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Tim Short is an author and former investment banker at Credit Suisse First Boston, where he specialised in whole business securitisations.
Thames Water has been struggling with a heavy debt burden and an unfriendly regulatory settlement. It now appears that a solution is in sight, which is good news. However, the nature of the solution raises some questions about corporate governance. Since the regulated water utility has 16mn customers, these questions are of some importance.
The solution proposed, a debt-for-equity swap, has a long and illustrious history in The City and should work here also. The idea is that that since the equity has no current value, the debt holders are next in line and they will become the new equity owners. This leads on to the slightly ticklish nature of the current position, which may continue for several months until the swap is completed.
The current equity owners have written off their investment and in at least one case, have stood down their director. This does not mean that, in a technical sense at least, there are no shareholders. The question relates to whether its shareholders are motivated to act under the current scenario. They have stated that they have no interest in contributing further capital to the enterprise. They have no skin in the game.
To the extent that they were also involved in the debt, some of which will survive the restructuring, they have largely been replaced by vulture funds and diverse distress specialists. They thus have no financial motivation to act in their capacity as shareholders under the current circumstances.
This matters because under English company law, shareholders have a number of potential actions which only they can perform.
One might say that a short period of uncertainty is of no concern, and the new shareholders are already waiting in the wings. They are, but this is a company that provides a critical function, and the standard cumbersome mechanisms of the operation of company law may be on the tardy side. In addition, Thames’s debt problems are not unique. We do not know if sector peers will follow down a similar slipway, but if they do, all will face the same invidious interregnum.
One obvious point to note is that shareholders appoint the board. Imagine that the chair steps down for reasons unconnected to the performance of the business. Who would supervise the process of replacing him?
Shareholders normally operate to restrict and control the board where necessary. There is no suggestion that the directors have or will award themselves excessive pay, for example. Yet were there to be such a suggestion, what mechanic of restraint would apply?
The Thames Water board’s most pressing task is to choose between two competing refinancing offers. One is from the Class A bondholders and one is from the Class B bondholders. The Class B bondholders have stated with some justification that their offer is cheaper. The board has stated that it prefers the Class A option, known as Plan A.
The key term to note when comparing Plan A and Plan B is the interest rate. Plan B provides new funding at 8 per cent. The Plan A finance carries a rate of 9.75 per cent and includes £200mn of fees. Both of these rates are much higher than the allowed rate of debt interest assumed by the regulator Ofwat, which is a measure of the level of current financial distress.
Because Ofwat assumes a different and much lower cost of debt, it has suggested that “higher interest rates are not directly added to customer bills”. However, this effectively concedes that such costs are indirectly added to customer bills. It is not difficult to see why this must happen. Thames after all only has one source of income: customer payments. If money is going out to pay higher interest rates, it can only come from those customer payments.
But while Plan B could raise more money on less onerous terms, Plan A has the advantage of reducing execution risk. By that term, I mean the risk that the company runs out of money before the debt-for-equity swap closes. The quicker Thames Water reduces the risk of entering temporary nationalisation via the Special Administration Regime, the more likely the board remains in place. Plan A is the best option for them, but is it the best option for the customers?
There is no suggestion that the board has any conflict of interest here, but were the appearance of that to arise, who in the absence of effective and active equity owners would act to eliminate that appearance?
Probably some thought should be given at the regulatory and governmental levels as to how customers can be protected in the absence of both a Special Administrator and anyone performing the duties of equity. Switching to Plan B saves customers money but it would be nice to be certain that the board are weighing that prospect equally in the balance with their own survival. This is the crux on which perceptions of a potential conflict of interest turn.
