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UK utility companies in hot water

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Date Published: 08/05/2024

The UK water industry operates in a complex operational and financial environment which has pushed the sector’s largest company, Thames Water, to the brink of insolvency and raised the prospect of a temporary government privatisation. Thames Water is at the centre of the industry’s solvency crisis, but it is not alone. The utility company provides water to 15 million customers across London and the southeast of England and has drawn growing criticism over recent years due to underinvestment to repair ageing infrastructure, pollution and other service failures, executive pay and shareholder dividends.

Thames Water’s crisis reflects both company-specific and industry-wide issues. Understanding both will help illuminate pre-emptive strategies the broader industry can adopt to safeguard against negative corporate outcomes.

Thames Water’s byzantine corporate structure complicates operations

Thames Water is owned within a convoluted corporate structure between its parent company, Kemble, and the operating company. Kemble Water Finance, one of several debt-issuing financial entities related to Thames Water’s parent, is reportedly on the brink of insolvency unless lenders agree to an eleventh-hour debt-for-equity deal. Urgent restructuring talks are underway to stave off the possibility of a “special administration” which would amount to temporary public ownership.

The corporate complexity dates back to a securitisation structure set up almost 20 years ago after a Macquarie-led consortium acquired Thames Water Holdings in October 2006 from German utility company RWE. The consortium paid £4.8bn, and inherited its then £3.2bn debt, reflecting an £8bn enterprise value. Thames Water was then refinanced via a whole business securitisation (WBS). This structure enabled debt accumulation while limiting creditor liabilities, complicating its financial stability. With an £15.6bn debt, rising interest rates have crippled the company’s liquidity as access to capital markets has become restricted, thereby reducing investment essential for infrastructure upgrades. These factors have contributed to poor operational performance and customer service standards.

Shareholders revolt

Thames Water’s shareholders, including major Canadian and UK pension funds and Chinese and Abu Dhabi sovereign wealth funds, view regulatory constraints as barriers to the company’s recovery. Despite proposing a significant customer price increase as part of a turnaround plan, conditional shareholder support was withdrawn when the regulator imposed stringent conditions. Last October, Thames Water published a turnaround plan that proposed to increase costs to customers by 40% by 2030 in exchange for additional shareholder equity.

Shareholders initially agreed and pledged an extra £750m by March 2025, with the first tranche of £500m due at the end of last month (March 31). Conditional shareholder support was withdrawn after the regulator imposed stringent conditions which made the turnaround plan “uninvestible” the utility company confirmed in a statement. Thames Water confirmed the operating company has £2.4bn in “cash and available committed facilities” and can reportedly continue to function for at least another 15 months even if parent company Kemble goes into administration, However, without new equity, Thames Water faces restricted capital market access, hampering its ability to fund necessary upgrades. A looming £190m Kemble loan maturity exacerbates the crisis, with a default considered probable without a loan extension. “Some form of default is probable and even if lenders agree to amend and extend (A&E) the upcoming loan, it is highly likely that the agreement would constitute a distressed debt exchange”, Fitch Ratings wrote in a note.

Government contingency plans to nationalise Thames Water – dubbed “Project Timber” – could result in some lenders lose up to 40% of their money, according to figures that underpin the potential nationalisation reported by the Guardian. Under the base scenario, category B who hold about £1.6bn of Thames’ operating company debt bondholders, would suffer a 35% to 40% haircut, while category A bondholders, who are owed about £13bn, would suffer a 5%-10% haircut. Shareholders would see their entire investment in Thames wiped out under the renationalisation plans, according to the report.

Thames Water bondholders have reportedly demanded a meeting with the company's management to discuss the situation after its parent company defaulted on its debt. The prospect of impairments to the debt issued by the utility company has rattled bondholders that had assumed the WBS debt finance structure has failed to provide the high levels of security expected.

Thames Water emblematic of industry-wide struggles

The industry-wide struggle must balance consumer affordability with essential infrastructure investment. Regulatory price caps, the burden of high interest rates on large legacy debt piles, the cost of living crisis, as well as the growing impact of population growth and climate change, all complicate this balance. In addition, the absence of internal auditors at many water companies has further weakened governance and contributed to financial instability. Internal audits help strengthen long-term operational and financial resilience and can help identify deficient procedures, systems, capabilities and oversight. Three UK regional water companies — South East Water, Sutton and East Surrey (SES) Water and Portsmouth Water — all lack internal audit functions, the Chartered Institute of Internal Auditors said in a letter to Ofwat Chief Executive David Black, reported by the Financial Times. Highly indebted water companies are struggling to service interest payments but continue to pay out dividends that are not commensurate with company performance. In 2022, the UK’s private-sector water companies paid out an estimated £1.4bn in dividends, despite soaring customer bills, underinvestment in infrastructure and declining service standards, according to an analysis by the FT.

Despite these challenges, M&A activity has continued, with Pennon Group’s recent acquisition highlighting ongoing sector consolidation. In early January, Pennon Group announced plans to acquire SES Water from Japan’s Sumitomo and Osaka Gas for £89m – financed by a £180m equity raise – to expand its operations across the country. Including the firm’s £291m of debt, the enterprise value of the deal is £390m. The deal is subject to a Competition and Markets Authority (CMA) review, which could be complete by this summer.

Reform and recovery

The Thames Water crisis demonstrates a critical need for reform in the UK water industry. Balancing customer affordability with essential infrastructure upgrades and responsible shareholder returns requires a new approach. Water companies must prioritise proactive measures like contingency planning, restructuring and capital raising. Investment in ageing infrastructure and service improvements should take precedence over shareholder dividends. Strengthening financial health through responsible debt management and robust governance is vital. BTG Advisory can be a valuable partner in navigating these complexities. Our expertise in contingency planning, corporate simplification, debt restructuring, independent business reviews, optimised exit planning and turnaround strategy can empower water companies to build resilience and navigate a challenging market environment.

Begbies Traynor Group can advise on schemes of arrangement procedures that allow companies to be restructured without formal insolvency proceedings. Our team can also devise strategies to recover and protect shareholder value, and save jobs. Separately, we can advise on the pros and cons of available options for raising capital and M&A opportunities, whether as an exit or growth strategy. Do not hesitate to contact our team today and let us be your trusted partner.

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