Time to Consolidate?
Is the tide of low activity in UK water mergers about to finally change? Jonson Cox, Ofwat’s chairman declared that the watchdog was open to new ideas on how to reshape the water sector at a recent meeting of the Policy Exchange. Cox stated that comparative regulation had been useful, but constraining. Ofwat no longer endorsed the old model of keeping an arguably excessive number of independent comparator undertakings in the market as a means of gauging competition and efficiency in the water and waste sector. This special water regime has undoubtedly had a chilling effect on merger activity (particularly trade deals) in the sector in recent years.
Cox was keen to stress however, that Ofwat were supporting neither the consolidation nor de-consolidation of the sector; rather that Ofwat and the Competition and Markets Authority ("CMA") are open to views from both sides. For those arguing in favour of greater consolidation, Cox noted, merging parties could not simply justify a merger by arguing that merging two water companies is necessarily efficient. Efficiency is not linked to scale in the regulator’s opinion. By contrast, Cox suggested, the water sector could be vertically de-consolidated by breaking up water and waste water companies into separate businesses. Cox stated that the logic of vertical integration no longer works partly because investors want to acquire the asset base and not the retail business. Indeed Cox said that de-consolidation could be simpler on the merger process because it could be more justifiable to merge water only companies or waste water companies together. This could mean that in a vertical de-consolidation context water deals could be more certain and less time consuming to complete.
Water M&A – Special Merger Control Regime – About to Change
Since privatisation in 1989 the water sector has been subject to the special merger control regime whereby acquisitions of water companies with a turnover of greater than £10m are automatically referred for a detailed ‘Phase II’ merger investigation before the CMA. This default position has always been a factor in constraining M&A activity in the water sector. But this default position will be fundamentally changed once Section 14 of the Water Act 2014 is brought into force. Section 14 gives the CMA a degree of discretion when considering whether a Phase II review is necessary for a particular qualifying merger, displacing the current mandatory Phase II merger reference (in all but the smallest de minimis mergers referred to above).
As currently, Section 14 requires the CMA to consider in particular whether a prospective merger will hamper Ofwat’s comparative regulatory approach. But even if there is a detrimental effect on Ofwat’s ability to regulate water mergers, the CMA must carry out a new balancing act and assess whether the customer benefits outweigh such negative effects.
Against the background of Ofwat's new view, when it comes into effect Section 14 will undoubtedly be positive for prospective M&A activity. However Section 14 will only come into force when the Minister for DEFRA specifies a date. Unhelpfully there is no guidance from DEFRA on when Section 14 will commence. Commentators have however estimated that it will come into force sometime during 2015-2017.
The May 2013 sale of South Staffordshire Water and Cambridge Water by Alinda Capital Partners to KKR for an undisclosed fee demonstrates how water and waste water assets are still appealing additions to any diversified infrastructure portfolio (provided the bidder is not already invested in the sector). The three listed companies that will be closely followed by the market for a potential public takeover are: (1) Severn Trent Water; (2) United Utilities and (3) South West Water (owned by Pennon Group Plc). In 2013 Severn Trent Water rejected a preliminary approach from a consortium led by Borealis valuing the company at £5bn.
While listed companies are a rarity in the water sector, the majority of assets are in the private ownership of infrastructure funds. The last great wave of water acquisitions by funds occurred in the early to mid-2000s. This means there will be funds like Alinda Capital Partners (who purchased South Staffordshire Water in 2007 and Cambridge Water in 2011) that will be considering exiting their investments in the coming years. Hence both the public and private water markets are likely to be rife with M&A speculation and activity in the next 4 years.
This does not apply to concentrations having an EEA-dimension as they are subject to the EU Merger Regime unless referred back to the CMA under either Article 4(4) (pre-notification referral to the CMA) or Article 9 (post-notification referral to the CMA) of the EU Merger Regulation (“EUMR”).