BREAKINGVIEWS-Thames Water mess may yet yield hedge-fund payday

By Neil Unmack

LONDON, June 25 (Reuters Breakingviews) - Thames Water seems like an asset nobody wants. It desperately needs to cut debt and raise fresh equity, yet its current shareholders have deemed it “uninvestable”. Recent bidder KKR walked away. Perhaps surprisingly, this apparent mess could be an opportunity for funds that have bought some of Thames’s 16 billion pounds of debt at discounted levels, and who could soon inject fresh equity at a rock-bottom price. Yet returns of perhaps 20% also come with plenty of risk.

Thames’s borrowings exceed 80% of regulatory capital value, a yardstick that the industry uses to assess the enterprise worth of a utility. A haircut has been on the cards since last year, when debt started to trade around 70% of face value, enticing sophisticated credit funds like Elliott Investment Management to snap up the bonds.

With no other bidders on the horizon, those investors are now left to pursue a classic “loan-to-own” trade. That strategy involves buying discounted debt to help steer a restructuring and then providing fresh debt and equity on terms that are lucrative from the investors’ perspective.

The first part of the trade has already played out. Thames nearly ran out of money last year and couldn’t access conventional debt markets, forcing it to seek a 1.5-billion-pound senior-ranking rescue loan from creditors, including Elliott. Those lenders demanded a high interest rate of 9.75%, along with extra fees. All in, they stand to make nearly 300 million pounds in interest and fees when Thames repays the debt later this year, according to Breakingviews calculations.

The second and much more important act, however, is Thames’s debt restructuring and fresh cash infusion, which is necessary to allow the company to carry out critical repairs and other investments. It could see Elliott and other creditors owning a hefty chunk of the company, which might turn out to be very valuable if a planned turnaround works. A committee of senior creditors has offered 3 billion pounds in equity funding and said it would accept a 20% haircut on the old pre-existing debt, which is distinct from the rescue loan.

A bigger haircut wouldn’t be a disaster for Thames’s streetwise rescuers, sometimes known as vulture funds. They may have acquired the debt last year when the bonds were depressed anyway, reflecting expectations of a writedown. Assume the creditors end up taking a haircut of 30% on the old debt, which is enough to bring Thames’s leverage down to a respectable level of just over 50% of regulatory capital value. That haircut would inflict minimal pain on any savvy creditors who bought last summer, when many of the bonds were trading at between 70% and 80% of face value. Next assume that the creditors as a whole pump in 3 billion pounds of equity, with the newer hedge-fund lenders like Elliott accounting for half of that sum.

The final step in assessing the payoff is what that 50% stake is worth when the creditors are finally able to sell – perhaps in eight years’ time, after the dust has settled on water regulators’ next five-yearly bill price review period. If Thames is performing like an ordinary water company by then, it might be valued in line with its regulatory capital value. That figure tends to rise over time as bills go up. It could be almost 40 billion pounds at the start of 2033, according to Breakingviews estimates which assume the number keeps growing at the rate the company has previously projected between now and 2030.

If leverage rises to 60% of regulatory capital value, after accounting for required investments in the water network, the total equity would be worth nearly 16 billion pounds. The distressed debt funds would own half of that. After accounting for the haircut on their debt and the interest and fees on the rescue loan, the hedge funds would have an internal rate of return of around 20%, according to a Breakingviews calculation. That assumes they previously bought about a third of the old senior debt.

That kind of payoff might anger taxpayers. The counterargument, however, would be that tempting private investment means offering a financial return. In any case, the payday is far from a certain return. Thames might never fully solve its operational issues, and it could struggle to be valued in line with other water companies. It could also have to fund extra investment with borrowing, pushing up debt and lowering its equity value. If Thames were only valued at 80% of regulatory capital value, and had leverage of 65% of that metric, the equity value in 2033 would be just 6 billion pounds, and the loan-to-own funds’ annualised return would shrink to a less exciting 10%. That suggests the so-called vultures are not feasting on an easy prey.