CASE STUDY 5

Capital Ideas

Keith Boyfield

Goldman Sachs employs some impressive people. Bill Young, a managing director within the bank's Financing Group, is one of them. He gave a thought-provoking presentation recently on the scramble for international capital at Oxera's conference on the future of infrastructure regulation.

The event drew a large and distinguished audience. Young's insights into the current health of the world's capital markets struck at the heart of many utilities' funding dilemmas. He posed a crucial question: what is the competitive return a utility must offer to attract the large amounts of capital required to invest in developing its infrastructure asset base over the next 20 years?

Young emphasised that given the large capital investment needed, the regulator must provide returns that are adequate to compete. The European Investment Bank estimates that €180 billion of investment in infrastructure assets is required over the next five years. And the competition is getting tougher, particularly with airport operators and toll road managers across Europe seeking to raise substantial sums of capital.

In fact, a wide range of commercial concerns need to raise considerable money to renew or develop their infrastructure asset base. Having said that, if the capital structure is balanced correctly between debt and equity, tremendous value can be created for both debt and equity holders. A good example is Autostrade, which manages 3,400 km of motorways in Italy, the most extensive high-speed road network in Europe.

Over the past two years, Autostrade recapitalised its balance sheet and ultimately issued €6.5 billion in bonds. That is a lot of money. But as Young points out, the offer proved an extremely attractive investment opportunity for many insurance companies and pension funds on the look out for low risk securities that could be relied on to pay a stable return. Since its recapitalisation, Autostrade's share price has doubled. And all of this despite the fact that Autostrade has a €9.5 billion investment programme to complete between 2004 and 2010.

Large concerns that generate reliable cash-flows – typified by the likes of Autostrade – may well prove more attractive to investors than the more modest regulated returns offered by companies in the water and electricity sector. If these businesses are to attract the vast sums of capital they require, then regulators need to recognise that they must be allowed to pay a competitive return to their investors. In practice, this translates into longer regulatory review periods rather than the current five-year review process, clarity on levels of returns and capital base, and the opportunity for companies to keep some of the benefits of outperformance. These attributes combine to reduce risk and make an investment attractive.

As privatised utilities become increasingly skilled at driving down costs and identifying operational efficiencies, one of the most promising ways of delivering value to share-holders is to devise more efficient capital structures to fund their capital requirements. This is where the correct mix of debt and equity instruments can prove extremely attractive.

“Debt capital is relatively inexpensive, both in sterling and euro markets,” observes Young. “In addition to credit spreads remaining near historic lows, interest remains tax deductible, which is very attractive. Also, properly apportioned debt capital can help a company's share price, as we have seen in the recent case of Autostrade.”

The international capital markets are seeing a blurring in the traditional distinction between debt and equity securities. Many investors in subordinated or mezzanine debt are the same investors who invest in equity. Rather than ask the regulators to define precise debt and equity targets, regulated utilities might find a more efficient mix of these hybrid securities, thereby lowering the cost of capital. Since the investors are primarily the same group of individuals, the incentives created for management should remain the same.

Another potential source of capital is the thriving private equity sector. As regulation tightens on publicly quoted companies, financial institutions are allocating a higher proportion of their capital to private equity funds, such as Apax, Blackstone Capital and the Carlyle Group, where regulatory requirements are less intrusive.

What is more, over the past 12 months, banks have been prepared to lend far more debt to private equity houses in frenetic competition for leveraged buy-out financing mandates. In this context, mezzanine debt can be important, since it enables a further tranche of debt to be raised. It also has priority ahead of equity in the event of bankruptcy.

Figures released by Standard & Poor's reveal that the number of deals with total debt over five times Ebitda (earnings before interest, depreciation and amortisation) surged to 35 percent in 2004, compared with 23.3 percent in 2003 and 16 percent in 2002. Indeed, when PIK (payment in kind) debt is included, debt multiples have soared as high as eight times Ebitda in some recent acquisitions.

In contrast to the US, however, private equity houses have tended to shun utility assets in Europe. This is because the returns offered tend to fall below the target rates of return set by private equity funds, which generally promise to pay their limited partners (investors) a return of 20 percent or more.

Private equity funds often lose out in competitive auctions to a new power in utility finance, the specialised infrastructure investment vehicles, typified by Macquarie Bank's Infrastructure & Specialised Funds Division. On a global basis, Macquarie manages €12 billion in infrastructure equity. Over the past decade it has invested in toll roads, airports, water, rail, power and telecoms assets. Last year it launched a European Infrastructure Fund specifically to invest in the more developed European economies.

The bank is looking for sustainable and predictable cashflows over the long term. It has already made four high-profile investments. In the UK it owns a stake in South East Water and it has announced a substantial stake in the consortium that recently acquired Welsh and West gas distribution network for £1.1 billion. However, its other two investments reflect the international breadth of the fund. Macquarie has taken a substantial stake in the dedicated rail link between Arlanda airport and Stockholm's city centre, and it also owns 70 percent of the company operating Brussels International airport.

Specialised infrastructure funds such as Macquarie's generally seek to target equity returns in the teens as opposed to the 20 percent plus levels required by traditional private equity players. Consequently, they can often outbid private equity houses for the available opportunities. This is exemplified by the experience of CVC, a private equity house that successfully acquired electricity transmission assets from Spain's Iberdrola, but then lost out to a consortium of institutional investors on the Northumbrian Water sale in 2003.

Iain Smedley, an executive director with Morgan Stanley and a rising star on the utility scene, is optimistic about the prospects for utility financing. In his view there is “a large quantity of capital from a range of sources focused on the European utility sector”. He points out that “in addition to private equity investors like CVC and KKR, key sources of equity capital now include specialist infrastructure funds, such as ABN Amro and Macquarie Bank's funds, as well as pension funds making direct investments, such as Ontario Teachers and Borealis, and special situation hedge fund investors like Perry Capital. These providers of capital have a sophisticated understanding of the sector and regulatory issues, and how to optimise the capital structure. They are frequently willing to invest all across the capital structure – equity, mezzanine, preference shares and conventional debt”.

Significantly, a clutch of financial players were among the key bidders when National Grid Transco put its local gas distribution networks on the auction block last year. Indeed, the winning bidders included Macquarie Bank, a consortium comprising Canadian pension funds Ontario Teachers and Borealis alongside Scottish and Southern Energy, and Hong Kong based utility CKI.

This auction demonstrated “real competition between financial and industry buyers for these assets – the process reflected the strength of interest from financial parties of all kinds, and their willingness to take on the operational and regulatory risks of a new business model”, says Smedley.

Smedley believes there are relatively few opportunities to invest in utilities that pay an attractive return. But when they come up for sale, they attract a lot of interest. As evidence Smedley cites the recent sale of Mid Kent Water, which was sold to Australia's Hastings/Westpac for a premium of more than 25 percent on its regulatory capital value after a hotly contested auction.

As far as funding requirements are concerned, the key message for managers running regulated utilities must be to continue to bear down on costs while at the same time exploring the potential to build on innovative new financial strategies. This should enable them to establish an optimal capital structure and deliver greater value to the owners of the business. And the message for policy-makers is that regulatory structures need to provide a framework of stability and attractive returns on capital to attract private funds to make the necessary investments in infrastructure assets.