Thursday, June 13, 2024

Ares Management: Mega-trends drive infrastructure debt

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This article is sponsored by Ares Management

Patrick Trears

Infrastructure investing is a broad category and covers investments that are often essential in some way, allowing investors to generate stable cashflow from consistent necessity of use. As governments and public lending markets grapple with regulations, rates and spreads that contribute to a scarcity of capital, the private infrastructure debt market is stepping up, creating new opportunities in a volatile investment market.

For more than two decades, Patrick Trears has specialised in infrastructure debt investment across the globe. Today, he leads Ares Management’s infrastructure debt strategy, which is focused on mezzanine and subordinated debt and manages approximately $9.4 billion in assets, as they see ample opportunity to benefit from industry tailwinds.

At Ares, the infrastructure debt platform has grown and now has roughly 30 investment professionals across the world.

Combined with global megatrends like digitalisation, energy transition, transportation, mobility and bank retrenchment, Trears sees the current moment as an especially exciting time to invest in infrastructure debt.

How do you approach infrastructure debt investment strategy today?

Over the past few years, our strategy has evolved. What we are seeing now is an infrastructure credit solutions business, which is giving Ares and other lenders the ability to provide flexible capital across senior, junior and unitranche deals. Things are changing, but we recognise the importance of staying disciplined and focused.

Over the past five years, a huge amount of infrastructure equity capital has been raised in the market – roughly $600 billion in infrastructure private equity compared to $130 billion in infrastructure private credit. Projects and companies require more credit than equity, so we feel credit is scarce and that we are in the right position to capitalise on the market scarcity as a lender. With investments that are typically floating rate, lenders like Ares can benefit from the current rate environment.

Moreover, infrastructure is inherently built through long-term partnerships and focused on essential assets, which we believe creates compelling opportunities for experienced lenders like ourselves to support much-needed infrastructure projects around the world.

In terms of specific sectors, we are focused on four primary sectors: digital, energy, transportation and utilities, but we see significant dealflow from digitalisation. The digital market has grown a lot over the past few years and includes diverse sectors like cell towers, data centres and fibre networks as well. The level of connectivity required today is huge, and we only see that accelerating with increased data demands, including everything from personal cell phone use to growth in artificial intelligence.

“Putting private capital to work for public good is proving to be a good deal for lenders, sponsors and communities”

We also continue to see the shift away from fossil fuels toward renewables and other sustainable energy sources, so we are eager to play a role in the energy transition. At the same time, transportation and logistics are being impacted by the energy transition, especially the electrification of transport networks. Identifying these trends early allows us to establish ourselves as scaled lenders in these sectors and drive value through capital investment.

When looking at investment opportunities, what specific areas, subsectors or geographies should investors avoid right now?

We avoid investing in unproven technology. Our objective is to back projects that are economically viable, have proven commercial uses and are insurable. We spend a lot of time exploring and debating emerging sectors but continuously revert to our core thesis that investors ultimately want exposure to stable operating assets.

From a geographical perspective, we avoid markets without strong contract law precedents, and so avoid most emerging markets in our strategy. However, even established markets need to be considered carefully. In Europe, there are many countries with different regulations and political implications, requiring a country-by-country analysis.

While there are many factors to consider in any sector or geography, we strongly believe that putting private capital to work for public good is proving to be a good deal for lenders, sponsors and communities.

What do you think drives investor interest in various infrastructure debt strategies, and how should investors think about it within their portfolios?

Investors like the stable, consistent cash yield from infrastructure investments and, maybe more importantly, the essential nature of the assets, which provides downside protection and potential portfolio diversification. Volatility is low when benchmarked against other assets and against public markets, and exhibits lower defaults relative to other asset classes.

“Shoring up core infrastructure is critical [but] public spending on infrastructure has generally declined since the global financial crisis”

With markets so volatile right now, we have seen a flight to quality in the past 18 months as investors seek out the strong downside protection inherent in the infrastructure asset class. In addition, over the past two years, during this period of high inflation, infrastructure has acted as a natural hedge because of the strong cashflow associated with the assets.

We are only at the tip of the iceberg in terms of the opportunity set; you can look around and see ageing infrastructure. Huge capital needs are required to address that, but we are still seeing municipalities with budget constraints and governments running huge deficits. Private capital is a solution to modernising infrastructure across the globe. Those tailwinds are here to stay.

There is a significant fundraising gap between infrastructure private equity and infrastructure debt. What do you think of this gap and how will you action around it and other trends?

For a long time, LPs were largely focused on equity when it came to infrastructure investing. Now, with elevated base rates and relative spreads, the opportunity for compelling risk-adjusted returns is also on the credit side.

While infrastructure private credit has an addressable market that is roughly three times the size of infrastructure private equity, the size of infrastructure private credit only represents 13 percent of infrastructure private funds raised. On top of this, 75 percent of current dry powder is concentrated within the top 10 equity managers.

As for specific global megatrends, we believe bank regulations across Europe and North America are contributing to an underlying need for debt financing, creating even more opportunity in the private credit market.

How do you view the lending environment dynamics and the shift to private markets impacting infrastructure debt?

Infrastructure capital has historically been the domain of public spending and bank financing. Although there has been long-term acknowledgment that shoring up core infrastructure is critical, public spending on infrastructure has generally declined since the global financial crisis.

“We have seen a flight to quality in the past 18 months as investors seek out the strong downside protection inherent in the infrastructure asset class”

Public markets tend to be very proscriptive. If a transaction does not fit within specific guardrails, banks and government entities will not finance the project. Private markets have been a valuable source of capital for our sponsors by offering flexible financing solutions, sitting alongside a company and working with them on capital needs.

We are also able to leverage relationships as a direct lender. Traditional bank lenders rely on broadly syndicated loans and high-yield bond markets, which means financing participants are often large groups that may be unknown and inflexible. Asset managers can negotiate terms confidentially and on their own or in small groups, building a strong foundation for long-term trust and collaboration.

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