Riding the equity boom

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Christopher Gasson looks at how the capital markets are ignoring the anti-privatisation rhetoric of some politicians.

What does the shortlist for the Deal of the Year in the Global Water Awards say about the state of theindustry? The first thing that stands out is that international capital flows are being replaced by local capital flows. Three of the transactions shortlisted for Deal of the Year are IPOs: Lydec in Morocco, Tallinna Vesi in Estonia and Manila Water in the Philippines. Of the three others, one is a large concession being awarded to a local concessionaire (in Selangor, Malaysia), one is a local currency bond financing in Poland (the Bydgoszcz water revenue bond), and one is a management contract in Algeria with all the investment provided by the client.

More than anything, it is a sign of the increasing maturity of capital markets in middle income countries. Historically, the stock exchanges of emerging markets have been dominated by sprawling family industrial concerns which make more money for insiders than outsiders. Institutional investors
tend to prefer to buy government bonds, which have a degree of transparency and accountability.

Water companies offer an attractive alternative. They are transparent because they are continually in the public eye. They also offer dependable revenues and a predictable return, and they are a better hedge against inflation than a government bond.

The appetite for water equities among institutional investors in emerging markets spreads far beyond Morocco, Estonia and the Philippines. As our investment survey starting on p8 shows, there is a strong appetite for water equities right across the world, from China to California.

It highlights a fascinating paradox. While private water has been politically on the retreat since 2000, all along it has been on the advance from a financial point of view. Since the dot.com bubble of 2000, demand for securities with a clear, dependable and rising return has been growing year-on-year.

Ten years ago, the whole utilities sector might have been in a position to meet that need, but the telecoms bubble and power deregulation has meant that only water still gives those good old utility returns. The problem is that there are just not enough water companies in which to invest, so values are going up. Water equities outperformed the market by 14.7 percentage points in 2005 and 13 percentage points in 2004. And this is the rub: rising valuations will attract more water companies to come to market to take advantage of the excellent financing conditions, regardless of the political rhetoric. The growth of the private water sector may in fact have an equilibrium rate. If supply of investment opportunities in the water sector is restricted, then valuations increase until more water investment vehicles are attracted to the market.

So what can go wrong?

The first thing to remember is that the main threat to water stock prices is not operating performance but the rise of other asset classes with similar risk profiles. In that sense, the greatest danger for over-valued water stocks comes from rising interest rates. Even then, with RPI related tariff regimes, water equities could prove a better bet than bonds.

In the meantime, we can expect a substantial rise in corporate finance activity in the water sector during 2006, with more water utilities taking advantage of valuations to finance themselves independently of
government. It is an opportunity for everyone: water companies, bankers, lawyers, equipment suppliers, and consultants.

Happy New Year!