A plug pulled

In the view of the Telegraph newspaper, consumers were handed a lucky break when the LongRiver consortium of institutional investors stopped knocking on the door of UK listed water utility Severn Trent and walked off in a huff.

The consortium – comprising Canada’s Borealis Infrastructure, the UK’s Universities Superannuation Scheme and the Kuwait Investment Office – had come to the door with three informal proposals. On each occasion, according to the consortium’s version of events, they effectively had the door slammed in their collective face.

In a statement, Borealis’ president and chief executive Michael Rolland said: “Since we submitted our [first] proposal on 14 May 2013, no member of the consortium or its advisers have met any of the directors or advisers of Severn Trent, despite repeated requests. The Severn Trent Board has shown no interest in discussing our pre-conditional offer with us.”

The Telegraph said that, because of the “highly leveraged and complex corporate structures” adopted by some UK utilities that have been taken private in the past, consumers and the wider water industry had “perhaps been served well by this outcome”.

With all due respect to that august publication, our view is that is it has missed a very important point. Whatever the rights and wrongs of the “first generation” of private ownership of UK water companies by private equity and infrastructure fund managers, we are now entering the “second generation” of ownership by institutional investors (of which a successful Severn Trent bid would have been a good example).

In theory, this is an evolution to be welcomed – at least it is if you accept the initial premise that the first generation of owners had a tendency to over-leverage (which is disputed, though it’s widely acknowledged that there were some unfortunate flirtations with complex financial instruments such as inflation swaps).

After all, pension funds, insurance companies and sovereign wealth funds are the supposedly long-term, responsible, financially conservative owners that the UK government has been hoping and praying will buy up swathes of the UK’s infrastructure.

Pensions and insurers have an instinctive wariness of debt because of their solvency requirements, so it’s hard to envisage them over-burdening the balance sheets of investee companies with leverage. They are also seeking to match their liabilities – meaning they are in it for the long term and unlikely to bail out under pressure for an exit or when the going gets tough.

Because of this, institutions are also likely to receive a warm reception from the regulator, as indicated by a recent interview we conducted with Peter Ho of Hermes GPE (which manages UK pension money and has a stake in Thames Water) when he said: “We’re engaged at the company and industry level to shape the development of the industry and add to its attractiveness – for example through lower leverage, which the regulator supports as well.”

This is significant given the comments of Jonson Cox, boss of industry regulator Ofwat, when earlier this week he said he would “lift the veil” on UK water companies’ “practices that do not stand the test of public interest” and said the industry should improve its standards or face tougher regulation. This was ominous, with a regulatory review – including the power to limit the amount customers can be charged over a five-year period – due next year.

For institutional investors, the kind of punitive review that now looks probable holds fewer fears than it would for shorter-term investors. After all, they will hold their stakes for the long term, in the process riding through a number of reviews – some of which will be favourable, others unfavourable. They can afford to take a pragmatic view.

This may explain why LongRiver was apparently prepared to stump up a price representing a premium to Severn Trent’s regulated asset base of around 34 percent (putting it at or near the peak valuation for UK water assets since the Crisis). It’s a stark reminder of the current lure of core infrastructure, the UK’s safe haven status – and the competitive tension arising from a dwindling supply of available assets.

The question on everyone’s lips is why Severn Trent rebuffed the consortium’s approaches – and appeared to do so with some haste and decisiveness on all three occasions. If the reports are to be believed, some of Severn Trent’s own major shareholders are among those left puzzled.