Over the past 20 years or so one theme has dominated the capital markets as far as the UK utility networks have been concerned - namely the move of ownership from public market investors to private market investors. This phenomenon has led to the situation where there are now only three large listed water companies and the vast majority of the gas and electricity distribution networks are now in private (i.e. non-listed) hands.
What is interesting about this trend is that it has been so long-lasting. Private buyers - who range from sovereign wealth and infrastructure funds to private equity and hedge funds - have bought every network that has come onto the market since the early 2000’s. Not a single UK utility network company has been bought by a trade buyer in that period (with the partial exception of SGN where SSE took a large minority stake), nor have any of the privately-owned companies come back to the market via a re-listing.
The reason for this trend is both simple and complex. The simple bit is this: private market buyers have consistently valued UK utility networks more highly than their public market colleagues. The more complex question however is: why have they been willing to pay more? There is no single answer to the more complex question. Each deal is different and as mentioned above the private market buyers themselves have a wide spread of business models and funding sources. Nevertheless, there are clearly some key characteristics of the private side that has allowed them to consistently out-bid public investors.
The first and perhaps most important is leverage. Private side-owned networks typically carry considerably more debt than publicly-listed network companies. This extra leverage means that returns to equity can become super-charged should the company perform well (in cash management terms). The second characteristic is that private side owners inevitably establish holding company structures above the operating company. This allows them to both carry even more leverage and also put in place efficient tax structures - especially for the repatriation of profits back to the largely overseas owners. The third characteristic is linked to the first two, and is the close alignment of management pay and incentives to company performance and particularly to cash generation and management.
When private side buyers first appeared nearly 20 years ago Ofgem and Ofwat decided to take a hands-off approach to ownership. They decided in effect that there was no detriment to consumers for these companies to be taken private. Safeguards were put in place to protect the viability of the regulated company itself (Opco). For example, all Opcos have to maintain an investment grade credit rating and the regulators can prevent cash flowing up to the holding company (Holdco) from the Opco in certain circumstances.
At the time some commentators including myself expressed concern that the structures being put in place by the private buyers could become problematic, and that the advantages private buyers had over the public market investors potentially distorted the market for assets and could in turn distort future investment decisions. However, despite these concerns the vast bulk of UK utility network assets have indeed been acquired by private side investors.
Over time however, political and regulatory concern over the structures and practices used by some of the private side buyers has grown. The nascent backlash took a huge step forward earlier this year with an exchange of correspondence between Michael Gove, Secretary of State for the Environment and the Chair of Ofwat, Jonson Cox. In this correspondence Mr Gove asked Ofwat to look at certain issues, including highly geared structures, securitisation, off-shore financial arrangements, high levels of executive pay, and high dividends. Whilst the issues of high pay and dividends can also be applicable to the listed water companies it is clear that the main thrust of the concern was aimed at the private companies.
In April Ofwat issued a consultation document entitled ‘Putting the sector back in balance’ as part of their PR19 process and on 3 July they published its decision document. Ofwat intends to impose a number of new, and potentially significant, requirements on water companies that they must include in their business plans for the PR19 price control period. First, those companies with leverage above the nominal company level (c60% debt/ Regulated Asset Value (RAV)) will need to offer up a benefit sharing mechanism. Whilst Ofwat will allow companies to suggest their own mechanism it is clear that consumers should be receiving at around 50% of the financial benefits of additional leverage.
Second, that companies must set out dividend policies for the period 2020-25 in their business plans. Ofwat will require the companies to clearly set out how dividend payments stem from service delivery. Also, Ofwat states that any company anticipating a dividend yield over 5% (against RAV) must provide further explanation and justification.
Third, companies must carry out a detailed financial resilience assessment. This is effectively to stress test the financial structure, including group structure, against a number of downside scenarios. Basically, the aim appears to force the companies to test whether or not they are carrying enough equity finance to absorb shocks.
Fourth, companies must set out their executive pay policies demonstrating a clear link between high pay potential and “exceptional delivery for customers”. The aim here appears to be to force companies to link management incentives more to customers and away from financial management.
On the face of it, Ofwat’s proposals could radically impact on the business models of the water companies and particularly on those with the more financially aggressive private side owners. The practical effect may be somewhat less dramatic however. For example, the benefit sharing mechanism will only apply to debt held at Opco level and not Holdco. To protect their returns companies may just move the debt up the structure - although that will likely come at a cost.
Nevertheless, this represents the most significant move by regulators to date to address some of the perceived problems thrown up by the move to private ownership. By themselves these proposals are unlikely to fully re-balance to attractiveness of these assets between public and private market investors, although they may eventually be seen as the beginning of the process.
Cornwall Insight Associate Peter Atherton is a well-known equity analyst having headed utility research at several eminent City institutions, most recently Jefferies, and is a respected utilities commentator.