Thames Water has announced £750m (€878m) of funding from its shareholders as it seeks £1bn of urgent funding to turn the privatised UK water business around. Investors, which include Canadian and UK pension funds, and global sovereign wealth funds are apparently committing the capital by April 2025 if certain conditions are met.

In last week’s analysis of Thames Water, it was argued that the regulator, Ofwat, was “outflanked” by private equity and possibly inadvertently encouraged the ramping up of leverage and an inadequate level of investment. But others point the finger more at the company’s board and its investors.

“Of course, it could be said that the regulator could have done a better job,” says Georg Inderst, independent adviser to pension funds, institutional investors and international organisations. “But at the end of the day, there is no question that the main responsibilities lie with the corporate management and its board – even for a regulated company. Investors and the public should be holding them to account.”

Ludovic Phalippou, professor of financial economics at Oxford University’s Saïd Business School, says: “This case illustrates the problems with the private-equity model. The investor is allowed to load debt onto a company and extract dividends. When things go well for the company, and sometimes even if they go badly, the investor makes their profit and the taxpayer is left to pick up the bill. Associated with this is the tax treatment of carried interest which is, frankly, ludicrously generous.”

Georg Inderst

Georg Inderst: “There are clear implications for reputational risk for investors in such a high profile infrastructure investment”

Carried interest is a share of profits earned by general partners of private equity, venture capital and hedge funds. The share of profits is already large at 20% of the total gain. Crucially, for tax purposes, it is charged as capital gain, attracting generally lower rates in all jurisdictions than on income tax.

This has been a hot political topic in the US, both on grounds of inequity and inequality. It also could raise considerable revenue, estimated at $180bn in the US over 10 years in 2021. There has been less debate in the UK. At least until now. 

Minesh Mashru, global head of infrastructure investing at Cambridge Associates, pushes back. “I do not consider that this calls the private-equity model within infrastructure in general into question,” he says. “It is very rare that this type of situation arises, considering the many thousands of infrastructure investments that have been made. The sector delivers robust performance for investors and enables access to finance for important infrastructure projects as well as technological change. Even in these very volatile times, the sector has proved itself to be resilient and provided investors good returns.”

Mashru adds: “It would be unfortunate if this became part of a wider attack on private equity, or if fundamental questions were raised about the benefits of carried interest to support alignment. Investors must take the necessary risks to create the utilities of the future, as we have seen recently within the telecoms sector and increased focus on digitisation.”

Instead, the focus should be on ensuring “alignment of interests between all stakeholders and that high investor returns are linked to good long-term performance by any asset”. He says: “There are many successful examples of this, especially recently in the renewables sector which continues to deliver and is significantly financed by private-equity investors.”

Perhaps, as Inderst suggests, “private infrastructure investors need to pay much more attention to earning the ‘social licence’ to operate essential services and public goods for the longer term”.

Pension funds ‘left holding the baby’

 Ontario Municipal Employees Retirement System (OMERS) 31.777% 
 Universities Superannuation Scheme (USS)  19.711%
 Infinity Investments (subsidiary of Abu Dhabi Invesmtent Authority)  9.9%
 British Columbia Investment Management Corporation (BC()  8.706%
 Hermes GPE  8.699%
 China Investment Corporation  8.688%
 Queensland Investment Corporation (QIC)  5.352%
 Aquila  4.995%
 Stichting Pensioenfonds Zorg en Welzijn (PFZW)  2.172%

Macquarie, the original private-equity owner of Thames Water, is now long gone, having sold the business in 2017. The current list of Thames Water shareholders is an interesting one. Many are overseas, including the largest shareholder (31.8%), Canadian pension fund OMERS, British Columbia Investment Management Corporation (8.7%) and even the China Investment Corporation (8.7%).

The largest UK investor is the Universities Superannuation Scheme with some 19.7 %, which is understood to be the pension fund’s largest single holding. Group chief executive Bill Galvin recently said he was backing Thames Water’s latest turnaround plan.

Inderst notes: “There are clear implications for reputational risk for investors in such a high-profile infrastructure investment. Water is clearly a very delicate area, and in most countries, water is not in private hands but in public ones – or at least in tightly regulated public-private partnerships. Thames Water had a long history of issues around sewage pollution, and you have to ask how investors felt that there would not be reputational issues. What is striking with Thames Water, in particular, is that most of their issues have been in the public domain for a long time.”

Mashru says: “Managers and investors have to be very focused on the reputational risk involved in investing in asset classes that are subject to public and political focus. This is a key due-diligence point in how investors must assess any opportunity going forward. It is as important to assess the reputational risk in any investment and part of their fiduciary responsibilities.”

He adds: “There will be some changes in the way investors behave going forward. There was a time when investors regarded regulated companies as safe investments – that view has now started to shift. [There] is likely to be a different approach to leverage and more scrutiny on supercharged leverage that has been undertaken by some investors.”

Inderst agrees. “It is clear that asset owners must look much more carefully at the finances and the operational management of infrastructure investments they are making,” he says.

“All too often, in the case of pension funds they are far too used to delegating responsibilities to investment managers, and even the big ones don’t necessarily have the dedicated appropriate resources to do this. For example, the inflation linkage of some of Thames Water’s financing strikes me as not very clever and should have been a red flag for investors.”

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