Sunday Brunch: Doing nothing can also create risk

“But as long as the music is playing, you’ve got to get up and dance.” Chuck Prince then CEO of Citigroup.

The quote from Prince has come to symbolise everything that was wrong with the financial system in the early 2000's. But it's not just finance companies that assume that they can carry on as normal. We see it in all sorts of other industries. Changing nothing, assuming the future will look like the past, is more common than we think. And inaction can bring with it massive risk.

The example I want to use today is Thames Water, but there have been numerous others over my thirty year career in finance. Companies that have seen the potential negative impacts coming, but assumed that they could carry on just that bit longer. Maybe they thought the regulator would 'rescue' them. Or maybe they hoped that lobbying would soften the blow. Or maybe it's just human nature? A bit like the urban myth about frogs and boiling water - we wait until we 'have to' change, rather than prepare. And then it's too late.

And tied up in this is a common fallacy about debt. I frequently hear that lenders don't have to worry about a company's long term risks. After all, most debt matures (gets paid back) in only a few years time. And so the lender will be long gone before it all goes wrong. But this ignores what is known in the industry as refinancing risk. Where a company has to raise new borrowing to pay off existing debt.

The bottom line - all financial investors should be worrying about the longer term. And if the company you are involved with is not facing up to the upcoming changes, and properly preparing for them, you really should be questioning why you are invested.

Thames Water lobbied for higher bills

The saga of Thames Water should be a lesson for all investors, both equity and debt. For those who are not familiar with the company, Thames Water is the UK's largest privatised water utility. And it's struggling financially. I would argue that to understand where we are now, we have to start with how companies create value.

In a way investing is simple. If a company can earn financial returns above the cost they have to pay to generate them, and they can keep doing this, then the company is (simplistically) creating financial value.

A regulated utility is a really clear example of this. The regulator normally sets two important things - the investments that the company should make to deliver the target services. And the financial return the company can make from this investment. Together these set the charges that the utility can impose on their customers. This should give the companies investors a fair financial return.

Once these are set, often for a five year period, then the company can only generate superior financial returns in one of two ways. They can be more efficient than the regulator expected - basically deliver the target level of service at a lower cost. Or they can lower their cost of investment by borrowing more.

And that process becomes easy if the regulator is not really measuring how well the company is delivering the services. And if they are not really punishing failure.

It's all ok for the company, until it's not. Until the failure to deliver, combined with the high level of debt, puts the company at risk of failure.

But utilities are different

Many people say to me, but regulated utilities are different. Well, yes & no. Regulation does remove some of the unknowns that normal companies face, such as future sales. But one overriding principle holds for all companies, regulated or not.

They have to be providing a service that the customers believe offers good value for money.

For instance, if people stop seeing iphones as being a 'better' product, or as being just too expensive for the value they create, they will stop buying them. It's that simple.

It's a similar but slightly different mechanism for regulated utilities. Customers expect them to provide a decent service. And they expect it to be provided at a fair price. If either doesn't happen, they start complaining. Maybe via the press, and maybe directly to their elected politicians. And then the pressure goes on the regulator to 'do a better job'. Which means making the utility provide the service that customers expect, at a fair price. It's the utilities version of customers no longer wanting to buy their product.

Same outcome, it's just we get there in a different way.

Which is where we are with Thames Water. Their water pipes still leak to much. And too much sewage flows into the rivers and lakes. And now the utility wants more revenue (higher charges to customers) to cover the costs of making the investment. But the customer thinks they have already paid for that level of service, so why should they pay twice.

Investors should have seen this coming. You cannot keep on providing what customers see as a poor service, at an unreasonable price, and expect to stay on business. And now both equity and debt investors have a problem.

Maybe they thought that as an essential service and a regulated utility, they could keep 'dancing' for a while longer?

One last thought - it's not only shareholders that can lose

Lenders to companies are also at risk if the company doesn't respond to the changes it faces. This can happen in two (connected) ways. One mechanism gets talked about the most. It's the company's credit rating.

Back in July Thames Water had it's credit rating cut to junk by one of the rating's agencies (Moody's).

Moody’s Cuts Thames Water’s Highest-Ranked Bonds to Junk

Thames Water asked regulators to help it avoid massive fines after it was downgraded to junk by Moody’s Ratings, adding to the financial pressure on Britain’s biggest water supplier.

BloombergJess Shankleman

The implications are straightforward. If you own a Thames Water bond (or more strictly one issued by one of it's parent companies) and you want to sell it, then the buyer will almost certainly pay you less than the price you paid for it. Probably a lot less.

This is the price chart for the Thames Water (Kemble) Finance Plc bond, that matures in May 2026. This is effectively telling us that the market doesn't expect this bond to be repaid when it matures.

But this is not the only way that lenders lose. The other risk is refinancing risk. Let's imagine that you are a bank and you lent money to a company. When you did your due diligence you saw the longer term risks, but you thought, that's ok, I will get repaid well before the problems arise. But let's think about how you get repaid.

Most companies do not have piles of cash sitting about to pay you back. What normally happens is that they raise new debt, to repay your loan. This is called refinancing.

But what happens if the risks you saw when you made the first loan are now closer, and more obvious. It's very possible no-one will lend the company new money to pay you back. And so there is a very real risk that the company defaults on your loan, and you get nothing, or maybe only a part, of your money back.

And believe me, losing your principal (which is what this is called) is horrible for a lender. In some ways a lot worse than watching the share price go down.

Please read: important legal stuff.