By Emma Haight-Cheng on 26th February 2018
Emma Haight-Cheng, partner at AMP Capital, explains how investors should distinguish between the debt assets of corporates anf infrastucture.
In the table below, we have compared typical infrastructure debt assets with corporate debt assets.
The difference between typical infrastructure assets and corporate assets has a direct effect on the nature of infrastructure mezzanine debt compared to corporate mezzanine debt as illustrated by the table below.
Infrastructure mezzanine debt, such as that offered by AMP Capital Infrastructure Debt Fund (“IDF III”), target returns of between 8% and 10%. While corporate mezzanine debt can offer higher returns in the 10% – 20%+ range, this is due to a vastly different risk pro le. Infrastructure mezzanine debt offers characteristics closer to that of traditional debt products, whereas Corporate Mezzanine can look more akin to an equity position.
Infrastructure mezzanine debt can be offered in a range of loan and bond formats and can be structured as xed or oating depending on investor requirements and return pro le. Typically IDF III focuses on oating rate assets but has the exibility to structure xed rate deals dependent on the transaction. Corporate mezzanine debt is typically structured as xed only.
Both infrastructure and corporate mezzanine debt offer similar tenors of 5 years plus.
With infrastructure mezzanine debt, instruments are typically structured as cash pay. The number of instances an instrument can PIK (or capitalise interest) is restricted within the nancing documentation. An illustrative example is shown in the term sheet below.
For corporate mezzanine debt, many instruments are PIK only, as they are effectively high yield or quasi equity with no limits on the amount of interest that can be capitalised or the number of times that interest can be PIKed. IDF III focuses on cash pay securities.
This is a key differential in the risk pro le between infra and corporate mezzanine debt. Infrastructure mezzanine debt focuses on defensive, non-cyclical real assets that constitute critical infrastructure, providing essential services, and thus bene t from high barriers to entry and limited competition. The defensive nature of infrastructure assets affords the sector a lower correlation to equity and xed income asset classes than one would expect with corporate debt. Cash ow generation from infrastructure assets is generally stable and predictable from defensive earning streams and stable operating platforms with proven performance history.
Infrastructure mezzanine debt is provided on a ring-fenced basis (i.e. cash ows from identi able assets are destined only for operations and maintenance of those assets, and debt service of related facilities) and secured on a second lien or similar effective basis against an individual asset or a portfolio of speci c assets dependent on the transaction. Infrastructure mezzanine investments invariably involve security over shares in the ring- fenced structure, by way of share pledge, which can be either primary or secondary and involves a right for the bene t of lenders to seize equity in the ring-fenced company or companies and deal in that equity (I.e. restructure, sell etc).
Corporate mezzanine debt, on the other hand, is typically unsecured and ranked only above common shares at the corporate level. This is a key differential for the risk pro le of the business.
Ring-fenced vehicles have recourse to a particular group of identi ed assets, rather than to the ultimate shareholders of those assets. This means that the vehicle is entirely separate from the Sponsors, including other assets on their balance sheets as well as other debt.
The ring-fenced debt is highly protected as assets and cash ows within the structure cannot be used for any purpose other than those speci ed; income produced ows through a pre-de ned waterfall and is received by equity only after all other obligations within the vehicle are met and the historical and predicted asset performance monitored by creditors. The lack of Sponsor recourse, conversely, affords lenders a share pledge over Sponsors’ shares in the vehicle(s), meaning that, were something to go wrong with the asset and resulting debt performance, lenders can take control of the business, without going through a formal insolvency process. Similarly, in a Sponsor insolvency process, corporate creditors can have no recourse to the equity or underlying assets in the ring-fenced vehicles and thus the vehicles are “insolvency remote”, in fact an insolvency event at Sponsor level has the effect of severing the ring-fenced vehicles from the Sponsor.
Negotiating a robust and comprehensive security and covenant package is a key part of the structuring and investment process for infrastructure mezzanine transactions.
Default and recovery rates
The interplay of sector focus and security structure impacts upon default and recovery rates.
To illustrate this, Moody’s research on rated infrastructure debt securities (which will include both senior and mezzanine issues) indicates that over a 10 year period, the average cumulative default rate is 1.1% for infrastructure debt versus 14.93% for non- nancial corporate borrowers.2 Mezzanine debt is likely to be rated one notch below investment grade. At the Ba level, the 10 year cumulative default rate for infrastructure debt is 7.68% versus 19.56% for non- nancial corporate borrowers.
Recovery rates on default are also higher. The average recovery rate for rated infrastructure debt securities that are senior secured is 75% for infrastructure versus 53% for non- nancial corporate borrowers.
This trend is also borne out in the project nance and unrated debt space. According to Moody’s, average corporate recovery rates on default for senior unsecured bonds and subordinated bonds in the years 1987 – 2015 were 48.8% and 28.2%.5 By comparison, the average recovery rate for unrated project nance bank loans in the years 1990 – 2014 was 80.4%.6 According to Moody’s, the most likely ultimate recovery rate for lenders was 100%, i.e. no economic loss in nearly 2/3 of cases in their study.
Infrastructure mezzanine debt will typically not have any equity warrants or kickers attached. Corporate Mezzanine however will often offer upside to compensate for increased risk and/or the structure of a PIK instrument.
Infrastructure mezzanine debt will closely follow similar covenants you would expect to see at a senior debt level including tests of cash ow (e.g. Annual Debt Service Coverage Ratio) and leverage (e.g. Net Debt / EBITDA or Net Debt / Regulated Asset Base).
There will typically be tests for both default and for lock-up whereby distributions to equity are prohibited until the ratios improve. There is also usually a time limit on the lock up period before it becomes an event of default. A robust covenant package is a critical part of structuring infrastructure debt transactions. Infrastructure mezzanine debt should also have a good level of information provision from management to creditors written into the facility agreements, affording creditors a detailed view of the assets and their performance on a consistent basis for the life of the loan.
Corporate mezzanine debt can vary quite heavily on the covenants in place by their very nature. As they are more akin to quasi-equity in both returns and risk, their covenant package will typically be looser and less restrictive.