Assessing leverage in infrastructure projects (and Infrastructure Funds)

Article originally published on Investing.com, written by Camila Affonso and Joseph Boukai, in partnership with columnist Carlos Heitor Campani.

In this article, developed in partnership with Camila Affonso and Joseph Boukai, Partner and Consultant at Leggio Group, our goal is to highlight the importance of assessing leverage when making investment decisions in infrastructure projects or funds. We'll walk through how to analyze the key risks and the quality of debt so you can compare opportunities, calibrate expectations, and avoid the trap of returns that look high but aren't sustainable. Let's get into it.

Why look at debt?

Assessing the debt of infrastructure projects, whether investing directly or through an FI-Infra (Brazilian Infrastructure Investment Fund), isn't a minor technical detail; it's a central piece of the investment thesis. By nature, this sector is capital-intensive and depends heavily on long-term financing.

If the debt structure is well built, investors tend to get predictable returns for many years. On the other hand, if it's poorly sized, even a good asset can turn into a headache, leading to lower profits, distribution cuts, and value destruction. So it's essential to look beyond yield.

The Analysis Compass: Two Essential Metrics

To start, two essential metrics help answer basic questions: "How dependent is this project on debt?" and "What's its capacity to service that debt?". Here they are:

1. Net Debt/EBITDA: indicates how long it would take the company to pay off its debt using current cash generation. The higher the multiple, the higher the risk.

   
   

2. DSCR (Debt Service Coverage Ratio): measures the relationship between available cash flow and debt service (interest + principal payments). For example, a DSCR of 1.3x means expected cash flow is 30% higher than what's needed to cover scheduled principal and interest payments, providing a safety margin of roughly 30%.

Important: These metrics need to be assessed case by case. A debt level that looks high in a cyclical sector might be perfectly sustainable in a regulated business with predictable revenue. Likewise, a comfortable DSCR today can mask risk if it's based on overly optimistic demand assumptions. And always remember: metrics are a starting point, not the final verdict.

Creditor Protection: Covenants

On the lender's side, there are covenants, contractual clauses that set limits (such as a leverage cap or a DSCR floor) and restrictions designed to protect the creditor's cash flow and, in turn, ensure debt service is met.

If a covenant is breached, the creditor may demand early repayment or additional collateral. For shareholders or fund unitholders, that's a delicate situation that can drain the company's cash. As a result, shareholders and creditors share an interest in keeping covenants properly respected, which increases the likelihood that creditors receive what they're owed.

The World of FI-Infra Funds

In Infrastructure Investment Funds (FI-Infra), these concepts connect to four main risks that affect the returns of fund unitholders:

• Interest Rate Risk: negative impact on the fund's share price from rising interest rates, both through mark-to-market effects and higher debt refinancing costs.

• Credit Risk: the possibility of default or forced renegotiation with creditors.

• Liquidity Risk: difficulty selling the asset or fund shares on the secondary market.

• Regulatory Risk: changes to concession rules, tariffs, or tax benefits that hurt unitholder returns.

When analyzing an FI-Infra fund, the focus shouldn't be the fund's own debt (typically low and not particularly meaningful), but rather the leverage of the assets within the portfolio. Is the fund concentrated in greenfield projects (i.e., under construction, with higher risk) or brownfield assets (mature assets, with lower risk)? Is the fund buying "sound credit" or "stretched credit"?

Red Flags

Management reports offer valuable clues that can serve as warning signs. Watch out for the following:

• Rising leverage trend: debt increasing without a proportional rise in cash generation or clear productive investment.

• Falling DSCR: especially if the ratio approaches the minimum levels required by covenants.

• Frequent renegotiations: repeated requests for waivers (temporary covenant forgiveness) or rating downgrades.

• Artificial dividends: distributions consistently exceeding cash generation (payout > 100%) or sustained by asset sales and/or non-recurring cash flows.

Conclusion

Leverage metrics aren't magic numbers — they're compasses for navigating risk with your eyes open. Looking only at annual yield is like buying a property based solely on the rental income, without checking its structure, its neighborhood, or other relevant factors.

When investors understand the key leverage metrics, covenants, and debt profile, they become better equipped to tell well-compensated risk apart from disguised risk (which is likely poorly compensated, if at all). In a long-term portfolio, that discipline is worth more than any "hot, quick tip." Investors who keep track of the quality of leverage in the assets they hold — whether directly or indirectly, through funds, for example — make fewer mistakes, sleep better, and are more effective investors.

*Carlos Heitor Campani holds a PhD in Finance and serves as Academic Director of iluminus – Academia de Finanças, Partner at CHC Treinamento e Consultoria, and Researcher at the Cátedra Brasilprev em Previdência and at ENS – Escola de Negócios e Seguros (School of Business and Insurance).

*Camila Affonso is a Partner at Leggio Group, Director of the Infrastructure Department at FIESP, holds a Master's in Corporate Finance from the Université de Bordeaux, a Specialization in Finance from COPPEAD/UFRJ, and degrees in Production Engineering and Mathematics from UFRJ.

*Joseph Boukai is a Consultant at Leggio Group, holds a Finance specialization from COPPEAD/UFRJ and a degree in Chemical Engineering from PUC-RJ.

Link to the article as published on Investing.com: https://br.investing.com/analysis/avaliacao-da-alavancagem-de-projetos-de-infraestrutura-e-de-fiinfra-200474340