Memorandum submitted by T. Martin Blaiklock,
Consultant, Infrastructure & Energy Project Finance
The Treasury Committee has requested comments
with respect to Private Equity.
I have been a consultant, banker and practitioner
in infrastructure and energy project finance,PFI, PPP and
the like,for the last 30 years or more, with both UK and
wide overseas experience. I also regularly give seminars on these
My concern with respect to Private Equity, therefore,
is with its impact on the performance and sustainability of UK
private sector, public service utilities, a topic which, surprisingly,
has seemingly been overlooked by the Financial Regulator (FSA),
sector regulators and the media in recent discussion on Private
1. Is the current regulatory regime for private
equity funds suitable?
In short, the answer is "no". This
response requires some qualification:
(a) The FSA controls the nature and governance
framework of investment flows by Private Equity managers in the
UK. In this context, whether the investment is in a public service
utility or commercial enterprise and where the funds originate
from are not the concern of the FSA.
(b) Each privatised public service sector
has its own sector regulator, eg OFWAT, Ofgem, CAA, etc.. When
these regulatory bodies were created, usually by Act of Parliament
in the late 1980s / early 1990's, it was not foreseen in the relevant
Acts that ownership and control of utilities in the sector(s)
would slip into anonymity, beyond public scrutiny and governance.
It was assumed, erroneously, that these private public service
utilities would fall under the normal governance criteria and
financial regulation as imposed by the London Stock Exchange and
(c) Time has shown that to have been short-sighted,
and the City et al. have used their ingenuity and incentive-for-profit
to exploit the investment opportunities that such utilities with
their strong cash-flow characteristics represent. To date, the
sector Acts have not been adjusted or repealed to claw-back the
regulatory levers necessary to protect consumers and the public
(d) Additionally, over the last 15 years
there has been significant growth in the number of PFI/PPP transactions,
representing private concessions for the provision of public services
and assetsnow totalling 6-700 in the UKwhere the
ownership and control of the Special Purpose Vehicle ("SPV"),
which carries concession responsibility, often lies with Private
(e) Finally, in the same context many UK
public service utilities are now owned and/or controlled by private
family groups or individuals, whose domicile may well be offshore
in some tax-haven. These too are, generically, Private Equity
(f) Some examples of a few Private Equity-owned
and/or controlled utilities may help to put some perspective on
the services involved:
BAA (Heathrow, Gatwick & Stansted,
Jubilee, Northern & Piccadilly
Lines of London Underground
Inland Revenue & Customs &
Isle of Man & Isle of Wight Ferries
NHS Hospitals (eg Darent Valley;
Norfolk & Norwich)
Arquiva (mobile phone mast &
Seafield Water Treatment Plant, Edinburgh
(g) At a recent Public Accounts Committee
session (Dec 11, 2006) a senior Treasury official admitted that
they (HM Treasury) had no control over who bought or sold PFI/PPP-type
of public service utilities, and they are seemingly content with
(h) No other Government I know is prepared
to accept such a scenario with respect to its public services.
All other Governments impose some form of "fit and proper
person" or probity test on all private owners of public service
utilities. This requires identification of owners/controllers
and proof of adequate corporate and financial governance measures
Hence, one concludes that UK regulatory regime
for (Private Equity) investment in public services is, at least,
out-of-step with other nations, and also inadequate.
2. Is there sufficient transparency on the
activities, objectives and structure of private equity funds for
all relevant interested parties?
What are the effects of the current corporate
status of private equity funds, both their domicile and ownership
(a) These questions are best answered by
Thames Water: since last October, as a customer
of Thames Water, I have been trying to find out as to whom and
where are the investors controlling Thames, the largest water
utility in the UK (13mn customers). To date, I have failed!
Para 4.31 of the Feb 2007 Ofwat Consultation
Paper into the recent takeover of Thames demonstrates clearly
that a group of "Macquarie Bank investors", under the
name of "Kemble Water International Holdings Limited",
some of whompossibly allare domiciled in Luxemburg,
control the strategic direction of the Company and, possibly more.
To date the Company Secretary has refused to
divulge to me the identity and domicile of such investors, and
OFWAT, The Consumer Council for Water, the Freedom of Information
Act, the OFT, the Competition Commission, my Member of Parliament,
and the Parliamentary Ombudsman have been unable to assist me
to force the Company to reveal such information. Yet Thames enjoys
a monopoly position as a provider of an essential public service
to 20% of the UK's population and London!
OFWAT has a duty under the Water Industry Act
1991 to "safeguard the future" of the water utilities
for the benefit of customers. If OFWAT does not know who are the
service providers, what chance is there of the future being safeguarded??
[Note: Under the Water Industry Act, if I receive
water services, I have a duty to pay. I also have no choice as
to my supplier of this essential public service. The fact that
I do not know who may be the beneficiary of my payments is not
covered by the Act. This seems contrary to natural justice!].
(b) GCHQ: Integrated Accommodation Services
plc, "IAS", is the owner and is the concessionaire under
a PFI/PPP arrangement for the GCHQ building. The ownership of
IAS at the outset (yr 2000) was: Carillion [40%], Group 4 [40%],
and BT [20%]. Carillion was in charge of construction and Group
4 in charge of site security, accommodation availability, maintenance
and service (eg manage the security staff: ref HC (955, p. 22)).
In May, 2004 it was announced that Group 4 had
sold off its GCHQ investment to two Private Equity funds. In May
2005, under the Freedom of Information Act, I requested from the
FCO (who has responsibility for GCHQ) details as to the identity
and domicile of the shareholders of IAS. The FCO responded that
they did not hold such information!!
(c) Water Treatment Effluent Disaster (Edinburgh):
in April 2007 a faulty pump at a PFI waste treatment plant at
Seafield near Edinburgh, serving 800,000 people and operated/controlled
by Thames Water, failed and may have caused an environmental disaster
in the Firth of Forth. It may also, in time, give rise to local
health concerns to a wide section of Edinburgh's population.
As mentioned earlier, Thames is controlled by
an offshore Private Equity company based in Luxemburg. Seafield,
which is controlled by Thames, will, like many such PFI/PPP projects,
indubitably be set up as a limited liability company. In 1999
Seafield won the PFI concession to build and operate the treatment
plant, and raised £5 million of equity capital and £95
million of debt as funding: a highly geared financial structure.
In the current scenario of pending environmental
disaster, if insurance monies are inadequate to meet claims, there
will be minimal capital in the Seafield company available to cover
shortfalls. Secondly, the owners, ie Private Equity shareholders
of Thames, will be largely unidentifiable and offshore, so outside
UK jurisdiction. Thirdly, the Private Equity fund managers will,
under the financial arrangements made with their fund, carry no
responsibility or liability.
Is this scenario desirable? I think not, but
this is the creation of Private Equity.
3. Has there been any evidence of excessive
leverage in recent transactions and what systematic risks arise
This question is best answered by reference
to two examples: in the water utility and road transport sectors
respectively. To these should be added the comments made in 2
(c) above in this context.
(a) Water: in the early 1990's, shortly
after privatisation, the rating eg Standard & Poors, Fitch,
etc, of the average water utility was "AA-", ie comprised
a "very strong capacity to repay debt". Now, 15 years
on, the majority of water utilities have a "BBB" rating
or thereabouts, ie "protection of interest and principal
is moderate", just above the investment/sub-investment ("junk")
(b) When the rating agencies all express
concern at the steady decline of the investment grade status of
the UK's private water companies' debt, as they have in recent
months, the time has come to worry!! Thames' debt is only one
notch or so above ";junk" status. The financial structure
for Thames proposed by the new Private Equity owners, which increases
leverage, will increase, rather than reverse, this trend.
[NB. Thames is currently rated "BBB-",
one grade away from being sub-investment level. Its debt can be
described as where "protection of interest and principal
is moderate". Thames is, therefore, nine levels below "AAA"
(c) In this context, I have expressed concerns
to Ofwat over their over-reliance under their regulatory regime
on ratings to assess the financial health of UK's private sector
water utilities. Ratings are useful, but not the only tool to
be used. Secondly, it is somewhat alarming that there seems to
be no "Plan B" for when a water utility does slip into
(NB. The Wessex Water case, oft cited by OFWAT
et al. as an example of recovery in such circumstances, is hardly
appropriate. The problems at Wessex were not so much a problem
of Wessex, as a utility, but the problems of their non-UK parent
at the time, Enron. It is also worth recalling that the rating
agencies placed Enron debt well into investment grade status up
to a few days before Enron collapsed!).
(d) Transport: a casual glance at the (unaudited)
accounts of Midland Expressway (the M6 Toll Road), owned and controlled
by Private Equity (a Macquarie offshore investment fund), shows
(end-2005) that the company has a negative net worth of £67
million, issued capital of £1.5 million, and paid no income
tax to the Exchequer. With £800 million or more of debt and
£1.5 million of equity capital, the project company, M6 Toll,
is indeed highly leveraged!!
In August 2006, Midland raised £1 billion
of new debt, paying off what was outstanding (£650 million)
of the original debt, and paid its offshore Private Equity shareholders
a dividend of £392 million!!!a return on equity of
over 200% per annum since the start of operations in 2001!!!
(e) The main conclusions drawn from these
two examples are:
(i) in the context of Private Equity investors
in public utilities, there needs to be (a) a rescue plan in place
in the event of default; and (b) requirements (eg on-demand performance
bonds) under the licences to incentivize utilities against possible
default. These are issues for sector regulators;
(ii) lenders to privately-owned/quoted public
service utilities seemingly are also attracted by the high(er)
margins (ie returns) that some of these Private Equity transactions
represent, leading them into imprudent lending. That is an issue
for the FSA, as deal collapse could place some banks in peril;
(iii) Private Equity investors are not averse
to paying themselves excessive profits/dividends, when the opportunity
4. Are developments in the environment and
structure of private equity affecting investments in the long-term?
Yes. Again, the answer is best provided through
(a) In the periods 2001-02, 2002-03 and
2003-04, before the takeover of South East Water by Private Equity
(Macquarie Investment Fund, ie Private Equity), some 60% of profits
on average were distributed as dividends, the balance retained
in the company boosting internal capital.
After the takeover, the dividends in 2004-05
and 2005-06 represented 150% and 250% of funds available for distribution,
ie the company was distributing dividends to its shareholders
(in the tax-haven of Luxemburg) more money than the utility was
generating as profit, ie the company was eroding its capital base.
Some might call this "asset stripping".
In addition, in 2005-06 this erosion of shareholder
capital amounted to £26 million. This will constrain South
East's ability to raise funds for new investment in the future.
(b) To constrain such activities, OFWAT
on occasion imposes "ring-fencing" on dividend payments.
However, it is not beyond the accounting profession to devise
methods (eg shareholder loans, consultancy fees, etc.) to circumvent
such constraints and to minimise taxation for the Exchequer. Conclusion:
sector regulation is ineffective on this issue.
The over-riding conclusion is that the intervention
of Private Equity as an investor class in private sector, public
service utilities in recent years has shown clearly that the financial
and operational regulation for such utilities is out-dated and
needs adjustment to be able to provide the public with the service
protection they deserve.