Amidst all the wheeling and dealing, ogling over prices and red-carpet style profiles on the new exotic entrants, it’s easy to lose sight of one of the most interesting things happening in the UK water sector right now – namely, how its return profile is effectively being re-written.
In all fairness, this has not gone unnoticed. Last December, PriceWaterhouseCoopers (PwC) published a report highlighting that the sort of 20 percent returns enjoyed by UK water company owners in the mid-2000s were a high water mark.
These days, PwC argued, returns are more likely to remain in the 10 to 12 percent range, with transaction multiples expected to stay in the range of 1.25 to 1.35 times enterprise value /regulatory capital value. “However, beware – if you pay this much for one of the low or underperforming water companies, you may need to lower your shareholder expectations,” PwC warned.
The key here is “shareholder expectations”.
Since the beginning of the year, institutional investors have been struck by what might be termed ‘core infrastructure fever’. This is especially evident in Europe, where, as Swiss private markets specialist Partners Group has pointed out, prices for core infrastructure assets have become inflated.
Within Europe, the UK water sector is arguably the object of a new gold rush, with some eye-popping premia being paid, if market rumours are to be believed. Case in point: February’s sale of Sutton and East Surrey Water to Japan’s Sumitomo Corporation for a reported 40 percent premium to the utility’s regulated asset value, generating a two times return for the sellers, an iCON Infrastructure-led consortium.
Thirty to 40 percent premia being paid in year three of the five-year regulatory cycle – surely that’s a tad too much? That’s certainly what most of you seem to think, according to the poll currently sitting on our website (see p.12). But that all depends on “shareholder expectations”.
Once we accept that some institutional investors are happy with returns of between 8 to 10 percent for core infrastructure assets, as Partners Group recently noted, then we have to face the very real possibility that returns for the UK water sector might be depressed beyond PwC’s 10 to 12 percent estimate.
The litmus test, once the dust settles down, will be to look at the prices paid for the water assets currently changing hands and, crucially, who the assets’ new owners will be. It’s easy to suspect that the end result will be a combination of high multiples and institutional investor ownership.
The next question then becomes: who are the winners and losers of a UK water sector offering lower returns?
A clear winner will be UK regulator Ofwat, which will be able to boast of lowering the sector’s cost of capital and ending an era of private equity type investors with what some cynics would see as bloodsucking tendencies. And the losers? That’s a trickier question to answer.
Depending on the balance of power, infrastructure funds might not be in the best of places if they become the minority participants in a roomful of institutional investors. In this scenario, it’s easy to see how a newly empowered Ofwat might shed few tears for their hard-to-achieve return requirements when implementing the next round of regulations.
But those willing to accept lower returns should also pause to think about the sort of message they are sending to the regulator and how vulnerable they will be to Ofwat’s whims.
The UK water sector is clearly in transition and its return profile is going down. Now we just have to find out how low it will go.