Sequoia Economic Infrastructure Income Fund Limited (SEQI.L) Earnings Call Transcript & Summary

Good morning, everybody. I'm Randall Sandstrom, and I'm joined this morning by Steve Cook. And we want to thank you for joining the SEQI results call for first half fiscal year '23. This call will cover the period 31 March through 30 September 2022. I'll give a brief introduction, which is on Page 2, and then we'll go into the full call. I want to say that we have a positive message for you this morning, and we feel we have good reasons to be positive about the future of SEQI. Our portfolio cash flows have been very strong during the first half due to short-term rate increases having a positive effect on our floating rate assets and because of being able to reinvest our fixed-rate assets at higher term interest rates. Because of this, the Board has decided to increase the target dividend by full 10% to 6.875p per share, which equates to a 7.5% current dividend yield. I think it's also very important to say right upfront that SEQI and Sequoia are here to stay. Infrastructure debt is what we do. The competitive landscape is improving, and we're aware that some smaller subscale funds have decided to withdraw from the market. On the other hand, SEQI is an established fund with an 8-year track record. We have a low cost structure and an OCR of 91 bps per year. We have scale at GBP 1.6 billion, and our shares are liquid with nearly 3 million shares a day traded. Importantly, our portfolio has also been stress tested by high interest rates, the highest inflation in 40 years, and we've gone through a global pandemic. We feel when you sum all of this up, we have a sound basis for being positive on SEQI going forward. If we turn to Page 3, we can take a glance at SEQI. And this page discusses diversity on the left-hand side and then some of the important characteristics of the portfolio on the right-hand side. You can see right across the top, we've got 12 different low-risk jurisdictions. When I say low risk, these are all investment-grade countries in developed markets and OECD countries as well. Down at the bottom, you can see portfolio diversity by sectors and subsectors. We've got 8 different sectors and 27 different subsectors. If you look on the right-hand side, you can see some important portfolio characteristics, and I'll discuss the important ones of these. You can see the number of investments, 72. This is high. This ties in with a number of sectors and subsectors we have, and this diversity helps to decrease the portfolio risk that we're exposed to. You can see that the average life is short at 3.9 years, and the portfolio modified duration is low at 1.6. And both of these serve to reduce our interest rate risk. You can see the equity cushion is relatively thick at 34%. And defensive sectors, we have 54% of the portfolio in defensive sectors now. So this helps to decrease the business cycle risk that the portfolio is exposed to. The portfolio weightings are below this. I'll talk about some of the more important ones. You can see in terms of ranking, we've got 58% of the portfolio in senior debt with the balance in junior debt. And mezzanine holdco is an important strategy to us because we find that it's a very, very noncompetitive space, particularly in the U.S., which is where we have most of our exposure. In terms of interest type, you can see that we have 58% in floating with the balance in fixed. And that large floating rate exposure has served us well as short-term interest rates have increased.

Thanks, Randy. Page 4 looks at some key financial highlights for the half year. And I'll go through these and put them into context and also talk a little bit about the direction of travel in some cases. So the first row shows that the average portfolio yield to maturity has increased materially from about 8.4% at the end of the last financial year to 11.2% at the end of the half year. And that's driven almost entirely by increases in interest rates such as short-term rates like LIBOR and SONIA and also long-term rates like treasury and gilt yields. On top of that, we've seen an increase in spreads in our credit markets. And the effect of those 2 factors, higher interest rates and higher spreads, has been to reduce the mark at which the portfolio is independently valued. I think it's very important to stress that, that is an unrealized change in the valuation mark. And as the loans get closer to the maturity, the price will accrete back up to 100p in the pound. We call that a pull-to-par effect, which is quite a material effect. In fact, we estimate it's worth approximately 6p per share over the next 3 years. The result of marking down individual investments has been to decrease the NAV from 100.5p to 93.64p, and we'll go through that in a bit more detail on the next slide. Over the same period, the share price declined from 102.8p to 81.9p, which is a consequence of the decline in NAV but also an increase in discount. I think that was driven by a number of factors, including concerns around inflation and rising interest rates. But I'm very pleased to say that, that is partly reversed already. And the closing share price last night was 90p per share, which represents about a 2% discount to net asset value. We have talked a bit about the direction of travel on dividends, and we're obviously delighted with the 10% increase. That is on the back of very strong cash generation on the portfolio. In fact, the cash dividend cover over the last 6 months was 1.4x. Now that does include a number of one-off receipts. If we exclude that, it's approximately 1.16x cash dividend cover compared to 1.06 of the previous financial year. We believe that increase is sustained and, in fact, will grow over time because we believe that the era of ultra-low interest rates is ending, and we're seeing that feed through very rapidly into the income our portfolio generates because nearly 60% of the portfolio is floating rate. Finally, on this slide, our ESG score has declined very slightly. This is not a consequence of the attitude or the approach we have to ESG. It's actually simply the result of valuation changes. The underlying investment activity remains very focused on improving our ESG score, and we expect to continue that path going forward. Turning to Page 5. This provides a NAV bridge for the 6 months ending the 30th September. And I think there's a few key points from this. One is interest income was very strong at 5.3p. Obviously that annualizes to about 10.6p, and that's significantly more than dividends of 3.13p over the period. Clearly, the down bar on the negative market movements has driven NAV over the period. As I mentioned, that is very predominantly -- in fact, over 90% of that is just driven by increases in rates and spreads. The other 10% or slightly less is a mixture of idiosyncratic factors, a markdown on the Salt Lake Potash position and the markup on previously problematical loans. In fact, on a net basis, there was almost no movement on the last 2. The other items on this slide are quite minor and as you'd expect for the fund.

Thank you, Steve. If we just turn to Page 6 now, SEQI has withstood some pretty significant market headwinds over the last 6 months. And if we just take a look at 4 of these, the first one is macroeconomic uncertainty. We're in a period right now of the highest inflation that we've seen in 40 years. We've experienced very rapidly increasing interest rates over the first half, and we've also seen weak economic growth. Infrastructure is a resilient sector as we know, and our infrastructure exposure has low business cycle risk, which has softened this effect. Next one, just moving right to the right is rising interest rates. And to put this in perspective, if you look at sort of an average increase in dollar rates and the increase in spreads and sterling rates and the increase in corporate bond spreads, and you sort of average those together, you're looking at an increase of 330 basis points. And as Steve mentioned on the earlier slide, yield on our portfolio has gone up by 280 basis points. So again, infrastructure debt has shown itself to be a low beta sector. Nonetheless, these rapidly rising rates has caused turbulence in the financial markets. And it's fair to say that there has been some near-term mark-to-market impact on SEQI's fixed rate portfolio as a result. I think the flip side of this, though, is that we have an ability to reinvest our short date -- relatively short-dated fixed rate paper at higher interest rates. And also, I think it's really important to say, as Steve mentioned, that there is a pretty significant pull-to-par effect that is quite meaningful going forward. On the bottom left-hand side, we talk about currency volatility. And the dollar has been really strong as the Fed has rapidly increased those short-term interest rates. And that's versus the euro and the sterling, and our hedging strategy has really managed this volatility well. And just most recently, we've seen FX movements moderate on the back of a more fiscally prudent U.K. economic strategy. And then lastly, in terms of losses, I think it's important to highlight what is our actual loss rate. And you can see right there on the bottom right-hand side of Page 6, if we consider all sources, it's 47 bps a year. And we need to remember that we have a B, BB credit quality portfolio. And to put that number in perspective, you can see that for a Ba1 portfolio, this is Moody's data, historical loss rate is 52 bps a year. So we've come in under strong BBs despite having a B/BB portfolio.

Turning to Page 7. This sets out some of the very favorable tailwinds that we're currently seeing, which will drive the portfolio performance in the coming years. The first one is the pull-to-par effect, which we've already talked about, which will add, all things being equal, about 3.3p to the NAV over the next 12 months and about 6p per share over the next 3 years. The second is rising interest income driven by the floating rate portion of the portfolio, and that obviously adds to dividend cover over time. The third box is very important. We talk here about attractive conditions for new investments. And this is a consequence of 2 factors. The first one is higher interest rates, which mean that it's higher for us to achieve our target yields. The second, these are the leverage loan markets and the high-yield bond markets are both having a very difficult year. For example, year-to-date issuance in the high-yield bond market is over 85% down compared to the same time last year. And what that means is that many borrowers who might normally look to finance themselves in those liquid credit markets are turning to private debt. And in turn, that means that we see a very wide range of opportunities. And when we have discussions with prospective borrowers, we find ourselves in a position of genuine pricing power. We can get good margins and fees but also attractive lending terms, for example, strong covenants. The fourth point is just the amount of infrastructure funding that's required. There's been a record level of private equity in infrastructure raised, that's about $874 billion. Nearly all of that will look for leverage. If we assume it's at least 2x leverage, which is conservative, that means that, that equity will need $1.5 trillion of debt. That's in a market when, as I mentioned, liquid credit markets, including investment-grade bonds, are relatively weak. Bank lending is relatively weak, and therefore, that creates a very significant opportunity for private credit. We're seeing that across all the jurisdictions that we lend in, but I'd also mentioned, in the U.S., the Inflation Reduction Act is creating a tremendous demand for infrastructure investments through the private sector, for example, as a result of the tax breaks that investors can get for investing in infrastructure equity, which in turn will also require more leverage to enhance equity returns and make the projects affordable.

Thank you, Steve. If we just turn to Page 8, please. We'll take a look at some recent investments and some short case studies on these investments. Right at the top, you can see Workdry as the U.K.'s leading provider of essential and emergency water handling infrastructure solutions. They've got a long track record. They've been around over 75 years starting in 1946. The company delivers pump leasing, temporary water and wastewater pumping solutions and modular water treatment and processing solutions to both the water utility sector and customers in the infrastructure construction sector. What we did was we made them a GBP 50 million senior secured loan, which was part of a larger GBP 170 million facility. And we're earning a yield to maturity of 9.5% on that loan. Down at the bottom is Green Genius, and this is part of a Lithuanian-headquartered Modus Group, which is an experienced renewable energy developer. They operate in 8 different European countries. And what we did was we provided them a loan in Polish zloty, and that equates to about a GBP 33 million equivalent loan. Again, it's senior secured, it's for a construction facility, and we're earning a really decent yield of 12%.

Thanks, Randy. Turning to Page 9. I wanted to add some comments on our ESG approach. As many of you will know, this is a very important initiative to us as manager and to the fund. And we have a very comprehensive ESG policy, which in fact is going to be shortly updated and will be available to investors through the fund's website. We started at the time of the last annual accounts reporting under TCFD, and there will be enhanced reporting going forward under a range of initiatives, including TCFD and SFDR. We're also increasingly looking at aligning our investment activities with the UN Sustainable Development Goals. And this slide indicates or shows 9 of those goals that we achieved or helped to achieve through our investment activities in infrastructure debt. To wrap up, turning to Page 10, I want to leave you with the following thoughts. Firstly, we've been through a considerable shock in terms of interest rates, inflation, slowdown in the global economy, before that, the pandemic. And I think the fund has weathered that storm very well due to its high proportion of floating rate loans, a short average maturity, which provides a bedrock stability for the portfolio. Going forward, that increased level of interest income and the increased, therefore, dividend cash cover has allowed us to increase the dividend, target dividend by 10% with prudent coverage ratio as expected on the dividend. And on top of that, we expect the NAV to improve through strong pull-to-par. Portfolio credit quality has been robust. We've seen a loss rate of less than 0.5% per annum, which compares very well to other forms of lending. And that is based upon a rigorous approach to credit selection and structuring, diversification and a proven working capability. On the origination front, we're seeing extremely attractive opportunities. In fact, I would say the fund has never seen a better environment to lending. Interest rates and margins are high, we have tremendous pricing power in our discussions with borrowers. And we're able, therefore, to be very selective indeed on the loans that we put on the portfolio's balance sheet. Finally, I just want to remind you that we're increasing the target dividend by 10% from 6.25p per share to 6.875p per share commencing in the third quarter dividend during January 2023. Thank you very much for your time this morning. And if you can submit questions, we'll answer as many as we can in the remainder of this call.

Well, thanks, everyone. I can see quite a few questions have come through over the last 20 minutes. And Randy and I will do our best to work through as many of these as we can. So I can see there's a couple of questions arising around FX hedging. And I'll talk a little bit about that and try to roll a few of those questions into the same answer. So I think the first question relates to the P&L statement in the accounts. And the question is, why does it appear to show a significant FX hedging loss? And I think the answer is that what's happened over the period is a corresponding liability on there, effectively about 100% hedged. So there is a loss on hedging but a gain on the asset values. Now at the same time, as I talked about asset values and sales fell in terms of the average price at which the loans are marked. So you've got those 2 things going on at the same time in the asset valuation question. When you actually cut through it all and disaggregate the noise, what you get is the effect that you can see on the NAV bridge on Page 5 of the presentation, which is we made a very small gain on hedging. And that's actually just driven by the way in which interest, sorry -- currency hedges get marked and interest rate component to their valuation. On an actual sort of NAV basis, like I said, we're pretty much fully hedged. Also, I'd just like to say, we're clearly -- clearly keep an eye on things like margin call risk and managing the FX hedging book. That's all been very smooth. We have excellent credit lines of our counterparties, and we've been able to manage that hedging risk throughout the process. Turning on to the next question. I've been told my microphone is cutting out. So apologies for that. I hope people got most of that last answer. The next question we've got on this list is around the PIK interest that we received over the period. And as we noted in the accounts and in the presentation, we actually had some exceptional levels of cash interest received predominantly linked to investments, to large investments that repaid. And when they repaid, we collected cash -- sorry, interest that had accrued in cash, obviously, so that adds on to the cash interest cover. But clearly, that's a bit of an exceptional item. And there were 2 loans in particular. One was [indiscernible], which is a subsea data cable, and the second was our refinery deal in Scandinavia, which incidentally was considered a problem loan over the COVID period. But obviously completely turned around and in the end was very, very profitable. If you strip out the effects of those exceptional items as it were, and you look at more of a sort of run rate, it's about 1.16x dividend cover compared to about 1.06 in the previous financial year. And then from the same source, a follow-up question. Any new impairments in recent months? No. No is the answer. Overall, we think the portfolio is in good shape. I think the usual caveat has to apply, which is any loan portfolio clearly has credit risk, and there's always a dispersion of performance around the mean. Some companies overperform, some underperform, but there's no immediate red flags. And we think overall, the portfolio is in really good shape. Randy, do you want do the next part of that question?

Yes, I'd be happy to do that. The third part of that question is what -- sorry, let me just read this. Do we see risks rising as a result of economies weakening? And I think there are a few points to talk about there. Firstly, with infrastructure, we're starting in a strong place. Infrastructure is a resilient asset class providing essential services as we all know. And that last point, essential services, what that means is that it's just not as sensitive as a discretionary corporate, for example, which people can either spend money on or not spend money on. Also with infrastructure using -- using infrastructure represents a pretty small percentage of one's disposable income. And so that also decreases the sensitivity to the business cycle. Secondly, SEQI has a large portion of its portfolio, as we mentioned earlier, in defensive sectors. That's 54% of the portfolio. And that significantly decreases the amount of business cycle risk that we're exposed to. And as part of that, we simply avoid high beta sectors such as energy, E&P. Another important point is that when we make a loan, we do a lot of stress testing. So what this means is that we look at different scenarios, sort of base case, a downside case A, a downside case B, for example. And really what this does is it stresses the revenues, and that stress feeds through to the loan covenants so we can see what the effects are of a decrease in revenues. And we always want to build plenty of a buffer.

I think linked to that, there's a similar -- slightly different question about the greatest GDP risk in the portfolio. Randy, maybe?

Yes. Happy to do that one as well. I would say that's the U.K. I think a lot of people consider the U.K. to be in a recession probably about now. And most economists expect that recession to last for the balance of -- for all of 2023. That's mitigated for us by the fact that we've only got 17.5% of our portfolio in the U.K. And as I mentioned earlier, we are in defensive sectors, largely defensive sectors. There's a related question or a subpart to that question, which talks about our OCR, our operating cost ratio and recognizing that it's low and how do we achieve that. The largest part of the OCR is the investment advisory fee. And when we set SEQI up 8 years ago, we tried to make that very competitive looking at the other funds that are out there. In addition to that, we rescaled and rebased the way that we calculate that fee, which has had the effect of making it even more competitive. And what that rebasing was, was to charge 74 bps per annum for any capital up to GBP 1 billion and then 56 bps per annum for any capital that's raised over GBP 1 billion. So that has the effect of not only making our fee pretty low, but our fee be a smaller proportion of the total fee as the fund grows.

Thanks, Randy. We've got a question in around Bulb, what recoveries that we have to date and what do we anticipate in the future and what effect will it have on the NAV. And I think -- yes, I'm very happy to answer that question. It's -- for the context, the Bulb loan is only about 1.1% of NAV, but it does seem to get quite a disproportionate amount of attention. So to answer the question, we've had GBP 14 million, 1-4 of cash received since last November when the company went to administration. That's about 1/4 of our loan amount has been received already in cash. We expect to receive significantly more cash than that. In fact, right now, there's about that amount of cash in the business as it stands, and there's more cash coming in. And the reason why we are going to get these recoveries is as people are very well aware, Bulb itself is in special administration and may be sold to Octopus. But we have security over the company, which provides all the IT, the systems, the brand name and all the employees. And that company called Simple Energy charges a fee to Bulb and will continue to be able to charge fees once it changes hands, which includes a payment for using the brand and using the IT systems, which means it's a very profitable business. So that's providing a recovery. And that also forms the bases of the mark on the loan, which obviously reflects where we expect recoveries to come. I think there's potential of slide above and beyond that. So one thing we're looking at is ways in which the value of the software can be monetized. And we'll be able to make announcements of that going forward, but we haven't given any credit for that in our valuation on the loan. That's all upside. The way we value the loan is really just based upon cash and cash income that's highly visible. I guess what effect will this have on our NAV, well, it will be minor but positive. I suppose minor in the sense that the loan itself, like I said, is only 1.1% of NAV. So clearly, that creates limited potential for increases and a meaningful contribution. But it's something we're very focused on, and we've marked it cautiously. And I hope there's upside above and beyond that.

We've also got a question on our floating rate exposure. And the question is, is there a desire to increase the proportion of floating debt? And I think the answer to that is that we're happy right now with the exposure that we have. As we mentioned, it's 57% of the portfolio, and that has really served us well as short-term rates have increased. I think as the interest rate cycle matures, we might look to decrease that slightly just around the edges but not yet. But as the rate cycle gets longer in the tooth and it matures more, we might look to do that.

I can see a question here about the investment income line on the P&L statement. And I think the short answer is that accountants don't look at portfolio income in quite the same way as we do, as investments -- as we were making the investments, I guess, it's fair to say. And that number includes realized gains and losses, includes interest income, fees, et cetera. And there's an element of FX going on there as well. And the best way to look at it, frankly, is the NAV bridge that we put into the presentation. And we have a very similar table in the investment advisory report in the accounts. But effectively, if you look at what I would call income from the portfolio, so interest income and fees, that was about 5.3p as I mentioned on the half year, which obviously annualizes to about 10.6%. So very strong interest income. And then the final question we have on the list is about the total NAV impact of problem loans, not just over the period but over time -- excuse me, and this is what Randy was talking about when he mentioned the loss rate. The loss rate is simply any credit losses and includes not just realized losses, but also if we sign an investment to avoid a loss, for example. If you calculate that over time, it works out at a bit less than 0.5% per year, which, as Randy mentioned, compares very well to -- through investment-grade debt. And one way to put that into context is that over the last 8 years, we've earned about 3% more than high-yield bonds, right? That's the illiquidity benefit or the premium you get for private credit versus liquid credit. But our loss rates have actually been slightly less. So our gross yield is 3% higher, and our credit losses are less than you've seen in the high-yield bond markets or the leveraged loan market. So I think that speaks to the sort of risk return characteristics of infrastructure credit.

Thank you, Steve. I think that's it on the questions. And just in closing, we would like to thank everyone for your time this morning on the call. And in closing, we'd like to say that we're in a good position to have confidence, and this confidence has been backed up by action. In the last 6 months, SEQI has bought back shares. The directors of SEQI have bought shares, individuals of Sequoia, the IA have purchased shares. And Sequoia continues to have a substantial position in SEQI shares. Further, these results demonstrate the positive aspects of having a resilient asset class such as infrastructure debt combined with a large floating rate exposure and short average life, which allows for reinvestment at higher rates. Once again, thank you for joining the call, and this concludes the call for this morning.