The proposed debt financing of Three Waters has received little coverage in the media but it brings its own set of risks to the reforms which could turn out to be ruinous for the country’s finances.
Disclosure: Before starting on a discussion of the proposed debt financing of Three Waters, I have a disclosure to make: whilst on Substack I am usually writing on topics that interest me based on my general knowledge and experience as a lawyer, in this instance I am writing as a lawyer who has practised as a leveraged finance and restructuring expert for 25+ years - starting in New Zealand at one of our leading law firms and then, for many years in the UK. I’ve acted for borrowers, banks, hedge funds and private equity sponsors putting these deals together and then restructuring them more times than I care to remember. The majority of these deals are in multiple jurisdictions including the US, Europe, MENA and Asia Pacific and cover all manner of sectors including utilities and privatised government assets. I failed at becoming an All Black or a writer so this is my bag.
These are simply my own independent views having reviewed the Department of Internal Affairs Information Memorandum on the debt financing (the Info Memo) and the Standard & Poors’ evaluation report (the S&P report). I have also reviewed the Castalia reports prepared for Communities 4 Local Democracy (C4LD) which first analyze the proposed reforms, including the financing as it is currently proposed, and then suggest alternative structures.
Last week I put a number of questions to the Department of Internal Affairs on their proposed financing structure and I have set out their responses below.
The topic of the Three Waters financing has received little if any coverage in the media save for a recent article by Dr Eric Crampton from the New Zealand Initiative titled ‘Three Waters Entities: Bad Debt and a Bad Precedent’. The lack of coverage is understandable in one sense because the financing is technical and in the early stages of planning but enough of the detail is known for serious questions to be asked and for the risks to be fully understood by the public. I first raised this issue in a tweet thread in July. This article will allow me to expand on those thoughts.
Leverage finance is the technique of acquiring or financing a business by lending an amount of money which is a multiple of that business’s EBITDA (earnings before interest, tax, depreciation and amortisation). The leverage is therefore the ratio of debt to EBITDA. If a business has EBITDA of $200 and borrows $400, the leverage ratio is 2:1 or in banker-speak 2x. If you lend that business $2,000, the leverage ratio is 10:1 or 10x. The higher the ratio, the greater the risk.
The other element of leveraged finance is that it is a form of cashflow financing. In other words, lenders look primarily at the strength of the underlying cashflows, rather than at the asset values, to determine its creditworthiness. If you have a business which has cyclical or unstable cashflows or is reliant on a small number of customers then that business cannot sustain high levels of leverage. Because of their essential nature and a customer base that is effectively locked in, utility businesses are always viewed by lenders as being highly attractive credit opportunities that are capable of sustaining high levels of leverage. But that doesn’t mean that the risks are no longer there, it just means that the lenders are confident that the strength of the cashflows is sufficient to repay the debt over time.
Therefore when assessing a potential financing proposal, lenders will look first at the sector, and comparable businesses in that sector, as a guide to assessing how much leverage is sustainable before looking at the specifics of the deal.
In the early 2000s telephone directories businesses were considered to have very stable long-term cashflows that made them suitable for high levels of leverage - from a leveraged finance perspective these deals were considered to be bulletproof. I did many such deals across Europe that had leverage at or around 10x and they all did very well until Google came along and wiped the directories business off the map. Overnight all of those leveraged businesses went into default and needed to undergo financial restructurings - that included New Zealand Yellow Pages which had the same highly leveraged financing structure at the time.
Although these deals can be put together relatively quickly - sometimes in a matter of weeks - once these deals become financially distressed or go into default they are incredibly difficult and costly to restructure. In fact, when compared to putting the deals together, the costs of a restructuring are eye-watering. In part that is because they take so long to conclude. When I met with the CEO of one European telecoms business to discuss the restructuring of his business - a former state telco - he said that his assumption was that it would concluded in 6 months. I had to point out that it would be 12 months at the earliest if everything went to plan - but more likely 18-24 months.
In this context we are talking about a financial restructuring of the balance sheet of the business - not an operational restructuring. In fact the underlying business may still be producing strong cashflows but because certain covenants in the lending documents which measure the financial health of the credit have been breached, the lenders will require a restructuring to occur which may include a further injection of capital into the business.
A water utility is clearly a better candidate for a leveraged financing than a telecom directories business. Google is not going to destroy a utility’s business plan, and its customers are not going to jump to another competitor, but that does not mean that this is without risk. In fact the essential nature of our water utility infrastructure to the nation means that the risks of the financing should be fully articulated and understood by Government and the public before we proceed.
Leveraged lending was identified as a key risk factor during the 2008 Global Financial Crisis and in its aftermath the US Federal Reserve issued Leveraged Lending Guidance which capped the amount of leverage that US banks could lend to businesses to 6x. The Bank of England issued similar guidance and these guidelines stayed in place for a number of years before being relaxed.
These days hedge funds that specialize in restructuring these loans maintain watchlists that monitor all leveraged loans globally where leverage exceeds 10x. That is because, like the mountaineer who is over 8000 metres, you are in the ‘death zone’ where any mistakes or delays, whether inside or outside your control, at best can be very difficult to correct and at worst can be fatal.
In its Info Memo, the Department of Internal Affairs includes a table of core ratios which includes, second from the left, the leverage ratio (debt to EBITDA). It clearly shows that debt to EBITDA in excess of 6x is at the top end of the scale and is considered ‘highly leveraged’ as I have described above.
For the proposed Three Waters financing the Info Memo states that leverage will start at 9x. Other key indicators are noted as ‘aggressive’. As set out in the below table ‘Financial risk profile overview’, the Government clearly states “we have assumed an ‘aggressive’ financial risk profile”. Leverage is in fact forecast to increase to closer to 10x because the Government intends to meet ongoing capital requirements with further borrowing and the terms of this type of financing does not usually require amortisation of debt (in other words, it’s an interest-only financing rather than capital and interest repayment).
I asked the Government on what basis it believed that it is appropriate to opt for a highly leveraged financing with an aggressive financial risk profile for Three Waters. In response a Department of Internal Affairs spokesperson said:
The terms ‘aggressive’ and ‘highly leveraged’ are used in a very specific way by S&P and in that context do not correspond to everyday understanding or definition of those words. The Water Services Entities will have similar levels of leverage to other water service providers around the world.
I also asked the Government for details of the ‘other water service providers’ that were being considered as comparable to Three Waters including the amount of debt and leverage ratios of those entities so that comparisons can be made. A Department of Internal Affairs spokesperson responded:
Publicly owned water services providers in the United Kingdom and Australia have comparable capital structures.
Before considering what the comparable deals are that the Government is relying on, I also queried the issue of balance sheet separation which has received some media coverage. Indeed in the first reading of the Water Services Entities Bill in the House, Minister Mahuta stated:
I now want to briefly touch on some of the important components of the bill before us. As a Government, we’ve had four bottom lines when progressing this reform. They are: … ensuring balance sheet separation …
However in paragraph 7.7 of the Government’s own Info Memo it states “Based on the indicative assessment set out above, we derive an issuer credit rating of ‘A’ reflecting a stand-alone credit profile of ‘bbb’ and a three notch uplift based on our view of a high likelihood of support from the Crown should the WSEs face financial distress.” This reflects the reality of the situation which is that given that this asset is a key part of national infrastructure any Government will be under enormous pressure to provide some form of financial support in a distress scenario. In fact, so strong is this likelihood that the credit rating receives a three-notch uplift to reflect the likelihood of Crown support.
S&P agrees with this assessment noting “our assessment that there will be a ‘high’ likelihood of extraordinary support from the Crown during a distress scenario is based on: a ‘critical’ role. We believe that a default of a WSE would have a critical impact for the government. WSEs operate essentially on behalf of the Crown and their main propose is to provide a key public service that could not readily be undertaken by a private entity ...”.
I asked the Government if it wished to make any comment on the fact that it is noted that Crown support in the event of financial distress is ‘highly likely’. A Department of Internal Affairs spokesperson responded:
WSE financial distress is a very unlikely outcome. Their failure is even more unlikely.
Therefore contrary to statements made in the House by Minister Mahuta and press coverage of ‘balance sheet separation’, the Government does not deny that Crown support, i.e. taxpayer money, is highly likely to be made available in the event of financial distress - they just don’t believe that that outcome will occur.
This brings us to those comparable UK and Australian water entities that the Government is relying upon as reassurance that the proposed levels of leverage are appropriate and without risk. The Water Industry Commission of Scotland (WICS) has provided advice to the Government on all aspects of our proposed water reforms. However in relation to water utility financing in Scotland, Scottish Water does not have any leveraged financing; instead it is funded through a combination of customer charges and funding from the Scottish Government. This is a totally different and lower risk financing route. Likewise Sydney Water is debt financed through the NSW Treasury Corporation and not via a leveraged financing.
By contrast the water sector in England does use leveraged lending as a means of finance and the picture there is not so pretty. Thames Water is the most highly leveraged English water utility with leverage at or around 10 to 11x. In a 2019 article ‘Thames Water braced for talks over £12bn debt mountain’ it was reported that it had hired restructuring experts Gleacher Shacklock to advise it on debt restructuring discussions with its bankers. Anglian Water and Southern Water, amongst others, have both recently been through debt restructurings in an effort to reduce leverage. Indeed S&P has downgraded or put on credit-watch a number of English water utilities due to a tougher regulatory environment, pressure on operating performance and increased financial pressure. Most of these utilities are operating with leverage levels at or around 9 to 10x.
A leading player in the leveraging of UK water utilities has been Australia’s Macquarie Asset Management. In the article ‘Macquarie’s $2bn dive back into choppy UK water sector’ the UK regulator Ofwat “warned Macquarie not to try any private equity-style leveraging play and to keep dividends to a minimum”. The article notes Macquarie’s British nickname as the ‘Vampire Kangaroo’ and goes on to state:
Macquarie is no stranger to the sector: it took an almost half-stake in Thames Water in 2006, selling out in 2017 amid accusations it had saddled the company with debt while awarding itself hefty dividends and allowing the company to occasionally dump raw sewage into rural waterways.
I’ve worked opposite Macquarie on UK infrastructure deals and seen their approach first hand. Macquarie and leveraged loans is like a thirsty Australian walking into a pub. It gets messy very quickly. They make Goldman Sachs look like the sober driver. In fact there is a very recent academic study published on Macquarie’s role in Britain’s water and energy networks and the adoption of private equity-style leveraged financing in the utilities sector. It concluded that:
The resulting financialised, highly-indebted corporate structures create costs and risks for utilities which raise concerns for social equity.
The study goes on to note that when Macquarie finally sold out of Thames Water in 2017:
Numerous media outlets published articles that were critical of the company's activities. This Is Money reported the sale of Thames Water with the headline ‘Vultures who left Thames Water with £10bn of debt: Controversial Aussie bank Macquarie sells stake in UK giant’. The Financial Times ran a lengthy article titled ‘Thames Water: the murky structure of a utility company’ and the BBC broadcast a radio programme titled ‘Macquarie: The Tale of the River Bank’ in September 2017.
Last week I asked the Government who was advising them on the Three Waters financing. A Department of Internal Affairs spokesperson confirmed:
The Government receives advice from a number of parties on matters that affect capital structure and financing. These include PWC, KPMG, Mafic and S&P.
Mafic was established in 2019 and is a New Zealand boutique infrastructure advisory firm, set-up and staffed predominantly by former Macquarie people - and on Three Waters they are simply following the Macquarie playbook. As a result, the Government is currently proposing that we adopt the controversial and risky Macquarie model of highly leveraged infrastructure financing. Worst still, we are in fact taking on more risk than even the English water utilities because we are also adopting a complicated and novel governance structure. In fact when Act’s Simon Court asked whether any projects in New Zealand or abroad employed a similar governance structure to the proposed Three Waters reforms, Minister Mahuta responded:
I am not aware of projects of a similar scale to the proposed three waters reforms that have employed a similar governance structure … the proposed governance structures for the water services entities are unique, reflecting circumstances that are particular to Aotearoa.
A Mayor who has been closely involved in the Three Waters process recently remarked to me that the proposed co-governance structure is in fact the ‘Tainui governance model’. In essence, we are combining Tainui co-governance with Macquarie-style leveraged financing. Such an unusual mix of massive debt allied to an untested model of governance is, in my professional opinion, a recipe for disaster. And a disaster that could easily turn out to be ruinous for the country’s finances.
It is a view supported by the Castalia report to Communities 4 Local Democracy (C4LD) which concludes:
The mega entities increase Crown fiscal risk. Because the Crown is effectively providing a credit backstop, and creditors’ powers are reduced relative to current local authority borrowing, the Crown is exposed to increased risk of mega entity failure. This risk is increased due to a combination of key factors, which we elaborate on below: complex governance and competing objectives dilute accountability of mega entity management to the directors, and ultimately customers …
In fact Castalia’s analysis shows that all capital expenditure requirements for the next 20 years can be financed without increasing water bills or changing council debt caps.
Castalia finds that the government’s modelled $97 billion capital expenditure under the mega entity reforms is financeable for 20 years under the C4LD reform model without increasing water bills or changing council debt caps. Castalia’s modelling matches exactly the WICS mega entity capex programme in terms of timing and amount spent. Of course, a range of financing options are available that would make financing even more accessible.
I am told that Castalia initially provided some advice to the Department of Internal Affairs and then to LGNZ in mid-2020 but that that advice was effectively buried during the consultation process. In my view the Castalia work very clearly sets out numerous valid concerns regarding the current proposal and suggests some less risky alternatives which are summarised in a recent Herald article by Castalia Managing Director Andreas Heuser.
There is no justification for taking the riskiest route to climb the highest debt mountain. Inevitably, as the infrastructure upgrade is undertaken, there will be challenges - whether economic, regulatory or operational - but those challenges are best faced when the structure is not subject to high levels of leverage. In response to my assessment that this is a risky financing proposition, a Department of Internal Affairs spokesperson stated:
The AA+ (foreign currency) indicative credit ratings for the Water Services Entities provided by S&P reflect a very low likelihood that they would ever be in a position that they could not repay their debts, or in S&P’s own words they reflect “extremely strong capacity to meet financial commitments”. This is supported in part by the provision of a Crown liquidity facility similar to that provided currently to the Local Government Funding Authority (LGFA) - the vehicle by which much current council borrowing is conducted. It is worth noting the indicative credit rating for the WSEs provided by S&P matches the current rating for the LGFA.
My response to this statement is that credit ratings are like weather reports - putting too much faith in an indicative credit rating at the pre-marketing phase of a deal is like believing that the weather at the summit will be excellent because it’s currently sunny at base camp.
There needs to be an objective, sober assessment of the risks. If there are less risky financing options available then they should be preferred over higher risk alternatives. I strongly urge the Government, LGNZ and opposition parties to re-consider the Castalia work and act in the best interests of the country.
Thomas Cranmer is a pseudonym. You can read Cranmer's substack here