By Daniel E. Muzquiz, Michael R. Sani and Stephen J. Hoffmann
Summary: Investors looking for sound and stable investments have been shaken by the recent volatility of the stock markets. One market acknowledged here that continually falls under the radar is the water industry. Here are a few thoughts before plunking down one’s life savings.
The severity of the global economic downturn and associated decline in equity prices has forced many investors to redefine their tolerance for risk. With volatility in the broad markets reaching unprecedented proportions, institutional and individual investors alike are looking for themes that exhibit more stable growth prospects. The water industry offers one such theme. Awareness has grown of global opportunities associated with the need to provide quality drinking water to ensure public health and supply the quantities necessary to sustain economic growth. The water industry is in transition as the true economic value of its primary resource is being factored into the cost of providing it. Private investment in the water industry is a key component of this transition.
While utilities such as telecoms and energy companies have suffered from stock market and commodity price swings, growing demand and more constant prices make the water industry, in general, less exposed to economic cycles. One of the attractions of the water industry today is that many companies in the water business represent a unique combination of value and growth. Value is derived from the essential nature and demand characteristics of water consumption. Growth is a function of accelerating earnings as the global water industry transitions to market-based solutions.
Private capital influx
The positive business model hasn’t escaped the attention of the world’s top water consolidators—Veolia Environment (formerly Vivendi Environnement) and Suez, both of France, and Germany’s RWE. Since 1999, these European flagships have spent over $25 billion snapping up the largest publicly listed utilities, equipment suppliers, and water treatment companies in the United States. The privatization of European water utilities, however, was the first phase of the massive financial restructuring of the global water infrastructure. Since privatization, there has been a number of changes that put pressure on the private sector equity ownership structure. The downside for the large multinational utilities is that the global acquisition of customers came with a heavy debt load—over-investing has caused available cash flow to lag. A good example is the recent sale of Northumbrian Water, a water and wastewater utility in northeastern England by Suez. Suez bought Northumbrian in 1995 at the height of the U.K. deregulation process. Financial constraints forced Suez to sell 75 percent of the utility, thereby substantially reducing debt.
Of greater interest, however, is the nature of the group that acquired Northumbrian from Suez. The utility was acquired by Aquavit, a consortium of institutional stakeholders led by Deutsche Bank and including United Kingdom (UK) brokers Collins & Stewart and the corporate finance firm Ecofin. As a financial buyer, the group is taking advantage of low interest rates and the utility’s inherent leverage to optimize its return on equity. The deal, which includes an unusually high proportion of equity, marks a change in the water industry. It’s believed that they’ll float the shares (British for a public offering) of Northumbrian and use the utility as a platform for add-on acquisitions. This consortium beat out the equity firm CVC Capital. It’s clear private equity capital is entering the water industry in a big way.
While large transactions will undoubtedly continue, the vast majority of investment transactions are expected to take place on a much smaller scale—the occurrence of which is of greatest interest to water treatment professionals. The water industry remains fragmented and ill defined, comprised of many firms classified as cottage or family businesses as well as diversified global behemoths. There’s significant potential for further consolidation and change. As such, there’s a growing incentive for private equity firms to become active in any one of a number of targeted segments within the water industry. For owners of small- and mid-market private companies engaged in water or water-related businesses, there’s an opportunity to take advantage of this reallocation of equity capital. From point-of-use (POU) dealers and assemblers to equipment manufacturers to water service providers to treatment technology companies, there are private equity firms looking to make acquisitions.
Private investment overview
Whether an owner seeks out a buyer or is contacted confidentially, it’s important to understand the different types of investors and thereby know which is the best fit in achieving the seller’s objectives. The sheer number and types of investing firms can be daunting. For the owner(s) selling a water business or looking for growth capital to get to the next level, it isn’t often clear just which type of firm is best suited to accomplish their objectives. Plus, there are many ways to categorize and breakdown potential investors. One of the more instructive approaches is to first distinguish between strategic and financial investors.
Strategic investors are generally defined as any company that’s looking to build upon a particular business model by acquiring a water company that, in some way, complements its existing activities. The key distinction between a strategic buyer and a financial buyer is the strategic buyer is often an operating company that believes acquisition of the target company enhances the operational aspects of their business. This can include product extension, geographic penetration, horizontal and vertical integration, among others. Examples of some well-known strategic buyers include ITT, Danaher, Pentair, General Electric, Crane and Flowserve.
Financial investors and private equity investors are often used interchangeably. Financial investors, however, can be categorized further by their investment strategies. These firms range from venture capital to more traditional private equity firms.
Venture capital: These groups typically commit risk capital in the very early stages of a company’s growth or for very high-risk situations. Examples include business start-ups, development-stage companies and commercialization opportunities. Owners that obtain venture capital should expect to give up greater ownership and control due to the unproven nature of their business model. Further, since profitability is often lacking, valuations tend to favor the buyer, who builds the potential loss of capital into the purchase equation. Venture capital in the water industry is in its infancy as many of these firms have little historical experience to draw upon.
Private equity: Traditional private equity firms are often more suited to accommodate the owner of a private water company that seeks to sell all or part of the business. Transactions can vary in purpose and include:
- Management buyouts—non-shareholder managers are backed by a private equity group, given the opportunity to participate in the equity ownership of their company and benefit from the value created under a new ownership group.
- Growth capital—generally refers to a capital infusion to enhance the ability of a company in an expansion stage to gain market share more quickly, develop new products, or improve competitive position.
- Acquisition capital—situations where a company sells all or most of its assets or stock so the acquirer has control following the transaction.
Putting up the coin
Traditional private equity firms often satisfy a company’s needs by providing capital for a wide variety of purposes. This capital would otherwise be difficult to raise from collateralized lenders such as a commercial bank. Private equity firms pursue businesses that are fundamentally attractive, but which lack either the high-growth characteristics sought by venture capitalists or the scale required to interest many large strategic buyers. Private equity firms typically focus on elements specific to their expertise. Some general aspects they look for in an acquisition target include:
- A fundamentally sound and durable business,
- Availability of a strong middle/lower management team,
- A fair purchase price in relation to historical performance,
- Opportunities for management and the buyer to add value to the business over time, and
- Investment criteria specific to the private equity group.
Another way of categorizing financial buyers is by their investment targets. Each financial buyer selects opportunities within a certain investment range. While definitions vary, the small market generally entails investment amounts from $1 million up to $15 million, the middle-market from $15-to-75 million, and the large market is above $75 million.
Private equity firms are looking for sound fundamentals that can be turned into a platform for further investment and/or acquisitions. Firms such as this provide owners with attractive exit options where they can realize much of the value of their company. In return, the private equity firm purchases a solid company with potential for adding value to the operations through infusion of capital and additional management resources. Private equity firms with these objectives are well suited for owners looking for an ownership transition.
It’s important for owners to ask themselves why they should sell or take on investors. There are many strategic reasons why an owner may want to sell all or part of the business. The water and wastewater industries remain extremely competitive and are subject to regulatory change and political mandates. Sellers may see an opportunity to move into new distribution channels, develop technological expertise, obtain new customers or combine complementary product lines, but need capital. If it’s a relatively established business, owners may desire to merge with a company that has greater financial and management resources to catapult the company to the next stage of operations, achieving economies of scale that are increasingly important in the dynamics of the water industry. Significant individual considerations exist in selling as well including personal factors such as age and health, management succession, and estate/tax planning considerations.
For the owner looking to capitalize on the interest of private equity firms in the water industry, it’s critical investment initiatives of the buyer match objectives of the seller. Private equity firms are positioned to be a positive force in the dynamic global marketplace for water and wastewater products and services as long as value is added over and above the simple infusion of capital.
About the authors
Daniel Muzquiz and Michael Zani are founders and principals of Phoenix Strategy Investments LLC, of Dallas, and have substantial operating and financial experience in all stages of the private equity business. Steve Hoffmann is a venture partner with the company and has over 20 years of experience as a water resource economist and environmental consultant to the water industry. Phoenix Strategy Investments LLC is a private investment firm that specializes in the acquisition and operation of small-market companies engaged in all aspects of the water industry. They can be reached at (214) 560-2274 or website: www.phoenix strategy.com