On the PE situation
jimbob wrote: ↑
Fri May 19, 2023 7:48 pm
bjn wrote: ↑
Fri May 19, 2023 7:15 pm
I thought it was a cleverer wheeze than that. Predatory owners loan the company lots of money, which then gets paid out as dividends. The company now owes the owners money, at some exorbitant interest rate, which it pays back, free of any company tax, for ever and ever. Typically the debt holding shell company is somewhere that doesn’t believe in taxing rich people.
Ivan will probably correct me. But I’ve been owned by private equity before.
Same here. KKR put up 10% of their own money, the rest was bonds on our company, in 2006 at a stupid multiple of earnings at the top of a highly-cyclical industry. In 2008, the CFO renegotiated the debt with the bondholders at 20 cents in the dollar which they took as otherwise they'd get nothing.
Meanwhile KKR had been charging our company significant "management fees" so they made a nice profit.
When I was seconded to Ofwat in 1990, then newly set up, one of the first things we had to do was respond to Northumbrian Water draining cash out of licensed water company into the holding company. Because we knew that would later enable them to hold us to ransom when they needed to fund and finance the large investments in the network that were as bound to come as tomorrow would arrive, especially since some of the cash plumping up the water companies was, according to the models of the water company, intended to enable them to fund and finance part of those investments. So some financial ring-fencing provisions were brought in to stop that more obvious kind of shenanigans. Because some other water companies had quickly spotted what Northumbrian did, and had proposals to copy them. I don't know if Northumbrian had to put the case back, or if they got away with that. But we did stop the others following suit. And this is not me naming the water company I felt I didn't want to name in an earlier post. This much is a matter of history and I am happy to name Northumbrian in relation to it. The same is true of others I name below.
Similarly, when the proposal to turn Welsh Water into a non-profit-making body turned up, Ofwat knew that this could rebound against customers if the water company wasted money (and Welsh Water had been demonstrating an ability to waste money on ill-managed private sector ventures) and ran out of cash. Because there wouldn't be an equity shareholder to take the loss on those ill-managed ventures, it would rebound on the customer. So Ofwat devised a ring-fencing trick that provided some protection. And for all that people complain about any money at all being paid out to shareholders in dividends, Welsh Water acts as a nice demonstration that taking shareholders out of the equation doesn't clearly make things better for the customer in the round. Investment capital has to be paid for, short of demanding that the tax-payer gives it to you for free. And high debt arrangements are not necessarily the best way to minimise the cost of it, as people complaining about high debt PE companies demonstrates.
Then Yorkshire Water turned up with a proposal to turn itself into a non-profit organisation like Welsh Water. But unlike Welsh Water, it would largely be a shell company that contracted out many of its activities to a company owned by the shareholders of the Yorkshire Water of that moment. When Ofwat explained how the ring-fencing provisions of Welsh Water would have to be modified to protect against the obvious abuses potential in that situation - to protect against the contractor inflating costs and making hay - they abandoned it. They had been rumbled. (Mr Branson had a similar trick in his first proposal to run the National Lottery, likewise quickly sniffed out by the Lottery regulator of the time.)
Essentially the PE takeover of a water company presents some of the risks of the situations like the above, while being sufficiently close to the intended model of water companies that the ring fencing arrangements don't protect against it, nor is there any obvious line that would cross at some point. And that does make it difficult to protect against. But given Ofwat were alert to the issues in the 3 cases above, they arguably ought to have been alert to this general issue. Though it is more difficult and I don't have an obvious solution in my pocket to suggest.
On how private water companies are supposed to work and the (other) risks to it working properly
When the water industry was privatised, it was because the govt knew that it had a very large capital program to fund in the water sector, and the public sector borrowing requirement - a restriction on government borrowing that seemingly evaporated later - couldn't fund it. This system would result in water companies having growing balance sheets for a very long time, and hence a perpetually growing requirement to fund the capital they had invested. Water charges would be going up for a very long time.
So it was always expected that the water companies would have to raise a lot of finance to pay for stuff, which customers would not pay for immediately, but through contributions to the cost of the investment finance. And, once water charges rise faster than inflation, to the extent that growth in investment requirements rose faster than efficiency gains.
A risk is that the water company fails to make the investments the charges are intended to fund. In theory, there is protection against this. The water company makes investments, which are then admitted to the "Regulated Asset Base" of the company (RAB), according to actual spending, with a test to ensure that it is legitimate spending. Very rarely, some spending is identified that is disallowed. Water charges include an allowance for interest on the RAB, at a Weighted Average Cost of Capital (WACC). In theory, if there was some investment that the company was supposed to make, and it didn't make it, then it doesn't get admitted to the RAB, and at the next 5-year review, they get no allowance for investments they didn't make. But there is also an element of pre-funding - there's a growth profile to the RAB during the 5-year period, and the allowed charges include a return on that. In theory, there is supposed to be later taking-away if you didn't make the the full RAB investments anticipated, but I'm not sure how well that works.
The general tendency has been for water companies not to make all the predicted RAB investments. So my suspicion is that the systems for adjustment against them aren't sufficiently rigorous, and it pays them not to make the full investments. Also not making the investments ought to rebound to some extent in prosecutions, but it is evident that system doesn't have the entire desired effect, and some take less notice of it than others. And I'm also concerned about the systems for assessing cash-flow in charge setting. Because that is taken into account, because they can't be made to make investments out of cash they couldn't reasonably be expected to have it. So that gives an incentive to get cash out of the company so as to prejudice the starting position for that - the old Northumbrian problem.
Another issue that got badly out of hand was when the cost of debt came down substantially, and it took quite a long time for all regulators to realise that this was not just a short term fluctuation that would average out over the regulatory cycle, but it was going to be very low for a very long time. Even today that nominal interest rates have gone up, they are still negative in real terms, and water charges have RPI correction (another mistake to use that rather than CPI). So the water companies made money hand over fist when they could borrow very cheaply, and the allowed WACC had been fixed at a constant level for 5 years. There was a lot of arguing about how to address this. But ultimately you have to recognise you can't get the genie back in the bottle, and you have to write off the public loss that was made through making a mistake. All you can hope for is to avoid future losses by avoiding repeating the mistake. I think it is now generally understood that the sensible thing to do is index the WACC to the market cost of debt.
And then there is another problem that debt is generally cheaper than equity, so that gives the companies an incentive to overgear with high dept and low equity, and that is an incentive to the PE outcome which isn't very good either. And it seems that has never really been effectively addressed.
On top of that there has been an insidious tendency, as I referred in a previous post, for Ofwat to keep water charges from exploding in the way always inherent in the way that this was set up, by trying to reduce the extent of the capital program that they should invest in. And the population of this country has grown by over 10% since the water companies were privatised, and by rather more than that in the southern parts of the country. And as people got better off, so wealthier people generate more sewage volume (even if they don't defecate any more than other people). And sewage volume is a major driver of overflows into the sea and watercourses. So the Ofwat-limited investments have been insufficient to deal with the growth in sewage volume.
And that is what I understand as the major points of how we have got into this pickle.