Nicholas DeBenedictis wears his business on his sleeves, in the form of "hot" and "cold" cufflinks, and an American flag pin on his lapel. He's the CEO of Aqua America Inc., which he has built into the largest publicly traded water utility in the U.S. by acquiring more than 175 local water systems during the last decade. He continues to buy 25 to 30 systems a year, and he's confident that his acquisition model is a beneficent one, both for the public and his shareholders. "The only way we can get hurt with this model," DeBenedictis says, "is overpaying for a bad asset, and a bad asset I define as an area where there's not enough water. We can't create water."
DeBenedictis is equally clear about whose acquisition model is not appropriate for water utilities. That would be the one used by the private equity investors who have been trickling into the industry of late. "It is unwise," he told an audience of industry leaders and regulators last year, "to put our precious water supply resources in the hands of strictly financial buyers who bring no operating experience and an ownership horizon that sometimes is as little as five years." Some of those regulators share his concerns. In March, the Public Utility Commission in Pennsylvania (home state for Bryn Mawr-based Aqua America) voted to reconsider the previously approved $400 million sale of Utilities Inc. to Hydro Star LLC, a private equity fund affiliated with American International Group Inc.
These are interesting times for the U.S.'s vast collection of water systems, nearly all of which are small, deeply embedded in a local political scene and thirsty for capital. Despite some consolidation, about 84% of the country's 50,000 regulated systems serve fewer than 3,300 people, and governments own about 85% of the sector. What's likely to change all that over time is the sector's need for investment. According to the U.S. Environmental Protection Agency, about $277 billion is required over 20 years to fix the country's deteriorating drinking water systems, with a further $223 billion needed for repairs to wastewater systems.
Various players have looked at this picture in recent years and seen opportunity. European utility conglomerates such as Germany's RWE AG and France's Vivendi SA (which owned a large but noncontrolling stake in Aqua America until 2002) went on a buying spree of U.S water systems in the late 1990s. But they often overpaid -- the weak euro at the time didn't help matters -- and are now retreating. Their exits, in turn, are one reason the private equity firms see an opening.
Meanwhile, Aqua America has grown steadily, though it is still a modest-sized company. Acquisitions have helped push its revenues to $496.8 million in 2005 from $307.3 million in 2001. It has a market capitalization of $3 billion -- half the $6 billion market cap of the total 11 publicly traded water utilities. Its water and wastewater treatment operations serve roughly 2.5 million customers in 13 states from Maine to Texas.
How does Aqua do it? DeBenedictis, who has led Aqua for nearly 15 years, would seem to be a major factor. His résumé includes a degree in environmental engineering and science from Drexel University, a stint running the Chamber of Commerce of Greater Philadelphia and cabinet positions in Pennsylvania's government. He's also an engaging storyteller with a big reservoir of lore about municipal and state politicians, sundry local tycoons and the evolution of the country's various water systems. He is frank about the edge his industry and government experience affords him. "If you know the rules better than your competitor," he says, "you can use the regulatory system to your advantage."
Most of Aqua's deals tend to be tiny, reflecting the industry's fragmentation. In May, though, Aqua announced one of its largest transactions, agreeing to buy Merrick, N.Y.-based New York Water Service Corp. in a deal valued at $51 million, including $23 million worth of assumed debt. In July, it made a handful of acquisitions. Its subsidiary, Aqua Texas Inc., bought the water and wastewater utility assets of Hood County Utilities Inc. for just under $1 million, picking up three water systems and one wastewater utility serving more than 2,200 Texas residents. That month, it bought two troubled water systems in North Carolina. And its nonregulated subsidiary, Aqua Waste Water Management Inc., purchased Charles M. Perna Inc., a wastewater and septage hauling company in eastern Pennsylvania, for $5.6 million at the end of July.
Public perceptions matter a lot in such deals. "Usually," DeBenedictis says, "the municipal government won't sell it to us unless they know they have a huge rate increase coming. And that's all on the record, because they've had to discuss it at the public meeting, and we've usually said, 'You're going to end up better with us than you would have on your own.' "
Aqua's strategy calls for establishing a presence in a given area and expanding into contiguous areas. That was the significance of the Long Island deal last May, Aqua's first -- but probably not last -- in New York. If the target is, say, within 50 miles of someplace it already serves, Aqua can use pipe to physically connect the systems, and most of its deals are within close enough range to do this. Integration mainly affects back-office functions. "Usually we keep the existing staff," says DeBenedictis, "and we keep the existing management, and ask them to follow our rules." Things like purchasing, accounting, HR and government services, on the other hand, are centralized.
Having bought, Aqua must then deliver on its premise for buying -- which is that it will make the needed investments in the local infrastructure. Aqua is cash-flow-negative, investing more money in its properties than it is collecting from customers. "We're going to spend a quarter billion this year [on infrastructure]," says DeBenedictis. Aqua aims to replace 1% of its pipe a year. "That doesn't sound very aggressive," he says, "but it's probably the most aggressive in the country."
Aqua's financial model -- which involves tapping both the public equity market and the tax-free debt available to utilities -- is central to DeBenedictis' beef with the PE firms, and he says that if PE deals start getting approved, he'll change it. Aqua makes its purchases with an even split of short-term debt and equity, then converts the short-term debt into long-term tax-free financing. On the equity portion of its investment, a regulated utility may only receive a rate of return that is deemed fair by regulators. DeBenedictis says he is prepared to borrow additional debt to help cover Aqua's equity commitment if buyout deals are allowed to generate bigger profits with higher leverage. "We have double A ratings," he says, saying that finding a lender shouldn't be difficult.
Yet it's not as though regulators are welcoming private equity firms into the sector with open arms. And since the larger deals they favor inevitably involve multiple regulators, there are multiple hurdles for them to clear. Utilities Inc. is based in Northbrook, Ill. The seller is Dutch utility giant Nuon NV. But because one of the 17 states Utilities operates in is Pennsylvania, the Pennsylvania Public Utility Commission gets its say about the proposed $400 million sale of Utilities to AIG-afffiliated Hydro Star. Chairman Wendell Holland said this in a statement in May: "I worry that these equity investors may have little, if any utility managerial experience. As a result, there could be dire consequences for the quality of utility service for ratepayers in the short and long run." In an interview, Holland would not discuss details of the transaction, but he says the regulator looks at financial and managerial expertise when evaluating any purchase. A buyer, he says, must be able to provide safe, reliable and affordable service to the community.
DeBenedictis contends that buyout firms' practice of financing purchases with loads of debt, only to flip them for a profit a few years later, could bring turbulence to the industry. He raises the prospect of a utility struggling to pay off the debt it took on under a private equity firm's ownership and forced to shift the burden onto its communities by raising water prices. And since the local utility is of course a monopoly, customers would be stuck. The other worry, he adds, is that limited operating experience could compromise the quality of service.
DeBenedictis began voicing his arguments about private equity firms after a couple of buyout deals in the regulated gas and electric utility sector were denied regulatory approval. "That's what woke me up to it," says the Aqua CEO, who also sits on the board of power utility Exelon Corp. In December 2004, regulators shot down Kohlberg Kravis & Roberts Co.'s proposed buyout of Tucson Electric Power Co., as they did to Texas Pacific Group's deal to purchase Portland General Electric Co. in March 2005. Meanwhile, on the unregulated side of the power sector, buyout firms have raked in huge returns. In October 2005, for instance, a private equity consortium (which included Texas Pacific Group and KKR) made close to 7 times its money in the sale of a coal-fired plant called Texas Genco LLC to NRG Energy Inc. for about $8 billion. The group owned the facility for less than a year.
In the water industry, a second private equity deal is currently under regulatory review in several states. In February, Australia's Macquarie Bank Ltd. and its affiliated fund, dubbed Macquarie Essential Assets Partnership, agreed to purchase Bridgeport, Conn.-based water utility Aquarion Co. from British utility Kelda Group plc in a transaction valued at $860 million. Macquarie said it was committing a total of $305 million in equity and would finance the balance with debt. Mark Naylor, director of the gas and water division at New Hampshire's Public Utilities Commission, says he is not worried that the would-be buyer includes a private equity fund. He says that he has been assured by Aquarion -- which would keep its management team -- that customers will continue to receive the same quality water and service. He adds that the state would still have to approve any rate changes. A spokesman for Macquarie says the infrastructure fund invests for the long term, but would not specify a time frame.
In a third private equity deal that closed in April, CAI Capital Management Co. bought Vancouver, British Columbia-based Terasen Water and Utility Services from Kinder Morgan Inc. for about C$125 million ($112 million). The unit (since renamed Corix Water Systems) provides water utility services mainly in western Canada, but also in the U.S. Peter Restler, a managing partner of CAI, said at the time that the company would be capitalized conservatively, but didn't elaborate. The firm plans to grow the company in part through acquisitions, he said, looking for targets in the U.S. and Canada.
Given the industry's need for capital, there won't be any shortage of targets, either for aspiring financial investors like CAI and Macquarie, or for Aqua America. As they compete, though, it's worth remembering that this sector -- which looks so simple with its steady cash flows, captive customers and elementary product -- can get surprisingly complicated. Like the other European giants who took the plunge in the 1990s, Germany's RWE can attest to that. In March, it announced plans to shed Voorhees, N.J.-based American Water Works Co. through an initial pubic offering.
And in a sector where culture and political skills count for so much, you have to like the prospects of DeBenedictis and Aqua America. He has, of course, had conversations with buyout firms, and he says he has nothing against them personally. His message is more of a question than a conclusion: "Are we all on the same page of the hymn book?" he asks, sounding very much like a man in tune with the choir. - Christine Idzelis
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