Utility Week

UTILITY WEEK | 12Th - 18Th MAY 2017 | 17 Finance & Investment Analysis L ong-term infrastructure investors have pounced on Affinity Water. The deal comes hot on the heels of the recent purchase of a 26 per cent stake in Thames Water's parent company Kemble Water by a consortium of Canada's Borealis, manager of Ontario's municipal pension fund, and the Kuwaiti Investment Office. Affinity supplies clean water, predomi- nantly in the Home Counties around London. Buckinghamshire, Bedfordshire, Berkshire, Hertfordshire and Surrey are key markets, although its supply area also includes Dover, Folkestone and – for arcane historic reasons – the Tendring peninsula of Essex. It sup- plies about 3.6 million people through its 16,500km network and, importantly, it does not undertake sewerage-related operations. Affinity's origins date back to the contro- versial offensive made on the former statu- tory water companies by French suppliers in the lead-up to water privatisation in 1989. The largest French water company, Com- pagnie Generale des Eaux, made several acquisitions that – via Three Valleys and Veolia – eventually morphed into Affinity. The sellers of their existing 90 per cent stake are Morgan Stanley and Infracapital: the remaining 10 per cent is being bought from Veolia Water UK. The two members of the consortium buy- ing Affinity are Allianz Capital – an offshoot of the massive German insurance company – and the publicly quoted HICL Infrastructure. Just under two-thirds of the cost is being financed by Allianz. It believes that, despite the ongoing political rows over Brexit, the UK still offers attractive prospects for long- term infrastructure investment. HICL, which is a FTSE-250 member, has prospered in recent years and is now capital- ised at £2.8 billion; it was the first UK infra- structure investment company to join the main market when it listed in 2006. In terms of its rationale for investing £269 million for its 36.6 per cent Affinity stake, HICL has highlighted some key benefits – no doubt Allianz shares similar views. HICL considers Affinity's future income projections lie at the lower end of the risk spectrum. It also welcomes the sector's mature regulatory framework and, interest- ingly, the lower operations risk compared with investing in a company with heavy sew- erage-related exposure. For Affinity's management, few changes are anticipated – but time will tell. The com- pany's chief executive, Simon Coates, says: "As a business, we will continue to operate as normal, focused on achieving our strate- gic objective to become the leading commu- nity-focused water company in the UK." In the medium term, the issue of the next regulatory pricing review will loom large. Last time, Affinity distinguished itself by being accorded "fast-track" status – along with South West Water, the core business of the publicly-quoted Pennon – which con- ferred certain financial benefits. In the lead-up to the 2019/20 review, the issue of the prescribed weighted average cost of capital (Wacc) will loom large, as always. However, this time round, the trend may be upwards if interest rates rise significantly, as is widely expected a¦er their plunge because of the 2008 financial crisis. Further US rate cuts seem virtually cer- tain, the term structure of UK interest rates is less clear, although some members of the Bank of England's Monetary Policy Commit- tee are believed to support higher interest rates – and better returns to savers than has been the case over the past decade. Clearly, if higher interest rates do occur, investors will expect the Wacc to be adjusted accordingly. Inflation, too, may come into the equation because the post-Brexit plunge in sterling seems certain to push up retail prices. In fact, because of their very wide operat- ing margins, a dose of inflation – a feature of the regulatory system for water – normally benefits water companies. More specifically, the acquisition of Affin- ity – once allowance is made for net debt of £850 million at September 2016 – values its equity component at £750 million. Given the March 2017 Regulated Asset Valuation of just over £1,150 million, this implies that Affin- ity's acquirers are paying a healthy premium. Such a premium, though robust by histori- cal standards, is lower than that recently paid by the successful bidders for National Grid's surplus gas distribution assets. The latter, though, do have higher demand growth pros- pects, especially if Hinkley Point C turns out to be the UK's last new nuclear build project. A¦er the announcement of the Affinity sale, it was to be expected that the share prices of the three quoted water companies, Severn Trent, United Utilities (UU) and Pen- non, would respond positively. In fact, the upside was modest, although Severn Trent did rise by 1.7 per cent on the day of the announcement. Having been targeted by private equity bidders for some years, Severn Trent is the most obvious read-across from the Affinity deal. Nonetheless, much of this speculation has been accounted for in its share price rat- ing for several years. Neither UU, a less likely target for private equity, nor Pennon, with its more cyclical Viridor waste business, saw its shares rise appreciably, hardly a surprise to sector fol- lowers. A¦er all, Affinity had undertaken a strategic review in recent months – and a sale to an infrastructure-based consortium was widely seen as a likely outcome. That scenario has now come to pass. Nigel Hawkins, director, Nigel Hawkins Associates Investors pounce on Affinity Nigel Hawkins considers the fallout from the acquisition of Affinity Water and the prospects for the company in a market dominated by uncertainty about Brexit. LONDON Luton Harwich Dover Folkestone Clacton Stevenage Harlow Woking Watford Saffron Walden Guildford AFFiNity'S SuppLy AreA

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