Pennon purchases debt-ridden water firm in £380m deal

Pennon, listed owner of South West Water, has bailed out a privatised supplier of some of England’s wealthiest addresses.

Sutton and East Surrey Water, one of the nation’s most financially distressed water providers, was placed on a “at-risk”, regulatory watchlist. In recent months it has been forced by its Japanese owners to ask for cash injections.

Pennon will raise £180 million in investment to fund its takeover. Sutton and East Surrey Water is valued at £380 millions. Sumitomo Corporation, Osaka Gas and the owners of Sutton and East Surrey Water, who are in dire straits, will each receive £89million for their shares.

Pennon will use the rest of its money to reduce its debts. The company is over 80 percent leveraged, with net borrowings amounting to £291m on a regulatory cap value of £351m. Ofwat, a regulator, states that water companies shouldn’t be leveraged more than 65 percent of their net assets.

It is an odd relic of privatisation. The company supplies water only to its 750,000 stockbroker belt clients, which include homes and businesses from Sutton to Gatwick, and from Cobham to the west, along the M25, through Dorking, Reigate, Caterham, and Edenbridge, Kent. Thames Water is primarily responsible for the sewage and wastewater of households in this region.

The company announced last year that it had lost £31m and was going through “a strategic review”. It was also trying to find a buyer.

Sutton and East Surrey Water, despite Ofwat’s demands that water companies in financial trouble stop paying dividends last year, paid out over £8 million. The regulator’s most recent report on the financial health of the water companies in the country grouped it with its two huge neighbours Thames Water and Southern Water as the least resilient.

Ofwat stated that Sutton and East Surrey Water’s financial metrics were being pressured by high inflation and operational issues. The company acknowledged it would need to increase funding to support the capital programme and strengthen its financial resilience.

S&P, rating agency, gave Sutton and East Surrey Water an unfavorable credit rating of BBB with a negative outlook, saying that “credit metrics are substantially below our expectations due to the accretion of the company’s debt linked to inflation and the deterioration in operating margins”.

Sumitomo Gas and Osaka Gas made a commitment last year to inject £22 million in Sutton and East Surrey Water by the end of the financial year, which is March. Pennon’s £89-million consideration includes £14-million of the £22 million that Sumitomo and Osaka Gas have already pumped into Sutton and East Surrey Water.

The Japanese owners received a poor return on their investment, having paid 3164m for the company in 2013. They would have recovered some of this money from past dividends.

Iain Cain is the CEO of Sutton and East Surrey Water since 2020. He was previously the managing director for retail water and customer service at Thames Water. Cain received £544,000 in salary and bonuses last year. This is a marginally higher amount than Susan Davy’s £450,000 bonus, a 54-year-old chief executive at Pennon who declined it.

Water industry sources confirm that, despite being on a smaller scale than the financial crisis at Thames and Southern, the rescue of Sutton & East Surrey Water must be seen as a response to the current financial situation. Thames shareholders have pledged to inject £3.75 billion into the company by 2030 in order to improve its financial situation, while Southern’s administration was saved through and a £1.65 million deal with Macquarie.

Pennon shares, a FTSE250 company, increased by 2 1/2p or 0.3 percent to 752p.

The state of Sutton & East Surrey Water is a microcosm that reveals much about privatisation in England.

The company, owned by foreign investors who have used it to pay dividends and to ensure that free cash is available to their shareholders, has accumulated a large amount of debt. It is now a business in a downward spiral due to levels of inflation in operational costs and interest rates that have not been seen for a generation.

These foreign investors are still taking dividends despite the fact that they need to invest. However, they do not want to put money back into the public utility. This is a service run by the community for its benefit.

The householder also has a poor performance: Of five key performance indicators, including interruptions of supply and repairs to mains, it missed four last. This led to Ofwat penalties that have worsened the financial crisis. Its chief executive, who is responsible for just 345 employees, is paid over £500,000 per year. Nearly half of that amount comes from bonuses.

Thames Water and Southern Water have also been experiencing similar crises, but on a larger scale. SESW, a local business that only supplies water, is a peculiarity of privatisation. Its three quarters million customers depend on Thames Water and Southern Water to transport their waste water and sewage.

Macquarie saved Southern from falling into a so-called “special administration” at the eleventh hour. Thames is facing a £7.5bn funding gap.

The privatised water sector has a special administration, which is designed to protect customers’ interests but not those of creditors or debtholders if shareholders decide to stop supporting a water business.

SESW, with Pennon’s rescue of SESW, has avoided this. It is not the only one. Ofwat intervened two months ago over the poor performance of South East Water (another water-only firm) in terms of supply interruptions and service to customers. The regulator had already placed it on its at-risk list of financial companies. It is now waiting for the owners, including Natwest’s pension schemes to respond.

Thames is another example, where the crisis is being broadcast live on televised hearings in Westminster. The sewage spills continue, the leaks do not stop, and it has debts that it cannot pay. Its continued existence is dependent on the goodwill of investors. This may not last forever.