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Left tail Right tail

At Infradebt we are not tied to investment labels. At the end of the day, all investing is investing. We believe the most important thing is a laser like focus on risk vs reward trade-offs, and understanding the distribution of outcomes. Life never turns out like the base case!

An interesting comparison is the difference between debt investing versus equity investing. In our day to day work we are constantly assessing the relative risk and return profiles of each component in the capital structure as well as the overall unlevered valuation of a project.

Debt is typically characterised as having a capped return profile with senior security over a business. If a business performs better than expected there is no increase in the debt return. If a business does worse than expected, there is a risk that debt will suffer a loss. Even worse, if the business becomes insolvent equity will throw the keys over to the debt investors!

Debt owns the downside risk and none of the upside. Hence it makes sense for debt investors to be attuned to the downside risks. A core tenet is not to lend more than the unlevered value of a business so that you can recover your capital in the event of default. Naturally, debt investing attracts the “permabear” crowd!

On the flip side, equity returns are completely uncapped with the possibility of earning outsized (multi-bagger!) investment returns if right tail events occur. The maximum return is potentially unlimited, and the maximum loss is your initial cost base. Those equity investors are an optimistic bunch of people.

Jokes aside, when does it make sense to invest in the equity? When you believe market participants (and debt investors) are mispricing the fundamental value of the project and in particular the quantum and probability of right tail outcomes. Right tail outcomes are very broad but wrapped into this concept is the competitive position of a business. See our previous article on investment moats!

When does it make sense to invest in the debt? When you believe the views of the market (and equity investors) are overly optimistic or have unrealistic views on the probability of future cashflows. Debt investors can take advantage of the unreasonable assumptions of equity whilst maintaining a conservative cost base that is less than the “true” value of a business.

Given we are Infrastructure investors we can apply these concepts to our asset class. In general, there are two generic types of infrastructure investing, “core” versus “non-core”. “Core” is code for real assets with high barriers to entry. These assets are usually monopolies with deep moats and long tenor cashflows. “Non-core” assets are more price takers and are generally priced as such.

“Core” cashflows tend to be long tenor and often linked to economic growth. Lenders view these assets as “safe” and debt costs are low. We think these types of assets make great equity investments. Given the state of valuations – this is a consensus view!

“Non-core” tends to have less durable and volatile cashflows and should be “cheaper” on a risk adjusted basis. This volatility makes the investment susceptible to the whims of lenders who may demand rectification of covenant breaches should they occur.

We think debt investments in non-core infrastructure provides significant opportunity for investors. Given the competitiveness in capital allocation to the infrastructure asset class, debt investment in non-core allows investors the opportunity to benefit from the (irrational?) optimism of equity whilst providing a defensive position against a volatile less durable business. Sometimes debt even earns outsized returns! 😊

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