Uncertainty over the impact of impending regulatory reform in the shape of this summer’s Water Bill has caused speculation of a slowdown in merger and acquisition (M&A) activity in the UK water sector. Concerns about Ofwat’s pricing methodology in the context of PR14 have also been mooted as having a potential negative effect on the level of premiums payable in transactions.
In fact, 2013 has seen a fairly high level of deal activity in the sector, notwithstanding the uncertain regulatory climate and that we find ourselves in the third year of the five-year pricing cycle. Sales of both South Staffordshire Water and Sutton and East Surrey Water reached financial close early in the year, while a small stake in Thames Water also changed hands in April and a consortium of investors made a bid to take Severn Trent private over the summer (now aborted).
Neither the publication of the Water Bill in June nor Ofwat’s final methodology and business plan expectations for PR14 in July appear to have dampened activity. In spite of the early December deadline to submit business plans, there has reportedly been a potential sale process involving stakes in Kelda, Yorkshire Water’s holding company, and Southern Water has recently announced the sale of a minority interest to Canadian investor Northleaf Capital.
Equally, premiums to regulatory capital value (RCV) payable for investments in the sector appear to be steady at or above 30 per cent, at least in cases where the whole business is sold (even the recent Northleaf minority acquisition of a less than 5 per cent interest in Southern Water is reported to have changed hands for just over 20 per cent premium).
Payment of a 30 per cent premium to RCV is comparable to the premiums paid in the same period of the previous pricing cycle pre-financial crisis. For example, Royal Bank of Scotland sold Southern Water in 2008 for £4.2 billion, estimated to be a 27-30 per cent premium to RCV (amid speculation that such levels were unsustainable). Similarly, Kelda was acquired in a take private bid in 2008 for around 134 per cent of RCV. In 2011, Cheung Kong Infrastructure took Northumbrian Water private for a 27 per cent premium to RCV, suggesting a resilience in the valuation of water companies under the PR09 regime, notwithstanding wider economic conditions.
This year, Sumimoto Corporation’s acquisition of Sutton and East Surrey Water in February was reported to be at a premium of 40-50 per cent to RCV, although analysts put this at closer to 30 per cent once discounted to take account of the groups’ property portfolio and non-regulated activities. This was in spite of the sale process being overshadowed by Ofwat’s controversial proposals (dropped in December 2012) to introduce flexibility in UK water company licences to remove parts of their business from the current wholesale price control framework.
It is notable that the consortium bid for Severn Trent, also at a 30 per cent premium, was rejected this summer on the basis of management’s “belief that Severn Trent has a value to our shareholders above the level indicated it was willing to pay”.
Despite negative commentary, and notwithstanding regulatory uncertainty and pricing concerns, it seems that both water companies and investors continue to expect a significant acquisition premium above RCV. Investors will have been reassured to note the removal of provisions from the published Water Bill that would have enabled new entrants in the sector to provide last-mile infrastructure. Incumbent operators had raised concerns that this could lead to asset stranding, and have a possible negative impact on underlying RCV. The Bill also includes a new primary duty for Ofwat to secure the long-term resilience of water supply and sewerage systems, and a general emphasis on long-term planning.
Ofwat continues to face difficulties in reconciling political pressure to push down bills for consumers with continued capital investment requirements. This balancing act was recently put into practice in the context of Thames Water’s proposed interim determination to fund its “super sewer”. Caution should be exercised in using this interim review process as a barometer for PR14, though – Thames may not be representative, having had the largest capital investment programme of any company during the current period.
The cost of capital argument will be a strong element of PR14 submissions across the industry and the outcome of that argument will be a significant factor in M&A prospects in the sector going forward.
Steven Bryan is a partner at Hogan Lovells LLP