The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

By Neil Unmack

LONDON, Feb 27 (Reuters Breakingviews) - Thames Water is in purgatory. Britain’s biggest water utility recently averted collapse via an expensive 3 billion pound loan from existing creditors, but it still needs to raise equity to cut debt, restore access to credit markets and fund a 20 billion pound investment programme. If interested parties like U.S. buyout group KKR KKR.N can rescue it and make a decent return, it would boost the UK’s flagging appeal as a destination for foreign direct investment and reinvigorate the global case for privatising public assets. That’s a big if, though.

The rescue is a pivotal moment for the UK water sector, which was privatised in the 1980s. Yet Thames’ troubles spread far beyond Britain. Top-tier providers of foreign direct investment like Abu Dhabi Investment Authority and Canada’s Ontario Municipal Employees Retirement System have already had to write down the value of their Thames equity stakes. If Prime Minister Keir Starmer ends up having to nationalise the utility it would send an even stronger signal to North American and Australian pension money as well as Gulf wealth funds to invest elsewhere.

Thames’ woes stem from a toxic combination of ageing Victorian sewers, London’s growing population and fines for poor performance, on top of an already creaking balance sheet. Under the UK system companies are allowed to make fixed returns set by watchdog Ofwat. Critics, including rating firm Moody’s and Thames itself, argue the current five-year price regime does not reward investors adequately for the risks they are taking.

The first question is how much money Thames needs. Its own business plan envisaged 3 billion pounds in fresh equity, but that was before Ofwat’s ruling on what rates the company can charge. That left a 4 billion pound gap between the spending Thames would like to do, and what it can charge for.

Meanwhile, the group may need more money to cover further performance penalties, which Moody’s reckons could total around 100 million pounds a year. And Thames needs to cut debt. At around 85% of regulatory capital value (RCV), a utility metric determined by the watchdog, borrowing is far above the 55% level preferred by the regulator. David Burlison, a Jefferies banker advising Thames’ senior-ranking creditors, recently estimated a total capital hole of up to 10 billion pounds. For what it’s worth, KKR has made a non-binding offer to pump in an initial 4 billion pounds, as has utility Castle Water, backed by the Pears family. A bid by Hong Kong’s CK Infrastructure has floated a figure of 7 billion pounds.

Unfortunately, calculating Thames’ equity is complex. Its RCV is only 20 billion pounds and it has around 17 billion pounds of debt after factoring in new funding, according to Breakingviews calculations. That implies a theoretical equity value of not much more than 3 billion pounds assuming a valuation in line with its RCV, which is roughly where utilities that can cover their cost of equity trade. But a new investor would have another option: they could take a chunk out of bondholders. That would both create value in Thames’ equity by reducing its liabilities, and lower the cash requirement.

That raises a second question – how big the creditor hit needs to be. If Thames’ debt was slashed by, say, 40%, it would fall to around 50% of RCV. That would be lower than most peers, and a prudent level given Thames’ challenges. Yet bondholders wouldn’t swallow such a move easily. After all, that kind of loss might come close to what could happen if Thames were placed in administration by the government. The alternative is to give bondholders less of a scalping.

The numbers could work. Assume a new owner persuades senior bondholders to take a 25% loss, which according to Breakingviews calculations is enough to bring debt down to around 60% of RCV. That would leave Thames more vulnerable and some creditors might carp, but it would be in line with where the debt is trading. Next, assume that KKR or a rival bidder invests 4 billion pounds upfront, and a further 1 billion pounds annually over the next four years.

Finally, assume that Thames turns itself around sufficiently to cover its cost of equity of around 7%, and is valued in line with its estimated 33 billion pound RCV in 2030. Incorporating debt around 60% of its RCV, that would imply an equity value of around 13 billion pounds, equivalent to an internal rate of return of 14% over the next five years, according to Breakingviews’ calculations. KKR and other investors would likely see that as adequate.

That’s especially the case given scope for the return to rise. Thames is currently petitioning the UK competition watchdog to loosen Ofwat’s pricing regime for the next five years, which could mean higher returns and a lower funding gap. Equally, the government could be so keen to see a deal and avoid a messy nationalisation that it may pressure the watchdog not to fine Thames if it misses targets.

Yet there are plenty of risks. The new owner could get stuck in battles with bondholders, who have threatened to backstop Thames themselves. Then it might have to surrender a big slice of the equity to secure a restructuring. Thames’ turnaround may take much longer or cost more money than expected. In recent years, the company’s return on equity has on average been negative.

A successful deal would partially validate the UK’s privatisation model, which relies on companies being able to fail, without requiring government funds or dragging down peers. It would make privatisation less of a dirty word for other politicians that may contemplate selling state assets – like new German Chancellor Friedrich Merz.

Still, a big creditor hit may spook other utility lenders. And a messy deal that doesn’t stop the rot could leave it vulnerable and in the crosshairs of politicians. UK water companies will raise bills by over a third over the next five years, delivering much needed investment but potentially angering voters. Thames Water may yield its successful bidder a decent return, but the risks are real.

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CONTEXT NEWS

Thames Water on February 18 secured court approval for a 3 billion pound ($3.8 billion) debt lifeline, warding off the collapse and state rescue of the UK’s biggest water supplier.

The government had been on standby to put Thames Water into special administration, a form of temporary nationalisation to keep it operating if it goes bust.

The lifeline, provided by senior creditors, will give Thames 1.5 billion pounds plus a possible further 1.5 billion pounds, extending its funding until May 2026.

A group of lower-ranked creditors opposed the deal, calling its 9.75% interest rate too costly. Judge Thomas Leech, however, said in his written ruling that the most likely alternative to the plan was Thames being put into special administration, rather than the successful implementation of the Class B creditors’ rival proposal.

The rescue package was provided by a group of Thames Water’s senior creditors including Abrdn, Apollo Global Management, Elliott Investment Management, Invesco, M&G and PIMCO.

(Editing by George Hay and Oliver Taslic)

((For previous columns by the author, Reuters customers can click on UNMACK/neil.unmack@thomsonreuters.com))