KKR & Co. is eyeing one of the riskiest deals going right now — buying the owner of London’s creaking water and sewage system, Thames Water. Giving a private equity firm the chance to profit from fixing the mess Thames got into under past private ownership looks bad but makes sense. The snag is that a transaction will require painful negotiations with, and between, the creditors who hold the cards.
Thames has two big financial problems: It has too much borrowing, and it needs to raise £4 billion ($5.3 billion) to deliver its capital expenditure program in full. Hence the company is exploring a debt restructuring. In parallel, it appointed KKR as preferred bidder last month after canvassing interest from new investors. Due diligence is now hastily underway.
The first goal should be to cut debt to a level where Thames might potentially regain an investment-grade credit rating. In practical terms, this could mean wiping out junior creditors and existing shareholders, and writing down the senior creditors’ £16 billion of claims so that Thames’ net borrowings fall to £12 billion. Leverage would then be a sensible 60% of regulatory capital value (RCV, the regulator’s measure of the capital invested in the business.) As compensation for taking a haircut, senior creditors would have to receive the equity.
Now for the tricky bit — the new money. The simple option would be for a fund run by KKR to inject £4 billion into Thames by buying new shares that amounted to a large controlling stake; the precise percentage of the holding would be the nub of negotiations.
KKR is an experienced infrastructure investor. The result would be a Thames with a strong credit rating, a budgeted investment plan and clean, unconflicted governance.
With that framework in place, the task of fixing the operations could get underway in earnest. It would be a long haul. Eventually, Thames could return to the public markets and KKR could start realizing some returns.
There would be banana skins on the way. Thames will likely miss performance targets, and it’s flagged future fines. The regulator faces a dilemma. Should it cut Thames some slack, so that penalties don’t eat up cash that could be spent on investment? That would benefit both customers and the utility’s new owners. But it would come at the cost of sending a message that water companies get let off when they’re in difficulty. The lesser evil would be to show forbearance. After all, punishment has already been meted out on Thames’ past creditors and shareholders.
Fast forward to the early 2030s, the soonest point Thames could plausibly stage an initial public offering. KKR would need to have increased the RCV, currently £20 billion, substantially. This measure of value expands with investment, and Thames is already looking to lift the measure 30% in real terms. Perhaps RCV could by then be around £35 billion. Getting there would depend on regaining the trust of the debt markets to support more capital expenditure.
While analysts value some of the publicly traded water firms above RCV, it would be more realistic to see Thames aspiring to be valued at a modest discount, say 10% to 15%. If KKR had put in £4 billion, it would want its share of the equity value to be worth around £10 billion to generate decent returns. Even assuming net debt has climbed higher, that looks doable. The math worsen if KKR has to put in more cash along the way.
As things stand, the alternative to this scenario would be the creditors staging the rescue. They just need to find £4 billion from those investors in their midst who are willing and able to invest in Thames shares. The creditors really need to do this — if only to prevent KKR dictating the terms of any rescue deal against their interest. But they’re a diverse group, the better-known members being BlackRock Inc. and Elliott Investment Management. Some will be able to hold debt and equity investments, and some only debt.
Given that all creditors would benefit from putting pressure on KKR, those who could invest in Thames equity should be able extract a quid pro quo from those who can’t.
Imagine that the creditors succeed in devising their own Plan B. The risk then is that Thames’ governance isn’t completely stabilized, even if its finances are. Even among the creditors that could own a slice of Thames, the tolerance for holding this illiquid stock for the many years it would take until an IPO will vary. Some will surely want an exit sooner rather than later. The logical thing to do would be to phone KKR and see if it wanted a second bite of the cherry.
It would surely be better to see Thames move to one long-term controlling shareholder as soon as possible and then focus on the repair job. The creditors need to have the credible threat of rejecting any KKR deal. The hope must be that this would be about getting the best terms from the US buyout firm rather than seriously wanting to take over.
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