Insurers hunt for 'scale premium' in infrastructure assets

Size and tenor of deals grow in importance as illiquidity premium fades

Insurers will need to invest in large, long-term infrastructure projects to achieve desired returns, as burgeoning demand is forcing down yields on smaller projects.

The illiquidity premium obtainable in small, shorter duration infrastructure investments is shrinking as insurers and other institutional investors increase their demand for physical assets, say investors.

But higher returns can be obtained on larger infrastructure projects, if an insurer has sufficient scale to take the debt of an entire project onto their balance sheets in a bilateral deal.

John Roe, head of multi-asset funds at Legal and General Investment Management (LGIM) in London, predicts insurers will be able to extract a scale premium unavailable in smaller investments through project bonds or funds in infrastructure projects of up to £250 million in value.

"The illiquidity premium is disappearing, because lots of investors are trying to access it. Based on the size of large insurers, the scale premium should kick in from around £70 million and keeps going to at least £250 million," says Roe.

"Beyond that, a couple of investors could club together to take a similar approach on even larger deals. It depends somewhat on the credit rating, so a BBB asset should offer a scale premium for a smaller outlay than an AAA asset," he adds.

Bilateral deals make it easier to resolve issues as only two parties are involved. They can also lower the cost of funding for the borrower, as no implicit premium is charged for the mismatch between the actual structure and the investor's preferred structure.

The cost of intermediaries such as banks is also cut out, increasing the returns an insurer can make.

"With fewer advisers sitting in the middle, you get to structure the investment to perfectly suit you, with lower frictional costs to set the deal up. Plus you give the borrower certainty of execution, which contributes to the yield enhancement, and reduces the risk of project delays," says Roe.

Last year, insurer Prudential and its investment arm, M&G, invested in a public-private partnership financing two-thirds of the new £167 million Alder Hey hospital in Liverpool. This, says Roe, is example of an insurer hunting for scale premium.

Other large insurance groups are expected to follow Prudential's example. In December 2013, Aviva committed £500 to UK infrastructure. In November, Friends Life awarded a £500 million mandate to MetLife to invest in infrastructure assets to deliver value to its annuity book.

Research by Sequoia Investment Management shows the historic rate of return on infrastructure debt was around 4.5% per annum, which makes it an attractive option relative to corporate and government debt in the current financial climate. 

The search for large infrastructure deals has been triggered by a flood of money from insurers and banks into the short end of the infrastructure space. European banks have been returning to the short end of the infrastructure debt market, which has contributed to the shrinking illiquidity premium.

Deborah Zurkow, head of infrastructure debt at Allianz Global Investors in London, comments: "In the seven- to 10-year space, there is a large group of investors who have shorter duration books, like property and casualty insurers who might not have long-tail liabilities, so there is more money in that space. "

At tenors of more than 15 years, there are deals of size and structure that still offer attractive returns, adds Zurkow. "At our end, we see there is still a premium for the expertise and the ability to get involved in transactions before construction in particular."

The fact insurers have capital already available to invest and do not need to raise it externally makes them attractive investors to those seeking project finance. "They don't need to raise it through a fund, so there's a permanency there that makes borrowers comfortable," says Zurkow.

But a lack of suitable projects in which to invest is a concern for insurers. LGIM's Roe says regulatory changes may increase the number of suitable projects. "In the latest version of the Solvency II regulation, the rules are a little bit more relaxed on small amounts of variation in the shape of the cashflows, opening up the range of appropriate deals," says Roe.