There is a water main break every two minutes and an estimated six billion gallons of treated water lost each day, enough to fill over 9,000 swimming pools. This is not a picture of the water infrastructure situation in an emerging market, but in the economic powerhouse that is the US, as depicted by the American Society of Civil Engineers.

What’s more, an estimated six to 10 million homes still receive drinking water through lead pipes and service lines, as President Joe Biden outlined last year when first proposing his infrastructure plans. The US Centers for Disease Control and Prevention have warned that there is no safe level of lead exposure for children: it can lead to slow development and cause learning, behavioural and hearing problems in children, as well as lasting kidney and brain damage.

When it comes to water, the need to modernise infrastructure for 2022 is not the only problem the US faces, as the issue may be in other subsectors as well. Decades of underfunding and underinvestment have created a genuine public health issue.

But is this particular tide turning? While President Joe Biden’s initial ambition of investing $111 billion in water-related infrastructure improvements was eventually watered down, the Bipartisan Infrastructure Law did secure $55 billion of investment in the sector. This comes on top of increased investment in the sector by private players, which has reached a high watermark.

According to insight from McKinsey in November, while M&A transactions in the sector remained relatively flat between 2012 and 2017, increasing by around 2 percent annually, between 2018 and 2020 that annual rate jumped to 16 percent. Private equity and infrastructure fund-led activity grew at an even faster pace – by 26 percent annually – over the same three year-period.

New York-based firm Ridgewood Infrastructure has been at the heart of this trend. In February 2020, it reached its $600 million hard-cap on the Ridgewood Water & Strategic Infrastructure Fund, whose investments include Vista Ridge, a 30-year contracted, 142-mile pipeline to supply the city of San Antonio, Texas, with approximately 20 percent of its fresh water.

“The water subsector represents one of the most attractive sectors we focus on,” says Ridgewood’s managing partner Michael Albrecht. “It’s a massive market which has had tremendous underinvestment. It’s extremely fragmented and that creates a deep opportunity set to invest.”

Ullico, the Chicago-based manager, is also dedicating significant resources to this space. It invests via the open-ended Ullico Infrastructure Fund and made its first such investment in 2012. The GP has since gone on to consolidate its investments in a regulated utility platform within the fund, adding the Arizona operations of Triton Utilities in December and the Michigan American Water Company in February.

“Existing utility valuations have been high for some time, so we started thinking about ways to start with a smaller utility and build up from that,” explains Jeff Murphy, managing director at Ullico. “That’s a way to get water into the portfolio, while also continuing to push the concession model.”

This kind of market requires significant hands-on asset management and a size that benefits infrastructure’s flourishing mid-market fund space.

“Many infrastructure subsectors don’t offer the combination of size, fragmentation and investability as the water subsector,” believes Albrecht, although he offers another reason for the growth of interest in this sector:

“There’s an opportunity to make a tremendous ESG and sustainability impact. It’s embedded in our process, and water infrastructure represents a huge opportunity to implement our ESG and sustainability goals, given that underinvestment. I think that’s a huge part of it.”

ESG considerations from GPs and LPs also go hand in hand with an increased interest in infrastructure as an asset class, according to Ullico’s Murphy, whose fund is predominantly comprised of US-based LPs.

“For a period of time, US pensions weren’t looking at infrastructure that much. Now, they’re very much allocating [to it] so there’s cheaper capital flowing into the sector and lowering that cost,” he says.

The three Ps: Pipes, prices, procurement

While there may be a demonstrable increase in interest and activity, it may well still take a brave investor to wade into the US water sector. Structural issues remain, with the aforementioned lead pipes high on the priority list of problems to solve.

“It’s been out of sight, out of mind for decades,” says Erik Olson, a director at the non-profit Natural Resources Defense Council (NRDC) and a former general counsel for the US Senate committee on environment and public works. “We’ve known it’s been a real public health danger, but most people don’t know they have them or have never checked, so there’s been very little action taken on lead pipes.”

Fixing that will require a substantial outlay that the announced federal funding can only partially cover. The US Environmental Protection Agency also estimates an investment of up to $839 million per year to replace and monitor the 9.7 million to 12.8 million lead service lines that are in use across the country. To which must be added funding to address ageing infrastructure in water distribution, whose 45-year-old network experiences significant leakage issues. For private sector players like Ridgewood and Ullico, this will also mean addressing the relationship with public authorities.

“A primary structural issue on the public side is the need for infrastructure investment broadly. Given that dynamic, the water industry has not allocated the amount it needs,” maintains Albrecht. “This represents an example of why the private sector could be a partner to cities and municipalities. On the private side, a tremendous amount of capital is invested every year. Given historic under-investment, it is only a drop in the bucket. We’re partnering with cities to provide solutions.”

Murphy is also confident that the private sector’s assistance could help alleviate some of the issues that have plagued the sector in the past, particularly with regards to customer rates.

“Rate maintenance is needed to procure the water, clean it, deliver it and [pay for] the customer service needed and those rates haven’t kept pace, even with inflation,” he argues with regards to publicly managed water.

“Rate setting has been more political and when people hear water rates are going up, there’s pushback. If you’re not doing preventative maintenance, your capital expenditures over time get much greater. If the maintenance had been done previously, they could have kept pace with smaller rate increases over time to cover their future capital costs. Those are much greater now. To solve the problem now is even worse. We would maintain assets a lot differently to the public sector because we have a contract saying ‘you have to perform at a certain level’.”

Awaiting the BIL

Given that the Bipartisan Infrastructure Law will deliver only half of Biden’s initial ambition, the historic federal funding still won’t be sufficient to fix long-standing issues. And given the majority of the funding – $43 billion – will flow through the Clean Water and Drinking Water State Revolving Funds, as the EPA outlined in a memo in March, there will be limited scope for private sector involvement. In other words, the BIL will not be an overnight solution.

“The federal spending, as welcome as it is, is not enough. Setting that aside, one of the key aspects is to send money to communities that need it the most. Disadvantaged communities should be prioritised,” says the NRDC’s Olson.

Murphy agrees that the priority is to fix the most basic needs through the BIL, after which there might be a greater role for firms such as Ullico.

“More than anything, what it will do is drive more activity in infrastructure generally,” he reasons. “Even if 80 percent of that money goes to municipalities, just generating that money will help on the private side as well. Once they get the money for the low-hanging fruit that has been on their list for a while, it will clear up their agenda to look at other things that need to happen, maybe through some more innovative structures.”

Starting the conversation with federal funding can bring indirect benefits to the private sector, adds Albrecht. Yet chronic underinvestment means the battle begins against the tide.