Exuberance doesn't just hit returns – it hits regulation too

UK water illustrates how intense competition can threaten to destroy the conditions that attracted investors to a sector in the first place.

When we talk about increased competition in the core infrastructure space, mostly we talk about how it hits returns – or, as we did recently, how it affects managers' strategies. But there is another area affected by the kind of exuberance we’ve seen in the core space: regulation. 

It's a vicious circle – investors pile into regulated assets looking for stable, predictable cashflows; market frothiness turns regulatory heads; and suddenly, the conditions that attracted them in the first place are in danger.

UK water is a case in point. A perpetual hive of activity – as recent deals for Thames Water and Affinity Water attest – there are growing signs that regulator Ofwat is considering changes that may make the sector substantially less attractive for the next five-year regulatory period, starting 1 April 2020.

Driven by “a steer towards affordable tariffs for customers”, as ratings agency Standard & Poor’s put it in a recent note, allowed returns on equity could be reduced to between 3.5 percent and 4.5 percent from today’s 5.65 percent. Ofwat is also proposing to link the cost of new debt taken on by companies to an index, exposing it to potential rises in interest rates. 

Finally, while the watchdog is thinking about broadening the range of metrics on which investors can achieve overperformance, to partially offset the cut in returns, it might also stiffen penalties – and make them potentially unlimited – to punish “inefficient operators”. 

If these measures go ahead, S&P predicts the sector’s cashflows will become more volatile, making it less attractive than it is today. Or put differently, we may soon look at the pre-2020 years as the golden age of UK water.

This is not entirely surprising when you look at some of the premiums paid for UK water assets and combine them with the political pressure the regulator is under. For example, Morgan Stanley and Infracapital recently sold Affinity Water for around £1.6 billion to a consortium of Allianz, HICL and DIF – a nearly 40 percent premium to its £1.156 billion regulated asset base, as of 31 March.

That’s a substantial premium on top of a regulated return for a company operating in a sector accused in a 2016 Public Accounts Committee report of making £1.2 billion in excessive profits between 2010 and 2015.

But that’s not the end of Ofwat’s worries. As S&P outlines in an April note, “high valuations suggest increasing acquisition-related debt leverage”, which means it’s likely “buyers will seek more complex financing solutions, which provide ratings uplift or ring-fence the operating company”. 

To further heighten concerns, debt has been pretty cheap for UK water companies, with Northumberland Water issuing a 10-year bond last October paying 1.625 percent. Perhaps unsurprisingly, S&P finds the sector’s adjusted debt-to-RAB ratio to be well above Ofwat’s assumed average of 62.5 percent (for example, Northumberland’s adjusted debt-to-RAB ratio stood at 78 percent for the financial year 2015-16, with Affinity’s at 77 percent).

Which brings us full circle to “affordable tariffs” and the consumer side of the equation. Way back in 2011, Thomas Putter, a former chairman and chief executive of Allianz Capital Partners, coined a very catchy and prescient term – “social dynamite”. In Putter’s view, Western consumers were unaccustomed to the idea of paying for their infrastructure and were proving resistant to it.

Six years of stagnating and/or declining living standards later and you can argue that resistance has turned into downright hostility, with some of that ‘social dynamite’ starting to detonate in the form of Brexit and the election of Donald Trump.

It’s against this tense backdrop that regulators such as Ofwat must strike a very delicate balance between one man’s profit and another man’s profiteering. That’s enough to make even the most experienced tightrope walker slip.