Cracks in the financial plumbing of Thames Water’s complex corporate structure are making debt investors nervous about a supposedly safe financial model widely used across Britain’s privatised utilities and essential infrastructure.
The growing crisis at the company this month triggered a default at its parent firm, which has ricocheted down to hit securitised bonds at the operating companies that were long thought to be bulletproof. The government is now working on contingency plans to nationalise Britain’s biggest water company that include mooted losses for these bondholders.
One tier of debt in the more than £16bn of borrowings within the so-called regulatory ringfence — which surrounds the core utility and means it has to abide by regulatory conditions — plunged to little over half of its face value. The fall highlights how bondholders are now bracing for severe writedowns, even though their investments are supposedly firewalled from trouble at the parent firm.
The bonds are part of a so-called “whole business securitisation” (WBS), a financing technique used both across the UK’s water industry and also for other infrastructure assets and regulated utilities that typically benefit from a consistent revenue stream linked to inflation.
The model, in which Thames Water’s cash flows service different tiers of debt, tends to result in higher investment-grade ratings for top-ranked bonds than standard corporate bonds at companies with similar levels of debt.
Thames Water’s woes are making investors nervous that the debt underpinning the funding model, which the UK government is relying on for the building of new critical infrastructure, could be more vulnerable to losses than previously thought.
“[WBS] was viewed, outside of government debt, as the gold standard of UK fixed income investment,” said Steve Curtis, a finance partner at law firm Latham & Watkins who has advised on a number of water utility debt issuances. “Where we are today represents a huge departure from the original expectations.”
He added: “I don’t think it’s the model which is the issue per se, it’s the shift in the regulatory and political landscape.”
The crisis at Thames Water has been exacerbated by a stand-off between water regulator Ofwat and shareholders, which include the Chinese and Abu Dhabi sovereign wealth funds. The two parties are at loggerheads over both the amount of shareholder equity needed to support the water company, which requires billions of pounds to maintain operations and overhaul its ageing infrastructure, and the size of increases in customer bills that can be imposed.
UK chancellor Jeremy Hunt said last week that it would be “completely wrong” if the firm’s customers had to pick up the tab for bad decisions made by its managers or owners.
Despite the tough talk and contingency planning, some in the debt market believe that the government will be loath to allow the situation to spill over into significant writedowns for the top-ranked bondholders. The same financial model, in which debt is raised against a “regulated asset base” agreed with regulators, is not only used at core pieces of UK infrastructure such as Heathrow airport, but is likely to be used to finance a number of new projects in future.
“The government wants to use the regulated asset base model to fund everything from Sizewell C [nuclear power plant] to the energy transition,” said one adviser close to the negotiations at Thames Water.
“The Treasury is deeply concerned about the consequences of impairing the WBS,” the person added.
Nevertheless, nervous fund managers have been offloading their bonds, according to several distressed debt investors who have been able to scoop up the debt at deeper discounts than their predicted losses. On Monday the Financial Times revealed that US hedge fund Elliott had been buying the bonds.
WBS traces its roots back to the nascent UK private equity industry of the 1990s, when buccaneering dealmakers such as Guy Hands used the cheap financing tool to fund buyouts of household names. The strength of English contract law underpinned a structure that relies on giving different classes of debt differing claims on the cash flows of a company.
The model is rarely used in continental Europe, however, while in the US it is mainly confined to niches such as fast-food franchises rather than essential utilities.
Thames Water’s WBS debt is a legacy of its 2006 buyout by Macquarie. The Australian infrastructure investor, which has drawn criticism for the billions of pounds in dividends it siphoned off during its decade-long ownership, borrowed even more on top of the ringfenced debt through a financing vehicle called Kemble, named after a village in the English countryside near the source of the river Thames.
Kemble’s debt now trades at 13.5 pence in the pound after the water company’s current shareholders backed away from stumping up a promised £500mn of equity and declared the company “uninvestable”, leading to a default on the holding company’s bonds.
In a sign of investors’ nervousness, yields on some of the safest “class A” bonds within the ringfence are now in excess of 9 per cent, compared with about 6 to 7 per cent before the current crisis. Traders are marking a riskier £250mn “class B” bond at little over 60 pence in the pound.
Ripples can now be seen in the implied funding costs of other water companies, with bond spreads starting to widen at privately owned utilities using WBS that generally have higher debt levels. Publicly listed water companies have been more insulated from the market jitters, however, with the spread — or extra yield above government debt — on a €650mn bond at United Utilities rising less than 15 basis points since it was issued in February.
While securitised debt is typically backed with hard assets, government regulation means that Thames Water’s bondholders cannot lay claim to the utility’s pipes and treatment plants in the event of an insolvency. Instead, the debt is secured on claims from the proceeds of a sale to a suitable owner.
This should in theory leave enough cash to repay their debt, but — adding to bondholders’ worries — if a new buyer demands a severe discount to the value that regulators ascribe to the business then investors may have to take losses.
To protect bondholders, the WBS has a series of covenants that lock up cash and impose other restrictions if certain metrics begin to deteriorate.
While Thames Water gave a presentation to lenders in December touting that it was “fully compliant” with its covenants, it forecast that its debt-to-asset ratio would be within 1 percentage point of a lock-up trigger in 2025, even if shareholders put in a further £750mn of equity.
Although these terms are designed to reassure bondholders, they could straitjacket Thames Water’s management, preventing a turnaround at the creaking utility.
“You’re locked into a programme which is very, very difficult to get out of,” said Curtis.
The complexity of Thames Water’s capital structure means that bondholders are now jostling for position, with rival groups banding together and hiring restructuring advisers. In an insolvency, providers of swaps would also rank ahead of bondholders, with Thames Water laden with inflation-linked swap liabilities of more than £1bn.
Further complicating matters, specialised insurance firms have also written contracts protecting some bondholders from a default. New York-listed insurer Assured Guaranty had more than $12bn of exposure to UK water companies at the end of 2023, with more than $2bn to Thames Water alone.
Rating agencies are also starting to take action. S&P this month downgraded Thames Water’s top-ranked class A debt to BBB-, the bottom rung of investment-grade, just one notch above junk.
Marcus Mackenzie, senior counsel at law firm Pinsent Masons, said that if debt within the ringfence started to slip “below investment grade I think people would begin to get nervous about what’s happening here and ask how sustainable are these companies”.
