Unlock the Editor’s Digest for free
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
In 2008, some companies that people thought were too big to fail failed. Shotgun M&A was a popular response, with Bear Stearns, Merrill Lynch, Wachovia, HBOS and Alliance & Leicester all moving overnight to new ownership. Though individual outcomes were mixed, the basic concept was successful enough to try again in 2023.
Money is more important than water to the daily functioning of financial markets, so the GFC had a sense of urgency lacking in the Thames Water crisis. That’s why, five months after Britain’s biggest water utility published its bailout plan, we’re still being confronted with stuff like this.
[Click to enlarge]
That maze above is an outcome-probabilities chart published today by JPMorgan. For what all these letters and interconnections mean, the bank also provides a key:
[Click to enlarge]
A reminder of how we got here: Thames Water Utilities is the Ofwat-licensed opco that’s owned by a topco called Kemble Water Holdings.
Shareholders of KWH have said they won’t provide a £500mn equity downpayment they’d previously pledged to make this month, because regulator Ofwat won’t agree to their demands. These demands, covering the 2025-2030 regime, are to “approve a 56 per cent real-terms increase in bills by 2030 as well as [give] leniency on dividend rules and fines for pollution and other service failures,” our MainFT colleagues report.
Kemble Water Finance, the main holdco, has a £190mn loan due April 30 that it can’t pay and probably won’t be able to refinance. Debt is secured by share pledges on the opco vehicle, Thames Water Ltd, so insolvency could mean lenders take possession of a big water company no one wants.
The least bad option in the short term might be to offer a loan extension, so Ofwat has more time to cave to shareholder demands. That’s the JPMorgan analysts’ base case:
On the margin, we think a short term extension to await regulatory/equity clarity may be in lenders’ best interests, but enforcement risk remains on the table. With 15 months of liquidity, and assuming holdco debt is extended, there is still a window to source equity from existing/new shareholders. However, better regulatory allowances from Ofwat are critical to drive up Thames Water’s valuation and incentivise equity investment. We think Ofwat may be willing to offer modest regulatory concessions, but will be constrained by competing political factors (unpopular bill increases vs. the risk of Thames collapsing).
Or, to put it in a visual form:
OK. But what happens if playing regulatory brinkmanship doesn’t deliver a decent compromise?
As referred to above, the opco’s £2.4bn in cash (as of Feb 2024) provides about 15 months of liquidity. But covenant levels will deteriorate as this buffer burns down, so the equity value will quickly move from little to nothing.
Holdco debt is on the same trajectory:
Agreeing on a debt-for-equity swap in these circumstances looks tricky. Disappearing equity value means there’s no guarantee that funding raised will cover the £16.9bn of holdco debt. What’s needed is a debt-for-equity swap at very deep impairments combined with new equity, but lenders won’t want to agree terms of a rescue without knowing how far Ofwat is prepared to bend.
Without an agreement, Thames Water could fall under state control via a special administration regime. SAR only applies to regulated opcos that are insolvent, however, or have flunked on service quality. The failure of a non-regulated entity like Kemble Water Finance is, in isolation, not enough.
Nevertheless, a lot hangs on avoiding negative equity. The balance sheet test written into SAR legislation would be triggered if Thames Water’s enterprise value is below its £15.6bn of net debt. Given the £3.25bn equity funding hole and need to pay countless environmental fines, it’s a challenge. If the holdco is declared insolvent, it becomes an even bigger challenge.
For what it’s worth, JPMorgan is cautiously confident that topco insolvency can be avoided, and focuses on the compromises required at lower levels:
One worst case outcome we see as plausible is an opco debt restructuring that marks opco gearing down to 55-60% (Ofwat’s gearing target). This implies opco haircuts of 15-25% at the class A level. A valuation discount of this magnitude may be sufficient to attract new equity investment, but if not, the UK government could step in and own Thames Water itself. In our view, special administration is not imminent, but remains a tail risk that will increase with time. Overall, opco haircuts of 15-25% reflect a plausible downside scenario that credit investors should consider when making their investment decisions, in our view.
All of this hints towards a way forward. It’s path two of JPMorgan’s flow chart above, where Thames Water’s opco is sold to new private shareholders that commit substantial new equity. Old shareholders would be wiped out and lenders would take whatever haircuts would be needed to reset gearing.
What’s missing are new private shareholders for Thames Water. High distress levels and uncertainties make that no surprise. When it’s in the interests of equity holders to advertise that their equity is worthless, which new investor is going to step up?
That’s why the most elegant solution is to engineer a GFC-style shotgun merger for the common good.
Next door to Thames Water’s patch is Southern Water. It’s about a quarter of the size by customer count, but its 62-per-cent owner, Macquarie, has lots of relevant experience. Raising the £3.25bn in equity funding is a big ask, but the Australian bank has proven itself to be a skilled manager of UK utilities, having extracted £2.7bn in dividends and £2.2bn in loans from Thames Water between 2006 and 2017.
Macquarie says on its website that it will “play a leadership role” in improving UK water-industry infrastructure and complains that most pollution incidents fall outside its direct control. “Macquarie wants Southern Water to go further and faster and to share learnings with its peers to ensure successes can be replicated nationwide,” it says.
What better way to demonstrate that commitment than with a bit of regulator-aligned benevolent M&A to create a national champion? If nothing else, it’d be a welcome example of a utility owner cleaning up its own mess.
Further reading:
— A quick guide to Thames Water’s serpentine capital structure (FTAV)
— Seven common misconceptions about the Thames Water crisis (FTAV)
— Let Thames Water die to teach everyone a lesson, says Citi (FTAV)
Read the full article here