If past industry performance is any indicator of future events, Main Street Municipal Water might soon become Big Private Water, Inc. Throughout the past decade, the water industry has experienced a flurry of M&A activity in which private, or Investor Owned Utilities (IOUs), have stepped in to acquire struggling public operators. Large players such as American Water (NYSE:AWK) have acquired dozens of small operations to grow their customer base, take advantage of economies of scale and raise profit margins.
In an industry where expansion is the key to profitability, the scarcity of cheap capital has put small public utilities in jeopardy. Drastic decreases in employment and household income during the 2008 recession resulted in lower cash available to municipalities, in turn making infrastructure investments for expansion extremely unlikely. Financing expansion with debt has become more difficult as well due to a rise in interest rates from their near-zero levels after the recession. The 30 year treasury yield, for example, has increased more than 25% in the past year. This inability to access capital makes privatization one of the few survival options that these utilities have.
In addition to capital requirements for expansion, the EPA estimates that over the next 20 years $300 billion to $1 trillion in infrastructure improvements are required nationwide to improve, repair or replace drinking water and wastewater facilities. Under current economic conditions, small public utilities cannot handle the financial burden of these upgrades and instead need private companies with greater liquidity and more assets to step in and improve infrastructure.
While the occasional “blockbuster” deal takes place, the overwhelming majority of M&A activity in the industry happens in the $500,000 to $2M deal value range as IOUs make tactical acquisitions based on geographic strategies and precise timing.
There is some pushback and criticism of water privatization by certain special interest groups. These groups cite corruption, desire for excessive profits and poor water quality as issues. The EPA and General Accounting Office (GAO), however, published reports on water infrastructure privatization endorsing and supporting privatization as a way to bridge the gap between current spending levels and money needed for infrastructure investment over the next 20 years.
Even if the economic environment turns to become more favorable to small public utilities (i.e., interest rates stay low as household income increases), public utilities face a considerable challenge in repairing, replacing or upgrading current infrastructure while simultaneously managing growth necessary for profitability. To meet these growing demands, privatization is expected to be a continuing trend in the industry as private utilities acquire small public utilities with the intent to improve and expand infrastructure.