The collapse of Thames Water highlights the potential risks of private market investments.
When Thames Water, the UK’s biggest water company, announced earlier this month that it was drowning under the weight of being £16bn in debt, many LGPS investors might have breathed a sigh of relief that they were not significant shareholders.
The utility giant, which was privatised in 1989, is owned by a consortium of institutional investors including USS, which held a 20% stake; Canadian public sector retirement fund Omers; Dutch pension fund PFZW; Infinity Investments; and Federated Hermes, the asset manager of the BTPS Pension Scheme.
But the collapse of Thames Water raises broader questions about the government’s push to promote pension fund investment in UK infrastructure.
Under water
The company risks going under water as rising interest rates exposed more than a decade of excessive lending and underinvestment. Last year, Thames Water attempted to borrow £1.5bn from its existing shareholders but only succeeded in raising £500m. This resulted in the resignation of its CEO and subsequent talk of renationalisation.
Speaking at a House of Lords hearing earlier this week, David Black, the chief executive of water regulator Ofwat, told members that the regulator should have intervened as early as 2006 to prevent excessive levels of gearing, but had been unable to step in due to a “hands off” approach to intervention adopted by New Labour.
He also argued that this was indicative of a wider problem: “It happens in the energy sector, it happens in the transport sector, so we are very clear we think that companies need a prudent financing structure and some of these legacy financing structures need to be brought up to date,” he warned.
The collapse of Thames Water is bad news for its external shareholders, who hold a very concentrated stake in the company. USS, which manages around £90bn on behalf of university staff, announced only six months ago that it has increased its stake to 20%. Investors are now forced to fork out more cash, in a bid to prevent potential nationalisation. But USS has also been quizzed by The Pensions Regulator over whether taking such a significant stake was in line with its statutory duty.
LGPS exposure
While Thames Water has been an extreme case, LGPS investors will be keeping a close eye on the latest developments. Having built up their infrastructure allocations over the past few years, with many funds holding around a third in private markets, LGPS funds that invest in UK infrastructure are likely to hold a private equity stake in utilities in some form, albeit often less concentrated.
For example, Border to Coast runs a significant private markets programme but invests through dozens of private equity managers, including Macquarie Funds. But the pool’s stake in individual firms is therefore a lot less concentrated.
The flipside to that is that a broadly diversified private equity portfolio is likely to impact a pool’s ability to exercise stewardship over the assets it holds.
In contrast, GLIL, the infrastructure platform owned by the Northern LGPS and LPPI, among others, does hold direct private equity stakes, including a 7.5% position in Anglian Water.
“LGPS funds will certainly be holding water companies and one reason is that the government has encouraged us to invest in infrastructure,” said William Bourne, principal and director at Linchpin Advisory. “The government might want to think about that,” he warned.
A safe haven?
Another reason for LGPS investment in water is that these companies have been promoted as core infrastructure assets which were very low risk, because they have little economic sensitivity, argued Bourne.
“Actually, water is quite risky, and the risk is not economic, but regulatory,” he said. “That is why a number of managers, including at Southern and Thames Water, have run into trouble over the last three or four years.”
A key reason for the increased levels of regulatory risk is that the regulators’ stance has shifted from prioritising low bills and paying relatively little attention to investment, to a growing awareness – driven by public pressure over sewage leaks and poor services – that investment was desperately needed. “There has been a culture of not spending which is now changing because people are realising that it needs investment,” said Bourne.
As a result, water companies have been facing a sharp increase in fines. Since 2015, around £141m has been handed out in fines, but more than two thirds – over £100m – of those fines were issued since 2021, as political pressure is mounting. This includes Anglian Water, which was hit by a £2.65m fine earlier this year for allowing untreated sewage to spill into the North Sea.
“One of the lessons to watch out for is that if investors think that there is increased regulatory risk in UK infrastructure, then they are going to charge a higher premium, they are going to want to have more to invest. There is a regulatory risk and investors are now going to think much harder about it,” explained Bourne.
A private equity problem
The perils of Thames Water have sparked a debate on the merits of privatising companies that operate in a natural monopoly. Others, such as the Financial Times’ Helen Thomas, have pointed out that water may not have a private ownership issue, but a private equity one. She highlighted that listed water companies such as Severn Trent, United Utilities, South West Water and Welsh Dwr Cymru tend to operate with much lower levels of gearing.
Between 2006 and September 2022, Thames Water’s debt pile grew from £3.2bn to £14.3bn with most of its borrowing being taken out against its assets.
Bourne broadly agreed with the assessment that the company’s ownership structures had accelerated the problems. “In theory, private owners could be perfectly decent, but the big issue is that private equity gears up, that is what they are there for. Academic theory would say that you should gear up because you have got a very steady income stream, but the chickens are coming home to roost now because the cost of finance is going up exponentially,” he added.
“Overbearing is not just bad news for the water industry, any company which is overgeared and had to refinance in the short term will struggle, they may have had interest rates of 1 or 2% and now they are going to be 7, 8 or even 9%,” he added.
Liquidity risks
Despite these challenges, LGPS investors should still remain open to the utilities sector, says Bourne. “It’s always in the price. Over the next few years there are going to be fantastic buying opportunities because people are going to get into trouble and if you have got the liquidity to provide the finance, investors are going to make a lot of money. But there is also a huge potential to get it wrong and many people have overpaid for what they have got,” he warned.
Investors who are seeking exposure to the asset class should be in it for the long run, Bourne added. “Water is a very long-term industry. We’re talking about a time horizon of 50 to 100 years. You shouldn’t be in it unless you’re there for the long term,” he said.
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