Guest Column | January 12, 2022

Private Investment Trends In Water And Wastewater Utilities

By Christopher Mackin

Initial advice for utilities considering privatization, public-private partnerships, and consolidation

As the population increases and more people live in water-scarce regions, more demands are placed on already stressed water resources and systems. In the U.S., many systems struggle with aging infrastructure and increasingly extreme weather events including droughts, floods, and freezes.

The water sector, municipal officials, and local governments face many barriers to properly addressing these issues — from fragmentation within the industry to increasingly stringent standards and regulations, as well as limited funding. Moving from publicly operated water services to privatization and/or consolidation may be an attractive option for communities that want to improve their water systems. Receiving investments from private equity partners and/or combining resources with nearby utilities offers municipal water systems the potential to improve their efficiency, sustainability, and fiscal stability. This consequently offers value to communities if it streamlines processes and reduces their costs.

There is significant demand for new water supplies, novel wastewater treatment, and potable and non-potable water reuse, but local decision makers should understand all of the variables to ensure their communities are protected. This article explores many facets of privatization, including:

What’s driving the current demand for improved water systems in the U.S.?
Why are investors interested in water and wastewater utilities?
What utilities should understand when considering privatization, public-private partnerships (P3s), or consolidation.
How to plan a successful merger or acquisition.

What’s Driving Demand In The U.S.?

Demand for private acquisition of water systems in the U.S. has been increasing for a while. Between growing communities in water-scarce regions, aging infrastructure, and years of underinvestment, plus financial stresses exacerbated by the pandemic, the private sector is positioned to help — especially when considering historically low interest rates and increased support from governments around the world to transform outdated systems.

Growing Population

Most of the growth within the water and wastewater treatment market is driven by rapidly growing population and urbanization. New residents can strain current systems as they move to areas with limited water supplies, and research has projected that many regions of the U.S. experiencing population growth — including parts of the Great Plains, the Southwest, central Rocky Mountain states, California, the South, and the Midwest — could see their fresh water supply decrease by as much as one-third1 within the next 50 years.

Aging Infrastructure

Increased demand for new water resources also spotlights issues related to aging infrastructure and years of underinvestment. Exacerbated by years of underinvestment and new challenges from climate change, many systems need investments to make them more sustainable both short- and long-term. Aging water infrastructure also loses water at an alarming rate, and it’s estimated that drinking water systems in the U.S. currently lose at least 2.1 trillion gallons of treated water per year2 (approximately $7.6 billion) to water main breaks and leaky pipes.

Financial Impacts Of COVID-19 On The Water Sector

Water and wastewater systems experienced financial shocks during the pandemic, and the cost of COVID-19 on water and wastewater utilities combined is predicted to exceed $27 billion3 due to utilities eliminating shutoffs for non-payment, anticipated increased delinquencies, and reductions in non-residential water demands. Taking all of this together with increasingly stringent standards, industry stakeholders may consider privatization or consolidation to help their communities better deliver on their promise of safe water and a clean environment.

Financial Support

In the U.S., President Biden proposed a comprehensive approach to improving infrastructure through his American Jobs Plan. While the plan was still up for debate at the time this was written, details included $111 billion in clean water and drinking water investments. The plan proposed prioritizing federal spending on several aspects of water quality proposing, including:

$56 billion toward upgrading and modernizing America’s wastewater, stormwater, and drinking water systems through grants and low-cost loans
$45 billion toward removing all of the lead service lines across the country
$10 billion toward monitoring and remediating PFAS in drinking water

The current administration also supports the Bipartisan Infrastructure Framework, a $1.2 trillion transformational investment in clean water infrastructure, clean power infrastructure, remediation of legacy pollution, climate change resiliency, and more. This plan is the largest investment in clean drinking water and wastewater infrastructure in American history. The framework calls for:

The elimination of all lead pipes and service lines in the country’s drinking water systems
$55 billion toward building out and repairing water infrastructure
$5 billion toward the Western water shortage

Outside of federal support, private markets are also well-positioned to provide much-needed capital along with innovative approaches that can help struggling communities. Interest rates have recently been at historic lows, and in March of 2020, the Federal Reserve slashed interest rates to 0 percent to shield the economy from negative consequences of the coronavirus. In turn, private equity firms have been able to leverage debt with lower interest rates to acquire and improve assets like water systems.

Investor Interests

Financial markets around the globe periodically experience volatility, as shown by the 2008 economic recession and recently with the COVID-19 pandemic. Now, investors are looking for financially stable, “recession-proof” businesses to act as a hedge against macroeconomic downturns.

“Water utilities have always been a safe harbor for capital during choppy times in the equity markets. Investors trade off beta or volatility for more predictable yet modest returns,” says Jud Hill, cofounder and managing partner at Ecological Service Partners, an investment fund dedicated to environmental services and water assets. “In fact, water utility equities have often been referred to as ‘widow and orphan stocks’ because of their low risk profile.”

To Hill’s point, investors have historically purchased water and power utilities as long-term holdings for their dividend income and stability. While this still holds true, the trend toward clean energy along with friendly legislation and heightened investments in renewable energy resources has some analysts predicting strong growth for the utilities industry over the next decade.

Water, wastewater, and reuse system assets that can boost a fund’s environmental, social, and governance (ESG) ratings are proving attractive. The S&P Global Market Intelligence report4 released in April of 2021 revealed that ESG funds outperformed the S&P 500 between March 2020 and March 2021. In 2020, flows into sustainable investment funds in the U.S. achieved a nearly tenfold increase from 2018, surpassing $51 billion.

Investors are interested in publicly traded water utilities because they have more potential to expand customer count than other utilities while producing steady returns.

“When looking at the whole picture, it is not surprising that many water utilities actually jumped 10 to 15 percentage points in value during the first quarter of 2020, coinciding with the onset of the pandemic. This was a classic ‘flight to quality’ or safety, as water has always had reasonably stable demand,” added Hill. “Now, water utilities are trading at their pre-pandemic values and have seen little volatility over the last 18 months.”

As described in the following sections, utility privatization, P3s, and consolidation offer water and wastewater systems different benefits, but there are key differences between these strategies that stakeholders should understand before moving forward.

Privatization

Privatization is when a government-owned property or business becomes privately owned. The current low interest rate environment will likely encourage increased privatization of assets as investors acquire them at low cost. When a public utility considers changing to become privately owned and managed, there are three key groups that will have to be convinced in order to ensure a deal goes through: policymakers, community members, and the press. These groups have the power to make or break a deal, so it’s critical to address their questions and concerns.

Utilities, their investors, and their partners should arrange public meetings with community members, prepare clear messaging about their proposal, and be prepared to make necessary changes. Most importantly, they need to listen to the customers. If utility customers are saying they value public utilities and have no desire for privatization, that carries a lot of weight. Elected officials will want to keep their constituents happy.

Public-Private Partnerships

Governments can also work in tandem with the private sector via P3s for potential cost savings. P3s involve cooperation between the public and private sectors in one or more areas of the design, development, construction, operation, ownership, or financing of infrastructure assets, or in the provision of services.

According to a report from the Reason Foundation5, the City of Tampa was able to save $85 million on a 15-year water public-private partnership, and also saved 50 percent on a 30-year deal for its desalination plant by tapping the private sector instead of using in-house service. The report also cites Seattle as another example of privatization cost reductions, where the city was able to save a combined $120 million on separate projects by not using in-house services.

Consolidation

Consolidation of utilities involves combining assets, liabilities, and other financial items of two or more entities into one. The different types of consolidation include:

Direct Acquisition: Higher-capacity utility acquires the assets, operations, and customers of another system and absorbs them into its existing governance, operational, and financial frameworks.
Joint Merger: Two or more relatively equal partners both adjust governance, operations, and financial frameworks to create a new entity that is owned and controlled by the previously separate parties.
Balanced Merger: Two or more entities consolidate with the goal of establishing a governance structure that provides a basis for at least some direct participation by the preexisting utility in future decision-making.
Regional Agreements: Do not combine legal entities, but rather, pool utility resources, buying power, and technical expertise to do more across a wider area than a single utility could do alone.

As an example, the City of Raleigh merged seven local utilities6 into a full-service regional water and wastewater provider, serving 570,000 people over a 299-square mile service area. The consolidation resulted in the creation of lower regional uniform rates, reduced operational and maintenance costs, and improved efficiencies in water and wastewater asset investment as well as access to lower cost capital. Overall, the consolidation of these systems is estimated to have saved the region an aggregate of approximately $350 million.

Successful Mergers And Acquisitions

If a water or wastewater system undergoes a merger or is purchased, there are certain things they should know to ensure they receive the best deal while protecting customers.

Build a strong team.
Going through an M&A process alone is not advisable. At minimum, utilities should have a business attorney, a Certified Public Accountant (CPA), a Certified Financial Planner™ (CFP®), and an industry consultant to protect their interests during the transaction.

Clearly define goals.
With their team of advisors, utilities should determine what they want to achieve with private equity partners or consolidation. Whether the current owner/operator is moving on completely or merging with nearby facilities, the level of involvement post-transaction will help determine the right private equity firm and avoid regrets down the line.

Know what the utility is actually worth.
Understanding a utility’s true value helps in framing negotiations and setting realistic expectations; a reputable advisor should be present to help with this process.

Understand earnouts.
Buyers will sometimes offer the seller an “earnout,” or contingent payments, which is money set aside until certain performance targets are achieved by the seller. Careful consideration should be given to earnouts because some contingencies can quickly turn into golden handcuffs.

Between the nation’s growing population and rapid urbanization, the need to identify and create new water sources continues to grow. This will continue to drive the private sector’s interest in the water and wastewater treatment market, particularly because water utilities are viewed as low-risk investments with consistent demand. Ultimately, privatization and consolidation of water assets can offer communities and investors improved efficiency, financial stability, and greater sustainability.

References:

About The Author

Christopher J. Mackin, CFP, is a partner at Bleakley Financial Group, where he and his sister, Michelle, are teamed up to provide wealth management strategies to owners of environmentally conscious businesses. Christopher is a Registered Investment Advisor and holds a certificate in Retirement Planning from The Wharton School and a BA in economics from Rutgers University.

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Guest Column | January 12, 2022

Private Investment Trends In Water And Wastewater Utilities

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