In the Thames Water debt game, all that matters is the final result

Back in April I wrote that investing in Thames Water looked a terrible idea. The owners wanted out, lenders were running for the lifeboats and the regulator was ready to pour a smelly combination of fines and less-than-hoped-for price increases all over it. But, as I went on to say, whenever there is a big debt restructuring, with the chance of regulatory gaming on the side, adventurous and avaricious investors will grab the opportunity to make some money.
That explains why a group of lenders this week struck a tentative deal with Thames to advance it up to £3 billion. These investors — which include the US hedge funds Elliott Investors and Silver Point — are not really investing in Thames. They are investing in the complicated financial restructuring that will play out over the next year, and betting they are more skilled at the game than all the other players. Are they interested in what happens in the coming court battles, what the regulator says about future price rises and the minutiae of Thames’s capital structure? Absolutely. Do they care about stopping sewage spills and better-quality drinking water? Well, sure, that might be nice too.
• Dominic O’Connell in April: Thames Water cannot escape that sinking feeling
The game is complicated, but it is already clear what a win looks like. Thames has too much debt — about £16 billion in total. For it to have a future as an independent company, a big slice of that debt has to be shed. To win the game, you have to make sure your debt doesn’t get written off and someone else’s does, or, a version of the same thing, buy your debt at a price that looks cheap once the dust has settled. It’s a mad scramble up a tree that is disappearing into a shredder. If you are on top when the shredder stops, you win. There are bonus points for extracting some fees during the race up the branches.
The warm-up has taken place over the past six months. To recap briefly, Thames’s owners, a group of investment funds including the Universities Superannuation Scheme, said the whole thing was a lost cause. They refused to put in any more money to balance the borrowing needed over the next five years. Without their support, Thames is likely to run out of cash in the new year and ownership will pass to its lenders.
That urgent need for cash gave the opportunists their way in. They bought into the outstanding debt to give them a seat at the table. Two groups formed; one based on holders of the “senior” debt (the class of borrowing that gets repaid first if Thames goes bust) and another on the “junior” loans, which have to wait until last to pick over Thames’s carcass. Both groups made an offer to the Thames board: here is the emergency money you need, and here are our terms. This week the directors said yes to the senior debt holders — much to the anger of the juniors, but the outcome most observers expected.
You might think that as Thames already has too much debt, how does it help to load on another £3 billion? That is one of the wrinkles of the game. This new debt will be “super-senior” — ie rank above all the other outstanding loans. And it will attract a big interest rate (nearly 10 per cent) and there are hefty fees paid by Thames to those providing it. This debt should be a very good card to hold, probably the best in the whole pack.
• Alistair Osborne: Thames Water floating on the never-never
The game gets going in earnest next month. On December 17 (the date could shift) Thames will start the court process to have the new debt approved. There will be fireworks. The juniors will do their best to convince the judge the whole thing is terribly unfair. Their best point of attack might be the actions of the Thames board — can it prove it took proper advice and acted impartially in accepting the seniors’ offer?
Two days later Ofwat will release its final verdict on bill increases for the next five years. There will be big rises all round, including at Thames, but not as high as the company wanted. At the draft determination in July, Ofwat said bills could go up by 23 per cent. Thames had asked for 44 per cent, and has since asked for more.
This is a complicating factor in the game; the less income Thames has, then (probably) the more debt will have to be written off. There is a further complication: Thames has 60 days to appeal against the decision to the Competition and Markets Authority. How do the different players in the game put a price first on what Ofwat will decide, and, second, the chance of a successful appeal?
The 60-day period will expire (if things go according to the provisional timetable) a couple of weeks after the court gives the final seal of approval to the new super-senior loans. Thames will at least have the cash available to fund an appeal, but will probably only do so if the super-seniors give the green light.
Once the level of bills is finally sorted out, the endgame starts. Thames has to find new shareholders to replace the old ones. They will only be interested if they are buying something that has a chance of making money over the long term. That means, in essence, a lot less borrowing and a workable settlement with Ofwat. The super-senior lenders will have the whip hand in that reshaping of Thames — their ideal outcome will be their emergency loan repaid (with interest and fees), just the right amount of their other loans cancelled and the juniors obliterated.
That is a lot of balls to juggle, and lots of opportunities for them all to come crashing down. However, this is hardly the first time the game has been played. There is a whole cadre of financial institutions, Elliott and Silver Point included, that are specialists at finding money-making opportunities in these kinds of situations. What is more, they know — or at least can be reasonably sure — that the referee is not suddenly going to blow the whistle and call the whole thing off. The government has to date shown little interest in taking charge by putting Thames into special administration.
So the game will play out. There will be lots of twists and turns, but for us the only part that counts is right at the end, when the players walk off the pitch leaving Thames behind. Hopefully there will be new owners in place, happy to make money only if they fix the basics and improve water and sewage services in London and the Thames Valley. That is far from guaranteed.
Dominic O’Connell is business presenter for Times Radio