On 16 March 2020 Sequoia held a conference call with its investors, a transcript of the call is below:
Sequoia Economic Infrastructure Income Fund (SEQI) Investor Call
At 1430 on 16 March 2020
Thank you for joining us today. We thought it would be useful to have a call in light of the evolving COVID-19 pandemic so we can discuss how SEQI is positioned and what Sequoia has done in response to coronavirus.
We will break this call down into several parts:
- First, we will summarise some of the key points published in the RNS and monthly factsheet last Friday, 13 March 2020, both of which can be found on the fund’s website, seqifund.com.
- Second, we will give a brief review of economic infrastructure debt and the stability of the asset class.
- Third, we will discuss the late cycle investment strategies that we put into place over 12 months ago as we have been expecting an economic slowdown as many of you know.
- Fourth, we will go over sectors in infrastructure that could be affected by COVID-19 and show that we have little direct exposure.
- Fifth, we will go over recent questions received from investors.
- And finally, we will discuss measures that Sequoia, as a company, has put in place to deal with the current environment.
We want to note upfront that this is a dynamic and developing situation. Everything we say is as of today, and in the case of numbers and percentages, as of the end of February 2020 unless otherwise stated. If anything material changes, investors will be updated through RNS announcements.
In an abundance of caution, we are putting a 2-week pause on new primary lending given the volatility in the markets. We will continually re-assess this and we will continue to work on projects that are currently in the pipeline.
We also want to remind investors that SEQI is a debt fund, not an equity fund. This means that the principal and interest due to the fund are contractual, not optional like a dividend that you have in an equity fund. The principal that was due in February was £35.4m and we received £35.4m. The interest that was due in February was £6.2m and we received £6.2m. In March, we are due £2m in principal and £6m in interest and we have every expectation of receiving this.
March 2020 RNS and monthly factsheet
At the end of February, the fund had an unaudited Net Asset Value of 106.36p per share with no material negative impacts on the valuation of the portfolio. Over the last 12 months, the fund’s total return on NAV was 9.2% demonstrating strong performance in recent times. The gross yield on the portfolio at the end of February was 8.3%.
After month end, the fund received £297m of net proceeds from the recent oversubscribed equity issuance, which were used to repay £224m outstanding on the Revolving Credit Facility. With cash of £97m and the £280m RCF completely undrawn, SEQI has strong liquidity and is in a good position to invest in its attractive pipeline of economic infrastructure debt opportunities that currently stands at £750m equivalent across 23 assets. Our liquid public bucket is 9.4% of NAV and we will discuss this and other points in greater detail in a few minutes, but before that we want to briefly re-examine the strong characteristics of economic infrastructure debt.
Economic infrastructure debt
Economic infrastructure debt is a stable asset class typically characterized by high barriers-to-entry and relatively stable cashflows, and it includes sectors such as Transportation, Utilities, Power, Telecommunications and Renewables.
Economic infrastructure is often supported by physical assets, long-term concessions or licenses to operate infrastructure assets, and these companies frequently operate within a regulated framework. This is especially true in the cases of the Utilities, Telecommunications and parts of the Power sector.
A characteristic that economic infrastructure sectors have in common is that they earn their revenues from demand, usage or volume. This means that the project’s revenue is linked to the utilization, such as a toll road where revenues are dependent or partially dependent on traffic volumes. This is in contrast to social infrastructure, such as schools and hospitals, which are often compensated for the physical asset simply being available for use.
To mitigate demand risk, economic infrastructure projects are typically less highly geared than social infrastructure, and they have higher equity buffers, more conservative credit ratios, stronger loan covenants and higher levels of asset backing for lenders. Economic infrastructure also provides higher returns than social infrastructure and it is a much larger market.
These characteristics of economic infrastructure – stable cashflows, high barriers-to-entry, physical assets, equity buffers and lower gearing – all form the bedrock upon which SEQI’s investment opportunities are based and analysed. This is not expected to change, regardless of what is going on in the markets, because these core features of economic infrastructure all contribute to strong fundamentals that are critical for weathering storms.
With that said, economic infrastructure debt is not immune to market volatility and there are certain actions we have taken, some of which were well before coronavirus. These actions have helped position the portfolio defensively for a potential downturn, which we have discussed with many of you over the last year.
SEQI late cycle strategies
We began employing sensible late cycle strategies over 12 months ago. These strategies include keeping a large portion of the portfolio in defensive sectors, keeping a strong allocation in senior vs mezzanine, and maintaining the portfolio’s credit quality even as spreads tightened. We put these into place over a year ago because we expected a slowdown in the economy, as the business cycles in the US and the UK reached their 10th year in Q42019 and Q32019, respectively. It is important to note that we did not chase yield as spreads tightened over the last few years. We did not need to do this to maintain yield because infrastructure debt remains an underinvested and uncrowded space.
- We have 47% of the portfolio in defensive sectors. These include Telecommunications, Accommodation, Utilities and Renewables which are viewed as defensive because they provide essential services, often operate within a regulated framework and have high barriers-to-entry.Our Accommodation sector, which stands at 10.9%, is less exposed to coronavirus than one may expect, because we have no exposure to the higher risk subsectors within Accommodation, such as old age care and acute hospitals.
- We have 58% of the portfolio in senior and 42% in mezzanine as opposed to more of a 50-50 blend, which positions the portfolio better for a slow growth environment.
- We have maintained the credit quality of the portfolio over the last 12 months while still achieving our target yield. We continue to not invest in CCCs profile names which we instituted as a policy shortly after launching SEQI in March 2015.
Infrastructure sectors and COVID-19
In summary, we have low direct exposure to coronavirus risk. This is in part because we have a very small exposure to the sectors most affected, such as Travel, Tourism and Leisure.
Infrastructure sectors that might be affected by the virus include Transportation infrastructure, Transport Assets and Healthcare/Elderly Care. However, our exposure to the more at-risk parts of these sectors is limited. In particular, in the Healthcare sector, we have no exposure to old age care or acute hospitals, so we do not expect any material direct impact from the virus.
Transportation infrastructure including Airports, Ports and Toll Roads could potentially be affected by reduced business and leisure traffic. Our exposure is limited, however:
- We have a small exposure to Airports and airport related businesses at 2.9% of NAV split across 3 assets. This includes a large airport in the UK, a light metro shuttle in France, and an airport ground services & air cargo handling company headquartered in Switzerland. We are monitoring these closely.
- We have loans to 2 Ferry companies at a total of 3.9% of NAV. The larger of these at 3% operates mainly between Germany, Denmark and Sweden, and the smaller position at 0.9% operates out of Spain. We do not see any impact currently for the Germany-Demark-Sweden ferry and we are monitoring the Spanish Ferry closely.
- Our only Toll Road is in Germany at 2.5% of NAV and it is performing very well.
- In the Port sector, we have stayed away from container ports which can be volatile assets. Our exposure is rather to 3 commodity ports which have lower cyclicality. These positions represent 7.5% of NAV and are split between primarily Europe, Australia and the US. Overall, we do not believe our exposure to ports will be directly affected by the coronavirus to any material degree.
Transport Assets include Passenger Rolling Stock, Ship Leasing and Aircraft Leasing where, as sectors, credit quality of lessees could come under pressure. Our exposure is again limited:
- We currently have no exposure to Passenger Rolling Stock.
- In Shipping, our exposure is 4.8% of NAV split across 4 assets so our single name exposure is quite limited. We are comfortable with our exposure to Shipping because we have avoided, in large part, commoditised asset classes and especially container ships, which can be volatile. Instead we have focused mostly on specialist ships on long-term leases. For example, one of our assets provides jack-up vessels used for the repair and maintenance of offshore windfarms in the North Sea. We therefore do not expect our exposure to ship leasing to be materially directly affected by coronavirus.
- We are keeping a close eye on our small exposure to Aircraft Leasing, because airline profitability is coming under increasing pressure as airline load factors suffer. Our exposure to Aircraft Leasing is small at only 3.5% of NAV and is split between 7 positions (5 of which have nearly run off). Our loans in this subsector benefit from equity cushions of typically 20% or more. However, in a downturn we would expect aircraft values and lease rates to decline so this is clearly something we are very cautious about. In fact, we started decreasing our exposure in the asset class over two years ago when airline profitability began to drop. We took it from 9% of NAV in 2015 to its current 3.5%.
One further position in our portfolio is a US educational facility that has an indirect link to China. Our loan is backed by the facility site in Washington DC, but the wider group owns and operates a school in Shenzhen, China. We spoke to the borrower at the end of February 2020 and they confirmed their Shenzhen school closed in February, as all Chinese schools did, and online classes commenced. In-person classes are scheduled to restart between 16-30 March 2020. Overall, we think our loan will not be affected by the virus, but we are keeping this investment under enhanced scrutiny.
In terms of sectors, it is important to note that, as an infrastructure fund, we have minimal direct exposure to the wider Tourism & Leisure industries. Nonetheless, we have instituted enhanced monitoring on the assets that are most vulnerable to coronavirus and a recession. We also continue to review all assets monthly as part of our normal monitoring and comprehensive valuation process run by PWC, who acts as independent valuation agent to the fund. The monthly valuation process is robust and allows for changes in individual credit conditions and market conditions to be reflected in the price of an asset, particularly the private loans. Our more liquid positions are valued using the average of broker bid-side quotes and these quotes are independently verified by PWC. Our private loans are valued using DCF methodology which considers both the individual credit of borrowers and market spreads. Again, PWC marks these independently of Sequoia and they receive all of the credit information on each position. They also perform their own monitoring as part of a belts and braces approach.
It is important to emphasize that the monthly valuation methodology remains unchanged in all market conditions, however, it is the inputs which are constantly reviewed and fine-tuned to ensure that relevant risks are included within the valuation of an asset. We have initiated a dialogue with PWC to discuss the most relevant coronavirus assumptions as market conditions continue to evolve.
Recent questions from investors
In recent days we have received a few questions about the fund’s portfolio and its exposures to certain sectors. We are now going to go through these and provide more color:
- What is the portfolio diversity and the largest concentration to any single borrower?
- SEQI’s portfolio diversity is strong at 74 assets, 8 sectors, 30 sub-sectors and 13 jurisdictions, with its largest holding representing only 4.0% of NAV. This single name maximum of 4% has consistently dropped since the IPO 5 years ago, and we will continue to lower it in percentage terms as the fund grows.
- What is the average portfolio LTV and equity cushion?
- The weighted average equity cushion for the entire portfolio is 35%.
- More color on the listed bonds portfolio
- Our public bucket, which consists of rated bonds, stood at 9.1% at the end of February. The purpose of this bucket is to provide liquidity in the portfolio. As publicly traded assets, these have been more volatile than private assets since the widening started in late January 2020. To put things in perspective, USD High Yield spreads have widened from +340 bps on 2o January 2020 to +740 bps on 12 March 2020. This is similar to the widening seen in late 2018 when equity markets fell close to 20%, and similar to the widening seen in 2012 toward the end of European sovereign debt crisis. Investment grade spreads have widened proportionately in similar fashion. We plan to selectively add to our public bucket and take advantage of these substantially wider spreads.
- What is our exposure to energy and oil prices?
- Importantly, we have no direct exposure to Exploration & Production. The Energy related positions we have include 3 Midstream assets and 1 Refining & Marketing position for a total of 9.9% of NAV. The Midstream assets are Gathering & Processing companies that make up 7.2% of the portfolio, and the weighted average equity cushion of these 3 assets is a strong 55%. What is important about our Midstream exposure is that there is minimal direct exposure to oil prices. The revenue models used by most Gathering & Processing companies are based on minimal volume contracts. This means the company earns its revenue based on volume and not the price of oil or gas. As part of our due diligence, we ensure the counterparties to these companies (i.e., the producers) are of sufficient credit quality.
- Our single Refining & Marketing position is the largest refining company in Scandinavia at 2.7% of NAV. Its refineries have received substantial capex investment over the last several years and, as a result, are relatively complex, which means they are capable of producing high profit margin products. Its marketing business consists of 503 petrol stations across Sweden. It has a substantial hedging program in place to guard against fluctuations in oil prices.
- What percentage of loans are to development/construction projects?
- 9% of SEQI’s portfolio is pre-operational. This is well under our max capacity for construction of 20%. These consist of 9 assets in 4 sectors: TMT, Utilities, Power and Other, where TMT is the largest at 5.5% and consists of 3 data centers in the US. Pre-operational assets have either not yet reached their commercial operation date or have started operations but are still in ramp-up phase.
Post capital raise opportunities
- Liquidity available after paying down the debt facility
- We have £97m of cash and £280m from the undrawn RCF, which gives us ample cash and liquidity to take advantage of select buying opportunities in this market.
- Opportunities in the market and how these are being assessed
- Our overall strategy in this market environment is to move up the credit spectrum without a meaningful give in portfolio yield, and in some cases a pick-up yield. We are seeing, for example, investment grade opportunities where spreads have widened substantially and we are looking to capitalize on these.
- Cash being returned on portfolio in the next 6 and 12 months
- The portfolio is expected to receive a total of £124m in repayments in the next 12 months out of which £59m is expected within 6 months. This is not outside the norm.
Update at Sequoia – strengthening the team
Sequoia recently brought on board a Chief Risk Officer, Anurag Gupta, who joined us from KPMG, where he was a Partner and Global Sector Head of Power in their global infrastructure advisory practice. The depth of Anurag’s strong infrastructure experience is a valuable asset to Sequoia as we evaluate the risks of new and existing investments.
Further, to support our enhanced monitoring while also deploying capital into the fund’s pipeline of investments, we are currently interviewing for up to 3 new Analyst positions which will further boost our support of the VPs and Associates as they continue to thoroughly review all existing investments as well as new opportunities. We also have a full-time Analyst joining us in summer 2020 who interned with us last summer.
With Anurag plus the 4 additional Analysts, the total headcount of Sequoia will climb to 19.
Sequoia’s and our fund counterparty’s coronavirus contingencies
The growing team at Sequoia will benefit from a number of new initiatives that support the staff’s remote working capabilities and overall wellbeing during this period of uncertainty:
- First, company laptops have been issued by the IT department to the investment team with VPN remote access fully implemented.
- Second, Sequoia’s phone system is accessible on these laptops via a softphone application over VPN which enables calls to be placed anywhere in the world that are routed through Sequoia’s recorded line. To enable these processes, we have made the necessary configuration changes to our business-critical servers. Further, these remote working measures have been tested and we are confident our IT systems can handle the increased in-bound VPN traffic and data requirements.
- Third, we are providing staff with the ability of remote working and we are instituting regular all-staff conference calls at pre-set times in order to make sure we are planning and efficiently executing our investment decisions. Our regular Investment Committee meetings will also be held via teleconference to ensure mission-critical activities continue uninterrupted during this period.
- Fourth, we have enabled remote access for Bloomberg which is an important feed to our portfolio monitoring and evaluation functions.
- Finally, we are instituting a strict policy on corporate travel to business-essential only travel (e.g., asset due diligence trips) and limiting the number of staff that go on such trips. Collectively, we feel these decisions will benefit staff health, reduce absenteeism due to illness and allow us to maintain our business activities.
Sequoia has also coordinated with SEQI’s main counterparties to ensure they have coronavirus contingencies in place. This includes Bank of New York, as Depositary, Portfolio Administrator and Custodian; TMF in Luxembourg as Corporate Services Provider; and PraxisIFM as fund Administrator and AIFM. We are comfortable that they have adequate measures in place.
In closing, we want to remind investors that SEQI receives contractual cash flows and that the loans we make have equity underneath them in the project’s capital structure. That equity is there to absorb any underperformance on the asset side before debt is affected. Infrastructure debt is a robust asset class backed by hard assets with high rates of recovery, and it has outperformed corporate bonds and leveraged loans in past times of market volatility.
That brings us to the end of the call. Thank you for your attendance.