In a new research publication from the EDHEC Infrastructure & Private Assets Research Institute, entitled "Low Tide, Benchmarking Risks in Infrastructure Investments: What the data showed about Thames Water," we ask what investors in Thames Water in the UK would have learned about the risk of their investment and its likely market value had they compared its characteristics to market and peer group data.
A large water and wastewater utility like Thames Water epitomises the “stable and predictable” cash flows that investors are attracted by in the infrastructure asset class. However, in December 2022, the value of this investment was impaired by almost 30%, an abrupt and unexpected loss of approximately GBP1.5bn (the company was previously valued at c. GBP5bn by its owners) for investors including UK, Japanese and Canadian pension plans. Only nine months earlier, in March 2022, some investors were still increasing the valuations of their stakes.
In our research, we show that a straightforward comparative analysis reveals the emergence of a high-risk, low-return profile that should have raised several red flags and prompted long-term investors seeking a ‘boring’ investment to reconsider.
For a large water utility to lose so much value so fast, the investment must in fact have been mispriced for several years leading up to the impairment. Our assessment is that its value had indeed been decreasing for years and will likely decline more from the current reported valuation.
Without this analysis, investors fell prey to a form of self-referencing or ‘absolute thinking’ that unfortunately remains very common in infrastructure investment: it’s about the one asset, not the market or peers. This narrow vision can obscure the big picture and the role played by market dynamics i.e., the systematic drivers of the fair market value of private infrastructure companies. Because infrastructure assets are large and illiquid, once invested, it can be hard not to ‘fall in love with your position’ since it is difficult to change easily or quickly. But taken in isolation, a single asset is often more of a story than a hard quantitative assessment.
In our paper, we argue that benchmarking the key characteristics of the asset would have provided a much better understanding of its risk profile. Taking a relative view requires representative and robust information to build benchmarks and point of reference to which the risks and performance of infrastructure assets can be compared. When this information is available, investors can better understand the kind of investments they have made, because they can compare them to the right benchmark. We use such a database of financial data for similar and comparable investments and examine the difference between robust but representative benchmarks and the data available for Thames Water and Kemble Water.
Most infrastructure assets are in some ways unique and will differ from the average in their sector or country. However, when compared with a large and robust sample, any large differences from the benchmark provide indication of not only how unique an infrastructure company is, but also of how confident (or worried) investors should be about its ability to deliver “stable and predictable cash flows”. The difference between an investment’s characteristics and its benchmark does not necessarily signal problems, but it is something that investors should be able to understand and explain; and, in some cases, it can be a red flag.
We discuss three red flags that investors could have considered long before Thames Water had to be impaired at the end of 2022. Had these red flags been identified up front, they could have been a cause for remedial action or a revaluation of the asset earlier on.
Red flag #1: the company should not have been expected to behave ‘normally’ as its incentives were distorted by an extremely low regulatory weighted average cost of capital (or WACC) that could only logically push it to take on too much risk to achieve the level of returns required by the market. While this is true of the whole sector, the gap between Thames Water’s market WACC and its regulated version is the largest of all of its peers.
Reg flag #2: As a response, investors in Thames Water created a structure to extract the maximum amount of cash as fast as possible, which also created a huge debt pile, leading to a necessity to conserve capital. It should have been clear from 2016 onwards that there would be no potential for further payouts for many years.
Red flag #3: Thames Water’s exposure to key risk factors that have been shown to drive market prices has been high, and rising, for a significant period of time: this leads to an increasingly higher market risk premium and therefore discount rate and a likely loss in value that was not recognised for years.
These findings should have at the least led the latest investors to question the reported value of the company – not to mention the fact that the reported valuation had in fact increased over time – because they all signal that Thames Water should have instead been losing value for many years. Using our own benchmarks to generate a comparable set of data points for a typical company with the same characteristics as Kemble Water, our measures of risk factor exposure, duration (exposure to interest rate risk) and likelihood of dividend payouts signal that the firm is likely to have lost between 30% and 50% of its value over the past decade, in large part due to the evolution of its risk profile and the market price of risk.
While this does not constitute a formal assessment of the fair value of Thames Water and its holding company, it is a robust point of reference from which investors should have questioned what they knew and the valuation of the asset.
Low Tide Benchmarking Risks in Infrastructure Investments: What the data showed about Thames Water
