In recent months, the non-quoted water companies have seen various changes in ownership.
Last year, Macquarie sold its 26.3 per cent stake in Thames Water’s holding company, Kemble, to Borealis – the infrastructure division of OMERS, the Ontario pension fund – and to the Kuwait Investment Authority subsidiary, Wren House.
More recently, the Universities Superannuation Scheme (USS) bought a near 11 per cent stake in Kemble.
Given all the adverse publicity over the weekend about the USS’s £17.5 billion pension deficit, this investment in Thames will be carefully scrutinised.
Yorkshire Water’s ownership is now uncertain. Infracapital, part of Prudential, has recently sold its 10 per cent stake whilst there is some speculation about the long-term commitment of both Deutsche Bank and Corsair Capital, whose combined ownership exceeds 50 per cent.
As for Anglian Water, 3i is considering selling its 10.3 per cent stake in the company.
The Affinity Water situation is intriguing. Its previous owners wanted out and the incoming buying consortium was led by Allianz: the quoted HICL Infrastructure bought a 36.6 per cent stake for £269 million.
The buy case for water company investment has been justified by private equity investors on several grounds.
Most importantly, as monopoly regulated businesses, they generate long-term income from infrastructure assets at the lower end of the risk spectrum.
Capital growth, especially from cost-cutting, is also very relevant.
Furthermore, the inflation-linked pricing formula also provides a valuable hedge against inflation – and can be offset against long-term liabilities.
The Affinity investment by HICL Infrastructure – currently with a market capitalisation of almost £3 billion – merits comment given that it instantly became the largest investment in its 115-asset portfolio, which ranges from Pinderfields and Pontefract Hospitals to the Dutch High-Speed Rail Link.
Whilst this deal fell within HICL’s three chosen sectors – PPP projects, regulated assets and demand-based assets – it scored heavily on HICL’s risk appetite criteria.
Five advantages were cited – a mature regulated framework, a large shareholding, lower operational risk (i.e. no sewerage assets), a robust capital structure and investment in Sterling, which eliminated any exchange risk.
Other infrastructure investors will have different priorities and alternative risk assessments but HICL’s analysis demonstrates why it paid a hefty premium over Regulatory Asset Value (RAV) to acquire a 36.6 per cent Affinity stake.
Currently, the sell case for water stocks is arguably quite strong.
Five specific reasons can be given, all of which a discerning infrastructure investor will analyse and model.
First, in terms of valuation, some recent utility transactions have been undertaken with premia of over 40 per cent when compared with RAV.
Such valuations are seen by some as very racy and may not endure.
The most egregious case of premium to RAV recently occurred when National Grid sold off majority stakes in some of its gas distribution assets, whose growth prospects were felt to be limited.
The buyers of these gas assets had other ideas – and paid over the standard premia to RAV.
Secondly, many private equity shareholders have done well out of their investments – and may feel further upside is limited.
The quoted Severn Trent provides a useful read-across. It was floated at £2.40 in 1989 and the shares are now £21.50 – equivalent to a nine-fold rise although some relatively minor adjustments would be needed to reflect various capitalisation issues.
Thirdly, and looming large over all water sector investment, is the next periodic review, which is due to apply in April 2020.
Perhaps inevitably, recent smoke signals have indicated a tougher review this time round, with the pivotal weighted average cost of capital (Wacc) assumption likely to be less accommodating than in 2014/15.
Certainly, some water companies under private equity control, most notably Thames – the target of a recent Ofwat financial fishing expedition – are vulnerable to tighter regulation: the latter’s net debt is £10.7 billion.
Fourthly, UK interest rates are expected to rise, albeit slowly; however, this view has been prevalent for almost a decade since the financial crisis of 2008.
The nominal Wacc prescribed by Ofwat for the next review will be closely correlated with the long-term structure of interest rates – especially the yield on the 10-year Treasury Bond.
Fifthly, following June’s unexpectedly close general election result, politics also comes into the mix. The next election is not officially due until 2022 but there is every prospect of a nation-wide poll well before then.
Given the Labour party’s better than expected performance – and the scope for a deal with the SNP – many investors will be distinctly nervous of a government led by Jeremy Corbyn.
After all, page 19 of Labour’s manifesto proposed the establishment of “regional publicly-owned (water) companies”.
On that basis, investors might well be whistling for their dividends – the key driver for private equity investment in the sector.
In the lead-up to the periodic review, further shareholding changes are expected, especially if Ofwat’s ranking system produces clear-cut winners and losers.
Interesting times on the water-front.