Episode 199: Sustainable Infrastructure Credit: the time is now.

A multi-decade opportunity for Insurance Investment Portfolios

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Stewart: Welcome to another edition of the InsuranceAUM.com Podcast. I am Stewart Foley. I'll be your host. Today's topic is sustainable infrastructure credit. The time is now a multi-decade opportunity for insurance investment portfolios, according to our guest, Jorge Camiña, partner, head of Denham Sustainable Infrastructure Credit. Jorge, welcome. Thanks for being on. Thanks for taking the time.

Jorge: Great to be here. Thank you, Stew.

Stewart: We are thrilled to have you. We've done some work with Denham of late, we just had Stu Porter on the show, as well as your partners at Aflac, and we're thrilled to have you. I want to start this the way we start them all: what's the town that you grew up in? What was your first job? Not the fancy one. And what makes insurance asset management so cool?

Jorge: I was prepared for the last one, but let's address first the other two. I grew up in a small town in the north of Spain, technically in the Basque Country, called Bilbao, in the suburbs of Bilbao. My first paying job was, I had two, one was I was a tennis teacher for young kids and the other one was I was putting basically chairs for concerts. A friend of mine, his dad had a business putting chairs. When there's a big concert, you put a thousand chairs. I was loading trucks with that.

Stewart: There you go.

Jorge: So that's how I knew I didn't want to do that.

Stewart: Yeah. That's a good motivator to go to college, right?

Jorge: A hundred percent.

Stewart: And what makes insurance asset management so cool?

Jorge: What I really like is that it's a very dynamic industry. Besides the headline of insurance not necessarily being the most exciting career path, the reality when you scratch through the surface and through maybe some misconceptions is that there are so many interesting things happening in insurance investing. The way insurance companies have evolved over the last 10, 15 years is just unbelievable. And being in the middle of it with my product is a really exciting time.

Stewart: That is so cool, and I couldn't agree with you more, to be honest with you. I'm definitely biased toward the insurance asset management world, and so I love to beat that drum whenever I get a chance. So, let's talk just for a second to set the stage. What do you mean when you say sustainable infrastructure credit? Just so that our audience, we're all on the same page as we launch off here.

Jorge: We've seen infrastructure investing, which could be very quickly associated with airports, power plants, gas pipelines, toll roads, things like that, essential services that make the fabric of society of things that we really need in our day-to-day and we just assume they're going to work. They are a very high capex or a hard asset, real assets segment of the market where you need to invest a lot and they are long life assets. So within that segment of the market, you can focus in assets that are sustainable and are contributing to the decarbonization of our society.

Our view at Denham is that over time we'll eventually drop the objective of sustainable and everything will be sustainable, or with sustainable optics or focus. But right now the reality is that we are focusing a sub-segment of the market, of those assets that are contributing to decarbonize the economy. Those could be things like wind farms, could be things like transmission lines connecting renewable power to the grid, could be batteries, could also be clean data centers, et cetera. And sustainable infrastructure credit is essentially the discipline within private debt investing, focusing on providing capital in the form of credit to those assets. And we find that generally that's a very attractive segment of the market for insurance companies.

Stewart: And there's a lot of, pardon the pun, there's tailwind with this. What is it right now that's making sustainable infrastructure so compelling?

Jorge: The title of the podcast is ‘The Time is Now’, and I really believe very strongly on that. I would highlight probably three elements. We're starting a multi-decade opportunity that was already driven by the commitment across multiple countries, multiple corporates, multiple stakeholders in society to work towards an energy transition by 2050. And the capex estimated to be required for that transition is $150 trillion. What is often forgotten when you give the headline that we have all heard many times, is that in order for that transition to happen, a lot of that capex is going to be provided by credit. We see all the time on the news, the headline about the next mega equity fund being raised, dedicated to an energy transition.

What is not so often advertised is that again, 70%, 80% of that capex is going to be done by credit and that we need more providers of that capital in the market to be successful in that energy transition. 
So that's element number one. We have a multi-decade opportunity that is driven by that energy transition commitment, that has been very recently turbocharged by the Inflation Reduction Act in the US. The Inflation Reduction Act, which is truly a game changing piece of legislation that will give us 10 years of multi-decade growth in the US and it's putting the US ahead of many other countries in terms of being probably the global leader in energy transition deployment and probably technology developer. Just to give you a sense, estimates for investment banking research is that the Inflation Reduction Act will bring around $3.3 trillion of capex over the next 10 years. And to put that into perspective, $3.3 trillion, that's about $300 billion per year, which is 5 times the volume that we are investing in this segment of the market as of last year. So this is really a major change in pace in how the US is betting on this.

So you have the multi-decade growth, but you also have this trend happening, at the same time we see a normalization on interest rates. You were an investor of this asset class over the last 10 years and you were talking to other investors. Everybody was very sold by the quality of the asset class, by the quality of the risk that you were taking, but they were not finding easily enough returns in the asset class. That has changed. Overnight, interest rates have repriced. We are probably going to see a new normal for the next years to come, and this is making this asset class a very compelling alternative to allocate into equities or to allocate into other segments of credit. So for the first time in many years, we have done normalization of interest rates.

So on one hand, you have the volume from the global energy transition. On the IRA, we have the normalization of interest rates and all of this is happening at the same time where the main provider of capital to this asset class, which was the commercial banks, are much more constrained than ever. We don't see the headlines as we were seeing them a few months ago of the banking crisis in the US, but the liquidity of banks and their ability to commit capital to this asset class is much more constrained. So when you put these three elements together, we are realizing that in order for any transition to happen and to be successful, insurance company capital and institutional capital in general has to flow to the infrastructure credit as a class.

Stewart: That's really helpful and I completely see your logic there. I get why the time is now. Can you explain a little bit about why infrastructure fits on an insurer's balance sheet? I think it's important... You make a great point that the return profile of this asset class is substantially different than it's been of late. Can you talk a little bit about that fit?

Jorge: Any transition needs insurance company capital. Now we have to establish why insurance company capital should be interested in the asset class. It's a combination of several features. One of them is essentially infrastructure credit, similar to other private credit strategies, provides two roles. It can provide investment grade quality credit to replace corporate credit, where you get paid an illiquidity premium. On the below investment grade, it can also provide the same illiquidity premium or give you over your higher yield credit investments, it'll give you a more resilient and stronger downside protection over other more traditional, private credit strategies that don't have the futures and the essentiality and barriers of entry of infrastructure credit.

But across both investment grade and below investment grade infrastructure credit, you essentially are looking for 4 or 5 attributes that make them attractive for the CIO of an insurance company. The first one is that yield enhancement, that illiquidity and the structuring premium. The second one is that resiliency again, because you are providing an essential service and you are lending to hard assets that have very interesting features in terms of long use for life and downside protection that is somehow uncorrelated to the economic cycle. There are Moody's studies and other studies that show how the asset class has behaved much better than corporate credit. So if you look at 10 years of cumulative losses, infrastructure has provided 1.4% cumulative losses over those 10 years, and that compares to corporates that is closer to 9%. So there's an over 6 times better recovery or better losses in infrastructure credit than in corporate credit.

So you have the yield enhancement, you have the resilient nature of the credit, but also, and this is a much more relevant feature these days, your underlying credit has an indebted inflation protection or interest rate protection, although these transactions are closed and you are locking your interest rate for the life of the asset or for the life of your financing. And the underlying asset that you're investing could be a utility business, could be a solar power plant, could be a transportation asset, et cetera. Those assets typically have embedded protection for inflation. So you want to have a credit profile that has very strong EBITDA margins and has very strong protection for inflation pressures, which is again a key area of focus for credit underwriting these days.

And it's a portfolio diversifier. Because of being such an essential service, you're typically swapping systemic risk, from the economy, to more idiosyncratic risk from a specific asset and a specific underlying service. And all of this, in a wrapper, that is structured protections from being in a deal with bespoke structures, bespoke covenants, usually with a small group of like-minded investors that if there's an issue, it's much easier to manage. So it's a long way of saying it's a very safe source of finding duration and it has a bonus feature to it, which is if, right now, you have an energy transition or decarbonization goal for your portfolio, you're contributing to that decarbonization goal or for the future, if in case you want to put that objective in your portfolio in the future.

Stewart: That's a great point. And our audience is always keen to hear about yield enhancement. So, what do you mean by that? And do you have an example?

Jorge: So yield enhancement is... We try to focus when we have conversations with our clients and with investors about the asset class, we try to make clear one thing, this asset makes sense for economic reasons. It has other bonus features, like we were saying before, but you are doing this, because it makes sense economically for your portfolio. Let's step in the shoes of an insurance company allocator. You have medium to long-term liabilities. What are your options in terms of allocation? You can just play it very safe and buy treasuries. Great. You're going to get a 5% return over 15 years. You're doing liability matching, but how is that product competing with your other competitor insurance companies that may be investing in higher yielding asset class.

So the next thing you can do is to invest in liability matching paper, loan duration that is safe, is you can say, "Okay, I'm going to buy certain paper that is safer in the market." Let's say utilities, which is a regulated business. You have protections, you have more limited competition and you have regulated returns. You can provide credit to those and make a pickup, make an extra spread over treasuries with a marginal increase of risk. And you can take this one step farther, which is, "Okay, I have long-term liabilities. One of my greatest assets of insurance companies that I have actually long-term liabilities. I can invest my general account proceeds in a way that I leverage that skill or that ability." So I can invest in a project, infrastructure asset that has a long-term contract with a utility and where I'm being paid a premium over the utility bonds and at the same time, I receive a premium for that illiquidity or that private paper, I'm actually investing with security over an asset that has alternative uses.

If I invest in a solar farm that has a long-term contract with the utility and I'm being paid a premium over the utility, you are running the credit risk of that utility and at the same time you have an asset that is somehow uncorrelated to that credit profile of the utility. Maybe sometimes it helps to put some numbers to this. So, let's assume that corporate credit these days is at, let's call it, 5%, like a 10-year corporate... So this is actually closer to 6% over the last movement, over the last few weeks, but let's say in the mid to high 5’s. And we have the alternative to invest in infrastructure credit asset at, let's say, low to mid 6%.

So the corporate credit is going to have 10% losses over 10 years. Yes, it'd be closer to 9%. The infrastructure asset is going to have, based on that Moody's study, about 1.4% cumulative losses. So at the end of those 10 years, in your corporate credit investing, you are going to have somewhere in the area of $140. You invested $100, you get back $140 after losses and after deal. And without taking into account reinvesting. You invested that same amount of money, those same $100 in infrastructure credit, at the end of the 10 years you get $160. That's $20 more. That's almost 50% excess return over what you get in corporate credit. And that's essentially trading your skill or your ability as an insurance company to manage illiquidity, because of your long-term liabilities. So that's a great way for the insurance company to give value to their illiquidity.

Stewart: It's very helpful to hear the impact of the cumulative losses on the realized investment outcome. That's an interesting way to look at it. So, if I put on my CIO hat for a minute, and I don't really have one of my own, John Patton left one the last time he did due dilly with us, so I just wear his. How, if I'm an insurance company, do I access this market? I think that one of the things that insurance companies always want to know is implementation. How do I... Yeah, I like this. It sounds fine. Whatever. How do I actually implement in my portfolio? How should I be thinking about it?

Jorge: One of the very interesting features of this infrastructure credit asset class, particularly for sustainable infrastructure credit, is that this is only a private asset class. So there is a very limited portion of the market that is available in public markets. I was looking the other day, when was the last solar or wind portfolio transaction issued in the public markets? I think the last utility-scale project bond was issued in the US in 2014. Doesn't mean that there's not a lot of activity going on since then, actually has been very, very busy in this space. The volumes are really being kept in the private markets. A lot of that volume has been in the balance sheets of banks, commercial banks. Commercial banks are very quick to disintermediate certain asset classes, like certain securitizations or middle market lending or LBOs, things like that. The reality is that for sustainable credit, they like the asset class for a reason, because it has a very low track record of losses and because it contributes to decarbonization. But they have been keeping that in their books. And there's about a 20% portion of that market has been available in the private markets through basically direct sourcing from insurance companies and asset managers, like ourselves at Denham.

So essentially it's an asset class that you need to have an origination effort into it. And our job here at Denham is to bring that additionality to insurers, to basically help them source and select quality paper that is not otherwise available in the public markets. And part of our job is to work alongside and partner with commercial banks in some cases, and so sometimes to capture a portion of their market share to basically create opportunity for institutional capital in this space. What we are seeing, as I mentioned at the beginning of the podcast, is the wave of opportunity driven by the IRA, by the energy transition combined with the situation of the balance sheets of banks. This is an imbalance. There's too much opportunity at the time where the banks cannot provide that capital. We are going to see a need and an opportunity for insurers and for managers like ourselves to step in and cover that gap.

Stewart: That's really helpful. And maybe, could you give a little bit of a background of how Denham plays in the sustainable infra credit space?

Jorge: Yeah. You spoke with our founder, whose name also is Stu, and one of our managing partners, Justin, a few weeks ago. We are an energy transition firm, globally, very focusing in sourcing opportunities across both equity and credit in sustainable infrastructure. We have been investing in the asset class before it was almost an asset class. The level of sustainability is relatively new, but the reality is that we have invested in our first solar or wind and renewables projects in the mid-2000s. At some point, we had the largest solar project in Italy, I think it was 2008, one of the... Again, back then it wasn't a huge deal. It was about 60 megawatts. And these days, those sources are much bigger. But the point being, we have been investing in this asset class globally in over 30 countries for many years. And that put us in a privileged position to help others to source the asset class and to address the needs of a portfolio to deal with issues that always happen when you have a large portfolio investing across multiple projects and multiple countries.

So we, right now, over the years, Denham has raised about $12 billion of capital and right now we have $3.4 billion AUM dedicated to sustainable infrastructure equity and credit. Over our first 24 months investing in sustainable infrastructure credit, we have sourced close to $800 million in transactions that we have closed. And we are seeing this opportunity ever-increasing from where we are today. So we are in a position to support insurance by companies providing them this additionality to their deal flow and this additionality to their deal selection to basically deliver alpha and deliver relative value over other credit asset classes.

Stewart: It's really helpful and I've learned a bunch today and I really appreciate you being on. On our way out the door, what are the 2 or 3 things that you would like our audience to come away from this podcast with?

Jorge: Thank you for that question. It gives me a good chance to close everything and put everything together. I would say the first one is growth. Sustainable infrastructure is an investment opportunity for insurers with an exponential growth over the next 24 months. And this growth is going to last multiple decades. Definitely the next 10 years, we have a lot of visibility for that. You're a CIO of an insurance company, I don't think you want to miss out on that. I think the volume of capex and the volume of opportunity that capex is going to drive, at the time where credit has repriced, is very attractive and a source of quality investments. So growth could be the first one.

The second one is that relative value proposition. You have to look at this asset class thinking risk-return. The risk is very attractive and the returns are increasingly, increasingly attractive and have improved dramatically over the last 18 months. So, revisit the asset class if you have looked at it in the past. Think about it if you haven't looked at it yet. It's very attractive, real yields, very attractive risk-return balances here. And lastly, even if you are here for the opportunity growth and for the relative value or alpha, think about this as an asset class in terms of sustainable infrastructure credit as an asset class that can help you to future-proof your organization. You're helping decarbonize your portfolio. That may be a concern or a priority you have today, or that may be a concern or a priority you will have soon. But for now, you are investing in an asset class that has growth, economic attractiveness, and on top of that, you're getting as a bonus that future-proof in the organization for decarbonization.

Stewart: That's great. That's terrific. I really appreciate you coming on. We've got a couple of fun ones on the way out. I don't know if you prepped for these, but you have optionality. One of the things I love about being in the investment business is people know what optionality is. It's perfect. So, the first one is; what's the best advice you've ever gotten or given? And the second one is, who would you most like to have lunch with, alive or dead? You can take either or both.

Jorge: Great. I'll go with both. Thank you, Stew.

Stewart: I love it. I love it.

Jorge: So, the advice I give to my kids, I'm not sure if it's the best advice ever, but I like to tell my kids this and I tell that to myself, and I was told that before; there's no second chance for a first impression. And the way I look at is, it's a longer way of thinking that or saying that you have to be prepared, you have to work ahead and you have to be thoughtful and real in your engagement with people. That's how I think about that. And your second question, I was prepared to talk about who I want to go out with for dinner, but I'll take lunch as well.

Stewart: Hey, we can change it to dinner. That works out too.

Jorge: Okay, okay.

Stewart: That's perfect.

Jorge: I think for this one, dinner may be more fun. But yeah, this is a controversial figure, so I don't want to mean that I endorse him or anything. But I find Elon Musk a very interesting figure that he's in the epicenter of so many major challenges for society. And at the same time, he's in every single controversy that you can think of. I think I will enjoy direct dialogue with him to understand how he really thinks about things.

Stewart: That's terrific. So, we've been joined today by Jorge Camiña, partner and head of Denham Sustainable Infrastructure Credit. Jorge, thanks for being on. Thanks for taking the time.

Jorge: Thank you, Stew.

Stewart: Thanks for listening. If you have ideas for podcasts, please shoot me a note at podcast@insuranceaum.com. If you like us, please rate us and review us on Apple Podcast, Spotify, or wherever you listen to your favorite shows. My name's Stewart Foley, and this is the InsuranceAUM.com Podcast.

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