This article was originally published on Business Day
Nigeria’s domestic institutional investors, whose portfolios comprise a significant percentage of Nigerian government paper, are facing unprecedented losses as rising inflation creates negative real yields. To preserve capital, domestic institutional investors will need to diversify their portfolios and consider alternative asset classes.
Nigeria’s economy has encountered multiple hits in the recent past. Inflation stands high at 13.39%. Exacerbating an already difficult macroeconomic environment is the persisting COVID-19 pandemic, deep currency devaluation, declining levels of government revenues (reported as only 7% of GDP, and largely applied to servicing debt), and ballooning public debt currently estimated at USD 84 billion.
More diverse portfolios that leverage blended finance, the strategic use of concessional capital as a risk buffer, could help spread risk and create better performing portfolios. Moreover, long-term yield generating, inflation-linked asset classes such as infrastructure provide a viable alternative to government securities, with predictable and stable cash flows. Channeling larger volumes of institutional capital towards infrastructure and other asset classes can create positive externalities for the struggling Nigerian economy.
The IMF estimates Nigeria’s infrastructure stock at 25% of GDP, well below the global average of 70%. It will require annual financing of USD 100 billion over the next 30 years to address this deficit. The multiplier effect created by robust and high quality infrastructure is well documented. The economic return averages 5 – 25% for every dollar spent, leading to inclusive economic growth, job creation, a stronger business enabling environment, and an improvement in living conditions given the provision of basic public services. In addition, national productivity and competitiveness are often higher in countries with adequate infrastructure. Sustaining strategic infrastructure investment is therefore a critical and urgent requirement to transform Nigeria’s economic trajectory and to help it achieve its industrialization aspiration. However, it is clear that alternative sources of capital are required, given the already stressed public purse.
Pension assets alone account for N10.8 trillion (about USD 28 billion), but most of these funds are invested in government securities, whose yields have turned negative in real terms due to rising inflation. Given the inelasticity of demand for infrastructure and its stable cash flows, it is well aligned to the investment needs of pension funds. The participation of other institutional investors, such as insurance companies (with assets valued at about USD 467 million for life insurance and about USD 648 million for non- life) and the Nigerian Sovereign Investment Authority (NSIA – the Sovereign Wealth Fund), are equally important. And, infrastructure facilitates the long-term asset-liability matching requirements of these investors.
In the immediate term, given the on-going portfolio losses of domestic institutional investors in the country, focus should be placed on alternative products and instruments that can be underpinned by blended finance approaches to preserve capital.
The following examples are illustrative of the multiple possibilities available:
1. Infrastructure Project Syndications
Overall, syndications enable risk sharing. Prior to the 2008 global financial crisis, when market conditions were favorable, infrastructure projects were largely financed by syndicates of commercial banks or with underwriters selling down a portion of the debt to other lenders. However, with the 2008 financial crisis came stringent capital adequacy requirements, including Basel III, significantly constraining banks and declining bank syndications.
Infrastructure assets can provide banks and asset owners with higher yields through syndications. This is a more attractive investment option than government securities, which are diminished by rising inflation rates. Through infrastructure assets, banks can utilize their expertise in structuring and appraising infrastructure projects to syndicate loans with groups of domestic institutional investors who could provide longer tenors that match the overall project life, and additionally achieve better long-term asset-liability matching in their own balance sheets. Qualified reputable banks and Development Finance Institutions (DFIs) can serve as the Mandated Lead Arranger (MLA) and lender of record (with preferred creditor status for the DFIs) to undertake the due diligence, appraisal, risk analysis and management, and ensure adequate pricing to generate attractive risk-adjusted returns for all.
Blended finance can be applied through early stage project preparation grants and credit enhancement instruments where necessary. The International Finance Corporation’s (IFC) Managed Co-Lending Portfolio Program (MCPP) is an example of a blended finance syndications platform that creates diversified portfolios of emerging market private sector loans to grant investors exposure to this asset class. It has raised over USD 7 billion from eight investors; which has been channeled to 96 commercially structured projects (a quarter of which are infrastructure) in 37 countries (a quarter of which are African). Through it’s A/B Loan program, it enables institutional investors to establish an investment vehicle and contract IFC to originate transactions. IFC is the lender of record, while investors participate through B Loans. This structure has raised USD 1.6 billion from Allianz, AXA, and Prudential. It has further raised USD 1.5 billion from Munich RE, Swiss RE, and Liberty Mutual Insurance; which can use unfunded structures to provide IFC with credit insurance or risk guarantees. Again, IFC lends for its own account, with the insurers’ credit coverage on a portion of the portfolio. Credit enhancement to improve the risk-return profile for investors is provided through IFC’s first-loss tranche; which is in turn backed by a guarantee from the Swedish International Development Cooperation Agency (Sida). This model can be adapted and replicated by local banks and regional DFIs to catalyze domestic institutional capital.
2. Blended Finance Infrastructure Project Bonds
Infrastructure project bonds can be issued during the operating phase when cash flows are stable, with the bond maturity aligning with the overall project life. Credit-enhancement can be an effective approach to enable participation from a broader group of investors, given the restrictions on some investors from investing in sub-investment grade instruments. InfraCredit, a blended finance facility that provides local currency guarantees to improve the credit quality of infrastructure debt instruments, is an important player in attracting larger volumes of financing from domestic institutional investors.
For instance, InfraCredit’s guarantee to North South Power for its February 2019 issuance of N8.5 billion 15-year Series 1 Guaranteed Fixed Rate Senior Green Infrastructure Bonds received a rating of AAA from Agusto & Co. and Global Credit Ratings Co. The issuer is rated A. This was the first certified corporate green bond in Nigeria and was oversubscribed, with firm commitments from 11 pension funds. Replicating this type of transaction would create a larger pool of attractive investment opportunities for domestic institutional investors, while benefitting the economy.
3. Blended Finance Securitizations
Whether through securitizing individual loans or receivables, or pooling large numbers of debt obligations, and issuing fixed income securities, this approach provides varying yields and can attract a spectrum of investors with differing risk appetites. Notably, the avalanche created by this instrument during the 2008 global financial crisis has introduced stricter requirements around transparency and the quality of the underlying assets. Mechanisms like the Capital Tool Company’s Trefi Technology Platform exist to provide real-time visibility on the performance of the assets underlying securitization transactions. Trefi is in use in the IMFACT healthcare securitization transaction in Kenya that was supported by Convergence in 2019. The vehicle provides a first-loss layer of protection and access to a collateralized portfolio of receivables through which investment grade notes are issued.
Structured blended finance products can provide attractive investment opportunities to domestic institutional investors without altering their commercial mandates and objectives. By leveraging products and instruments that mirror the structured finance products they are already familiar, blended finance can help improve the quality and pipeline of bankable infrastructure projects to drive long-term economic transformation in Nigeria, without exacerbating the public debt burden.
The bottom line is this – the current market conditions are not favorable for domestic investors who are seeing value destroyed by the rising rate of inflation. The on-going pandemic and difficult macroeconomic conditions suggest little respite for investors in the short/medium-term. Domestic investors must therefore urgently consider alternative asset classes to preserve their capital and identify a pathway for consistent income and capital appreciation. Infrastructure assets structured through blended finance approaches might be their best bet.