They are low-risk, they are regulated and, most importantly, they are boasting threefold increases in profit over the past year. It is no wonder that bidders are scrambling to buy the UK’s water companies.
It started with a trickle, with Aguas de Barcelona’s £165m springtime takeover of Bristol Water, but this month saw three major bids in as many weeks, with the City’s finest riding the wave.
In the pipeline is German group RWE’s disposal of Thames Water, the takeover of AWG, which owns Anglian Water, and the sale of South East Water (see table).
A quick survey of the landscape shows that the rash of bids for water utilities is driven by two types of investor: private equity funds from oil-rich Gulf states or pension funds, particularly from Australia and Canada.
The sale of Thames Water could be Europe’s largest infrastructure deal this year. The Qatar Investment Authority paired with UBS to make what is believed to be the highest tender to date, at £10bn. Rival bidders include private equity group Terra Firma, Australian bank Macquarie and compatriot utilities group Alinta.
Slaughter and May corporate partner Charles Randell, who is leading the team advising Thames Water, says: “There is a trend among a number of pension funds in this country, in Australia and in Canada, which have very demanding pension-funding requirements, and a number of those investors are looking for secure, low-risk investments that operate better returns than bonds. Regulated utilities aren’t subject to recessionary cycles.”
In Australia pensioners pay into superannuation funds. Having exhausted investments over there, funds are now looking to the UK. According to Freshfields Bruckhaus Deringer corporate partner David Higgins, unlike private equity, these funds seek steady if not dramatic returns over the long-term, with which they can match pension returns.
Higgins is the lead partner advising the Osprey consortium, whose increased bid of £15.78 a share for AWG was recommended by the water company’s board last Monday. The key investors in the Osprey consortium are Colonial First Estate of Australia and CPP Investment Board of Canada, which the Canadian government formed in 1997 after underfunding of the national pension scheme emerged.
So why is the water sector flavour of the month? UK water utilities are regional monopolies, regulated by Ofwat (water is the most maturely regulated sector). It is Ofwat’s frequent auditing that is contributing to funds’ love affairs with water, enabling fairly accurate projections of profit.
Ofwat controls the maximum price at which companies can sell water over five-year periods. Until 2010, its companies can sell water at up to 4.2 per cent above inflation, the highest rate permitted since 1995.
But there are rumblings that bidders are overpaying for water companies. In the case of AWG and Thames Water, bids keep increasing to deter rivals. Osprey’s original bid for AWG represented a 14 per cent premium on its share price the day before the sale announcement. Although AWG recently revealed its profit had trebled to £109m, it has the highest debt levels of any British water company.
Berwin Leighton Paisner (BLP) corporate partner Patrick Somers says: “Highly leveraged deals such as these carry a risk element. These are very favourable times in terms of the financial instruments available that enable these highly leveraged deals to stack up. The danger is that all it takes is one to default on the debt for market sentiment to go belly up.”
It is a truism that assets will fetch what they will fetch, and that investors will only be interested in water if they think there is an advantage to buying now rather than later.
Merrill Lynch head of global infrastructure investments Michael Carrick says: “I don’t think it’s a question of overpaying. The risk profiles of water companies are now beginning to be better understood and in recognition of that, the value of the companies is rising.”
Analysts predict that Ofwat’s next price controls, for the 2010-2015 period, will be tougher and more in line with recent fiats, when companies were allowed to charge only 1 per cent above inflation. For private equity funds looking to flip an asset in four years’ time that matters.
But for other investors, particularly the new kind of long-term investors we are seeing, such as the pension funds, this is less important.
“People are investing because they have access to stable regulatory framework rather than because of a particularly favourable return. It’s a utility that’s always going to experience investment and I’m confident that the regulator will encourage sensible pricing,” says Carrick.
BLP’s Somers – formerly general counsel at Lattice, which owned gas company Transco before it merged with National Grid in 2002 – predicts that although water is flavour of the month, we can expect to see increased interest in other utilities in both the UK and Europe in the near future.
The magic circle has the strongest representation in this sector. But there are challenges.
Somers says: “I would agree with magic circle partners when they say that you need experience in certain areas. But what we’ve tried to do is bring people in from infrastructure backgrounds, and the client really appreciates that: we know the loopholes they’ll face.”
BLP is the longshot entry in the race between firms to advise on water deals. Somers’ team is advising not only the Thames Water board, but also South East Water on its £665m secondary buyout by Hastings Infrastructure Fund, a
subsidiary of Australian bank Westpac, which already owns Kent Water.
Expect as much of a battle between firms to score instructions as between their clients to grab the asset. Freshfields for one has laid down the gauntlet. “Utilities deals are here to stay,” says Higgins, “and we intend to be on the most high-profile [ones].”