we're looking at these days.

Orhan Sarayli: I think as an example of that, Greg, so far this year through June 30th in the US we have done more volume than we did in all of 2022 in terms of dollar volume invested.

Greg Campion: Hmm. And is that driven by any one sector in particular, or is that pretty broad based?

Orhan Sarayli: Yeah, great question. The midstream environment post- pandemic after oil and gas prices sort of plummeted, sometimes to negative prices, as expected it has rebounded. And the appetite, particularly with geopolitical concerns sort of driving energy security, natural gas demand has been very strong and we have seen a tremendous uptick in natural gas midstream activity. And we have benefited from that, and we have invested quite a bit. I'd say that's probably been the leading sub- sector that we focused on. Economic infrastructure is being resilient.

Greg Campion: Okay.

Orhan Sarayli: Social infrastructure opportunities, what we call public private partnerships, or P3s, those continue to sort of hold their own. So yeah, so there are certain sub- sectors that are benefiting from that. And digital infra, again, also is one of those sub- sectors that it is just a trend that's not going away.

Greg Campion: Yeah, yeah. Well I think, to your point, the kind of lower correlation with the macro economy for this asset class and some of these really long- dated essential assets that you're talking about, it would make sense that you see less of a slowdown in terms of the deal pipeline I guess during times of economic volatility.

Orhan Sarayli: Knock on wood, we hope it continues.

Greg Campion: Okay, so we talked a little bit about sourcing. Let's talk about the other side of the equation. So let's talk about on the investor side. Who's buying infrastructure debt these days and why? I mean we know that this traditionally has been an attractive asset class for insurance companies, but tell me kind of your latest thinking there. What you're seeing, what you're hearing from LPs where that inbound interest for the asset class is coming from today?

Orhan Sarayli: Yeah. I'd say historically, and this goes back decades, it's been primarily banks and insurance companies who were the main participants in the infrastructure debt market. We have definitely seen that evolve. As asset managers and sponsors have developed their own infrastructure debt strategies as part of an asset allocation model, that investor set has diversified. We have seen pension funds start become increasingly interested in the space. It is a good alternative to infrastructure equity and other alternatives, and generally fits within their alternatives bucket. We continue to see strong demand from banks and insurance companies. We are starting to see, incrementally, more demand from family offices and wealth management channels. So it is definitely becoming, I'd say, a more conventional type of product. You could argue, I would certainly argue, that 5% allocation, which seems to be kind of a broad range where a lot of asset allocation models sort of point to... In my opinion, infrastructure is too core an asset to be that small a bucket. But I'm biased.

Greg Campion: Yeah. Makes sense. Okay, well that's interesting to hear that it's broadening out. I guess what are some of the most recent trends if you look at insurance companies specifically? What are you seeing in specifically out of that channel?

Orhan Sarayli: Yeah. It's really interesting in that I'd say, for the first time in a few years, we're seeing an uptick in appetite from insurance companies regarding infrastructure debt, particularly investment grade infrastructure debt. I think, based on my conversations, I think people are viewing that with the potential for a recession. Who knows, but certainly there were concerns there. With the potential for inflation, the way its run. Having a product that has appeared to be resistant to both recessions and inflation is a good diversifier from a fixed income portfolio perspective. And on top of that, you get all the other benefits that we've talked about with infrastructure. It generally has shown incremental value pickup because it's generally a private market, so you have an illiquidity premium that you normally see. But on top of that there's just a structuring premium that we think is embedded within the pricing. So both of those I think, from a diversification perspective and a relative value perspective, we believe that's what's driving the incremental appetite, particularly from insurance companies. And it still of course fits very well from an asset liability management perspective for a lot of those types of investors.

Greg Campion: For sure. You mentioned that insurance companies are maybe a bit more interested in the investment grade. How about the non- investment grade part of this market? Where are you seeing interest there?

Orhan Sarayli: Well we think, and we'll find this out as the cycle plays out, but in this interest rate environment and in this M& A environment, particularly for the large type deals, if there is a slow- down I think investors are starting to see non- investment grade infrastructure debt as potentially an increasingly attractive alternative for infrastructure equity. It demonstrates all the positive aspects of infrastructure that the equity product brings. We have always felt that right now where rates are, the infrastructure debt product brings commensurate current yield relative to core or core plus style equity options. Plus we believe the opportunity set of deal deployment is very good for debt, uncertain for equity. So we think when you combine all those aspects, we think pension fund investors and all other investors who invest in infrastructure equity might start looking at non- investment grade infrastructure debt as a good alternative for the next couple of years.

Greg Campion: Hmm. That's interesting. And then I'm just curious, I know that it can be kind of a mix of fixed and floating rate debt out there, but most of the transactions that are being structured today, how does that look? Is it more fixed rate debt, more floating rate, and then what are the implications there from an investor's point of view?

Orhan Sarayli: I think it has varied. We still see strong appetite for both. It's kind of running 50/50.

Greg Campion: Okay.

Orhan Sarayli: Broadly in the market from our perspective. Sometimes it's out of the investor's hands. Sometimes if you're not credit worthy enough to get interest rates swap lines from banks, you're almost by default having to do a fixed rate instrument. But for most of our borrowers who are credit worthy, it really is just a decision on their part. And we have seen some investors who want to lock out any interest rate volatility and just do a fixed rate instrument. Plenty of demand from sponsors for that, but we continue to see a lot of sponsors who believe that their assets can handle a rising rate environment and are willing to take the risk of floating rate.

Greg Campion: Got it. Got it. Okay. So we've talked a little bit about sourcing, we've talked a little bit about who's buying. Let's talk about some of the big trends that are sort of underpinning this asset class in the years to come. So tell me, what are some of those more big thematic trends that you and the team are looking to invest into?

Orhan Sarayli: Well beyond the general broad investor appetite into the space, which has led to a tremendous influx of funds into the space, I would say the biggest one has certainly been the energy transition. With the focus on decarbonization, globally, we don't believe that's a trend that's going to go away overnight. And that has been the biggest driver. I would say most of our power and renewables portfolio, since I've been here, it's almost all renewables. And so that's a trend that we don't see going away anytime in the near future. If anything, we have seen government policy look to support that increasingly more and more. Having said that though, you look at Europe and you start seeing there is still reliability. Essentiality and reliability, that's what infrastructures stand for. And reliability sometimes means that you have to stick with the old fossil fuel style. So in some ways the amazing trend, Greg, is every single sub- sector within infrastructure is almost firing on all cylinders as a result. So while you have broad trends like decarbonization driving energy transition, and the Inflation Reduction Act and legislation like that supporting substantial investment in the space, you still have old core infrastructure assets that still are very valuable assets. So I think the trend of energy transition has only grown the infrastructure opportunity set, while still not really diminishing substantially the existing core and core plus style.

Greg Campion: Yeah.

Orhan Sarayli: So how long those trends will stay in place, I don't know.

Greg Campion: Yep.

Orhan Sarayli: But right now it's a great time to think about infrastructure because the growth across the space could be tremendous.

Greg Campion: Okay.

Orhan Sarayli: You're talking trillions of investment required globally to meet the needs.

Greg Campion: Really a long- term structural trend underpinning the growth there. Now here's a question for you. In terms of how you and the team are structuring these transactions, pricing them, looking for value, I wonder are there parts of that market though that get almost too much investment and become overheated? So if you think about different parts of the renewable spectrum for instance, how are you assessing kind of value in that space?

Orhan Sarayli: Yeah. As I sort of mentioned when we started this topic, the influx of capital has been tremendous across all of infra, in particular in renewables. Primarily solar and wind. When we established the group here at Barings, solar and wind financings were some of the most attractive risk return opportunities. They were all contracted and we were getting very nice spreads on those deals. Now what we're finding as more and more capital comes in the space, and, if you will, the low hanging fruit of opportunities is kind of now gone in the utility scale space, what you're finding is sponsors now have to reach to get their return targets met. And so what we have seen is a trend where perhaps there's more risk being pushed onto not just the equity but also the lenders.

Greg Campion: Okay.

Orhan Sarayli: Whether that's commodity price risk, whether that's credit counterparty risk, whether that's operating risk or cost risk. We've seen power generators now look to terminate their offshore wind contracts because the prices they had agreed to no longer are economic for them. So they're willing to pay, in one case, almost 50 million in penalties to terminate a contract because it's not economic for them to build the offshore wind platform. So there is more risk in the space. And because of the influx of capital, we have not seen what we feel to be a commensurate increase in return for that risk. So the amount of renewable activity for solar and wind that we did six years ago is no longer an indicator of the type of activity we're doing in this space now for solar and wind. Having said that, there are still plenty of other renewable categories where we are seeing interesting risk return attributes.

Greg Campion: Yeah. Such as?

Orhan Sarayli: So for example, food waste.

Greg Campion: Hmm.

Orhan Sarayli: What do you do with all the food waste? A lot of the food waste unfortunately gets thrown into landfills. And states such as California are encouraging people to figure out alternatives, and in fact passing legislation to encourage a new way of handling that.

Greg Campion: Mm-hmm.

Orhan Sarayli: So what you're seeing are renewable fuel style systems where you'll take food waste, recycle it, and convert it into renewable fuels. And the states are stepping up and entering into contracts to support that effort. And that becomes interesting because then you start getting into renewable energy and social infrastructure blending into one.

Greg Campion: Right.

Orhan Sarayli: In many ways. And we have done a number of those deals. Not all renewable deals are like that. Some renewable deals rely purely on subsidies, and it's possible we may find those deals attractive, but we see enough opportunity in traditional contracted deals around renewable fuels and waste processing that we think that's a segment that's going to continue to grow.

Greg Campion: Yeah, interesting. So it's not just investing in" renewables" with a broad brush, you got to really lift up the hood and look at the supply- demand capital dynamics in each space to see what the risk return opportunities are really looking like. So it's interesting to hear a little bit of that kind of nuance there. You mentioned some government policy, and I think it's worth talking a little bit more about that because that I think can be a big driver of where there are potential investment opportunities in this space. So obviously we've got the Inflation Reduction Act here in the States. In Europe, there's the European Fund for Sustainable Development. So tell me just broadly how you and the team are thinking about riding the tailwinds of those big government programs, or how do you invest into that as a trend?

Orhan Sarayli: Selectively, carefully, with a lot of thought. What we are seeing right now is, again, potentially great opportunities. It used to be we would want to do a hundred million dollar deployment on deals, and we'd want to see the best wind and solar projects. Having said that though, we are seeing a lot of small growth companies looking for capital up and down the balance sheet, senior, junior, equity- like, and we're finding that our investors for ESG or other reasons are very interested in supporting these type of efforts. So we are spending a lot of time underwriting to make sure we're comfortable with the business model, but the amount of small startup entities taking advantage of these opportunities... And you mentioned some federal and regional things, it's occurring at the state level too. It's occurring at the local level. There are possibly thousands of similar opportunities popping up constantly. Our biggest issue, Greg, is funneling through all the opportunities to make sure that we're seeing the best and the most representative of what we think infrastructure should be going forward. But it's not from a lack of opportunities that I'm worried about.

Greg Campion: Okay. So that kind of brings me to one of my last questions here is thinking about you mentioning how do you funnel through these opportunities? And I would imagine you need the right team in place to be able to do that. So let's talk a little bit about, and full disclosure obviously we're an infrastructure debt manager and we're probably biased in the way we answer this question, but what do you think investors should look for in a manager if they're looking to deploy capital into this asset class?

Orhan Sarayli: Well, if we go back and we kind of summarize some of the things we talked about from the market perspective, the majority of the market is private and not openly available to investors in general.

Greg Campion: Yep.

Orhan Sarayli: It is a market that you rely on a long history and trying to determine that essentiality, whether that's from history or from past experiences. And we also have said it's evolving and changing, and a lot of different sort of skill sets are sort of blending into what the new infrastructure world's going to be over time. So I think what that means is what I would look for in a manager I would certainly want an institution that has multiple skill sets. So for example, it's not surprising but real estate and infrastructure blend in many, many ways. And that is a marriage that we think is going to continue to evolve over time. And we work very closely with our real estate folks because, at some point in time, there are a lot of opportunities that involve taking a real estate skillset. Whether it's because it's a real estate is your credit counterparty, a developer there that you're working on. Or, for example, some of the most interesting deals we've done have been ground leases around renewable assets, and understanding how to think from a real estate perspective about your collateral there.

Greg Campion: Right.

Orhan Sarayli: So structured credit is another example. Increasingly more and more as you get into what we call distributed gen, or individuals like you and me or small companies doing their own renewable systems, it's very tough to underwrite that with a single financing. So what you'll do is you'll do a structure credit financing around a pool of borrowers like that.

Greg Campion: So you just named the last two podcast episodes that we did. So are you saying I should have just invited you to our commercial real estate and structured credit podcasts?

Orhan Sarayli: Or vice versa.

Greg Campion: Yeah.

Orhan Sarayli: And I talk to my Barings colleagues all the time. Digital infra used to be called Telecom.

Greg Campion: Right.

Orhan Sarayli: And we have great analysts on our public fixed income desk that I rely on, along along with our energy analysts. So having that skill set across the institution is huge, along with the origination aspect. We like to think, as a team, we have the relationships out there. And certainly that is a critical part of it and we believe we do because of who we are, but the institution matters too. The institution has relationships across the globe, and we are lucky in that we get opportunities coming from all over the organization, including our parent MassMutual. So that is an important aspect because, as I said, you can't find these deals on your computer screen. You have to go out and know where to dig them up. And from that perspective, I believe we have a clear advantage in that regard. And on top of that, as I mentioned, a lot of the team that we have here on our infrastructure were former bankers. We have been at buy and hold institutions. Remember the banks have been 90% of the capital provided to this space. There are a lot of lessons learned, and you have to know the sponsors, you have to know how the structures work, you have to know how they go through cycles. We are only now for the first time dealing in an interest rate and inflation cycle that generations of investors have not lived through. We have because we've been doing this for over 20 years, and in the case of Barings for even longer than that. So we believe having that experience, having the origination expertise, and then having the institutional knowledge to handle how the infrastructure industry's going to evolve, those are huge. And what we like to think at the end of the day is, let's not ignore the global aspect. We are called global infrastructure, and the reason for that is if you look at infrastructure it's not a North America dominated market. It is very global, and in particular it's Europe and North America. And what we like to do is deliver a representative portfolio to our investors. We are about 50/50 North America and Europe, and that is about what the infrastructure market is generally.

Greg Campion: Okay.

Orhan Sarayli: And that's an important aspect, having that global diversity, because infrastructure in Europe is not exactly infrastructure in America. Europe is more economic and social infrastructure, the US is more energy focused. Having that blend is important.

Greg Campion: Makes a lot of sense. So it's the origination platform, it's experience, and it's being able to take that global perspective. Well listen, Orhan, thank you for what has been kind of a whirlwind tour through infrastructure debt. It's been educational for me, hopefully for our listeners as well. But I know it's probably only the tip of the iceberg, so one thing I would do is I would point people to the white paper that you and your colleagues have just published. It's called The Evolving Opportunity in Infrastructure Debt, and I will link to that in the show notes so people can click right into that and check that out. I want to give you the opportunity to have the last word here, so if there's any one key message you want to leave listeners with today, go for it.

Orhan Sarayli: Well, I think as I mentioned earlier, this is as exciting a time as I've ever seen in the infrastructure debt space. I think both from an investor and from an opportunity set perspective, between the organic trends and the cyclical trends. It's tough for me to figure out what is challenging about infrastructure debt relative to other asset classes right now. I'm clearly biased, I make no apologies about that, but I think it's a product that holds its own from a credit performance perspective, from relative value perspective, and I think right now we're benefiting from both. Whether it's legislative policy or organic trends that I don't think are temporary. And I think if you haven't thought about this product as an addition to your portfolio, I think it's a great time to start thinking about it.

Greg Campion: Well, it's nice to hear some strong conviction about an asset class at a time when I think not a lot of people have very strong conviction around markets right now, just given some of the uncertainty and volatility that we've seen. Well, this has been great Orhan. Hope to do it again sometime soon, but thanks for joining me. Thanks again for listening to episode number 11 of season eight of Streaming Income. This is the last episode of this season, we will be taking a month off and we will be back in September. If you'd like to stay up to date on our latest thoughts on asset classes ranging from high yield and private credit to real estate and emerging markets, make sure to follow us and leave a review on your favorite podcast platform. We're on Apple Podcasts, Spotify, YouTube, and more. And if you have specific feedback, you can email us at podcast @ barings. com. That's podcast @ B- A- R- I- N- G- S. com. Thanks again for listening, and we will see you in September.