Economic playbook 3: Financial Engineering.
MFU had been part of the Nordstrum company now for ten years. In that time the company had built up a portfolio of international infrastructure companies. Some they had sold on and some they had kept. Debt had risen two-fold now from the earlier base of £1.5 billion to almost £4 billion. This had been achieved through leverage based on the fixed customer base and reliable annual income and the now large company with interests in other continents. The CEO Darren Middlefold had also seen his pay package generously remunerated, with a 100% increase in effective annual income. This was provided as he was now responsible for a far larger company group and this also reflected worldwide changes in CEO pay for international companies. Shareholders had raised concerns about the burgeoning pay packages in a period of economic austerity, but as the larger shareholders were not individuals, the pay rise was always accepted.
There had been investment in the pipework, sewage treatment plants and sewer networks for the last ten years. But the ageing sewer network and pipe infrastructure was requiring significant investment and replacement. Upgrading the network was beginning to consume more cost and time from engineers than MFU had originally expected. Debt repayments and restructuring the company was taking much of the capital, so engineers had been asked to continue to report issues, but Nordstrûm would effectively prioritise those that created the least reputational damage if they were not fixed.
By 2015 investment funds had become increasingly attracted to essential national assets. Electricity networks, water systems, roads and communications offered long-lived infrastructure, high barriers to entry and relatively predictable revenues. Water was particularly attractive. Customers could not change provider and demand varied little with the economic cycle.
In contrast to commercial companies where risks had to consider that a company may fail and investments could be lost, infrastructure companies couldn't fail. That didn't mean that investments may not be also lost, but the risk was lower. Demand for the infrastructure service or product was remarkably predictable, customers could not choose another provider, and government could not realistically allow the essential service itself to cease. This is what made water infrastructure behave very differently from an ordinary commercial business.
Sapphire superstructure investment funds had noticed the opportunities that MFU presented and offered an opportunity to MFU shareholders, of an increase in the share price. Meanwhile, Nordstrûm were also considering diversifying into other areas and dispensing with some of the companies that did not match their new portfolio. An agreement was made and the deal was struck.
The water regulator observed the change of owner and reminded the new owners of their obligation to provide customers with fresh water and that a price cap was in force. No matter the limitations. Sapphire raising capital from pension funds, insurers and institutional investors. Some investors were based in the UK, other sovereign wealth funds and institutional investors represented an international group of companies, a Teachers' Pension Fund, A Retirement Scheme, a North Atlantic Sovereign Investment Fund. All these were happy to come together to visualise the investment as a long-term commitment to regular returns.
Sapphire investments offered Darren Middlefold an acceptable retirement package and he was replaced by Sarah Platt. Her background was investment funds, mobile phone networks and retail, it was not water provision.
Sarah and Sapphire Investments had a meeting shortly after the acquisition and spoke about opportunities for investment and growth. Sapphire was different to Nordstrum, the value of the company was not in the asset base that could increase, it was in the water monopoly and the reliable customer base with an annual income. This allowed them to ask investors for finance to continue the network improvements that had begun with Nordstrum. In return they reduced some of the debt base through the sale of the international infrastructure assets. Sapphire wanted to build MFU and ensure a reliable customer base, as the regulator required. Sarah wanted to be the champion of clean water and reduce the pollution incidents into rivers and the ocean.
For network upgrade, Sapphire investors bought bonds in the company, and this realised a manageable rise in debt to £6bn. The accountants accepted that the asset base remained strong, and debt remained cheap. This left sufficient head room for capital investment.
But the debt pile was starting to worry lenders, and other water companies were getting into difficulties with managing debt and repayments. The government was also inviting CEOs of water companies to explain why the combined debt of the old regional water companies was nearing £100bn, when it had been zero prior to privatisation. The CEOs reminded the government what they had inherited and what network improvements had been undertaken. However, the adverse publicity was not positive for the investors, and they felt the risk of investing was higher than they had anticipated. Interest rates rose by one percentage point.
Although this was a relatively small rise in interest rates, the impact was to reduce the ability of Sapphire to borrow more money and invest in new infrastructure. Each project was now vulnerable to cutbacks, and engineers were asked to prioritise repair and replacement schemes. Developments were given a traffic light colour system, red for most pressing, orange for needing consideration and green for could wait.
This slowdown in investment was felt most severely through the rise in pollution fines from the regulator. However, once factored into the financing of the investment fund, even these fines were tolerated and built into the debt calculation. The ten years following the purchase of MFU by sapphire funds were marked by increasing public scrutiny of the new water businesses.
Sarah came down from her office to talk to the engineers about the increases in storm run-off events. Coastal pollution incidents had started to reach the news paper headlines. A surfer had been hospitalised with hepatitis, that was linked to a recent pollution incident. Local surfers, swimmers and environmentalists formed a pressure group, Astonia Beach Combers (ABC), with an image of a beach covered in sanitary waste. They arranged beach clean ups, providing white suits and gloves, with images and videos posted on social media.
Sarah didn't need the adverse publicity, and she asked the engineers for solutions. They came back to her with a £1.2bn list of projects, and a note about an old domestic water retention project, that was quietly shelved by Nordstrum some years ago. This scheme planned to install water capture systems in all new builds and retrofit at cost to households. The cost of this was containable ten years ago, but the cost could not now be met, through borrowing limits.
A notable development was a speech by Edward Doyce, now 88 years old, at a party-political conference, where he described privatisation of the regional water authorities as an initial success. But the financial structure that had once been intended to support investment had gradually become a constraint upon it. The companies had engineers motivated to address the old systems and develop new technologies to deal with sewage, water runoff and leaks. He even accepted that Sarah Platt was pushing the system to improve, but increasingly their decisions were being determined by the demands of debt rather than the needs of the network.
Sarah had to go back to the investors to ask for money to improve the network. Sarah knew she would not get all the money she needed, and the cost of more debt would be high and require some unpleasant compromises. Her dreams of championing surfers and anglers with clean water was slipping.
Sarah took a couple of Paracetamol to fight the headaches that had recently become a daily feature and sat in her car on the drive of her detached house. Sarah sat for a while listening to her favourite country music playlist, before going inside and thinking about dinner and children.
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