May 8 (Bloomberg) -- Brandon Freiman was sizing up water investments for KKR & Co.’s $4.6 billion infrastructure fund in 2011 when he came across a debt-burdened New Jersey city that Tony Soprano skirts by to open the Time Warner Inc. HBO series.
By December 2012, Bayonne, KKR and the United Water unit of Suez Environnement, Europe’s second-biggest water company, struck a first-of-its-kind deal in what bankers say may become a U.S. model. Results were almost immediate: Bayonne, at risk of a credit downgrade, cut debt by more than a third. Moody’s Investors Service raised its outlook to stable from negative.
Public-private partnerships, or PPPs, are common for capital-intensive infrastructure projects such as toll roads and bridges. Government funding lands there too: The nearby Bayonne Bridge is getting a $1 billion overhaul. Municipalities steered away for years from private funding for water projects until Bayonne after failures such as a decade ago in Atlanta, which endured surprise rate increases and service complaints.
“It’s just been really, really rare in the water space,” Freiman, the director who oversaw the accord for KKR’s Energy & Infrastructure fund, said in an interview. “These are difficult deals to get done.”
With the U.S. government estimating as much as $1 trillion in water upgrades needed by 2020, many are reconsidering. Bayonne’s 40-year, $307 million deal, called a concession agreement, was followed by another when the California town of Rialto agreed in January to a 30-year pact with Goldman Sachs Group Inc., Barclays Plc, Table Rock Partners LLC, Ullico Inc. and Paris-based Veolia Environnement, the largest water company.
Allendale in northern New Jersey is also considering an agreement with United Water to assume operation and maintenance of its water department, according to the borough’s website.
Bayonne, which received a $150 million payment upfront, has since had inquiries from municipalities in Texas, Colorado and Florida, said Steve Gallo, executive director of Bayonne’s municipal water utility and Mayor Mark Smith’s chief of staff.
Without the deal, the city was facing rate increases of 24 percent to 30 percent, Gallo said yesterday.
“Nobody likes to pay increased rates on anything,” Gallo said in an interview. “With this transaction, we were able to mitigate that down to an 8.5 percent immediate increase, a couple years of no increase, and then a steady increase of less than 4 percent. Across the board, it made sense. It insulates you from huge rate shock.”
Since the Bayonne water pact, inquiries have picked up, KKR said. “We thought if we can get one done, then that will really illustrate our ability to demonstrate the concept,” Freiman said.
The deal’s “a potentially groundbreaking transaction that may lead the way for further private equity participation in the water-system asset class,” Su Gao, an analyst for London-based Bloomberg New Energy Finance, said in a report.
Global Water Intelligence, an industry publication, gave the Bayonne concessionary agreement a “distinction” award at an April 22-23 water conference in Seville, Spain.
KKR isn’t only interested in U.S. water, acquiring the central England water supplier South Staffordshire Plc from the Greenwich, Connecticut-based infrastructure fund manager Alinda Capital Partners Plc, the companies announced today. Terms weren’t disclosed. The deal was agreed to on May 3, they said.
Rialto and Bayonne participants said the two-plus years needed to work out the contracts ensured fewer missteps. Municipalities get global water expertise and a capital injection that spares funding for libraries, police and schools. Unexpected cost rises that plagued earlier agreements are tempered by a rate-stabilization fund.
In exchange for the 8.5 percent initial rate increase, or about $5 a month per Bayonne residence, rates freeze until 2015, when a 3.5 percent raise is scheduled. After that, rates are calculated each year at a fixed rate for 70 percent of the water bill increase with the rest tied to an inflation index.
Private placements, or loans typically in a 5 percent to 6 percent range, help smaller communities that may struggle to compete with big cities to sell bonds tied to water infrastructure, said Kathleen McNamara, a municipal strategist at UBS Wealth Management in New York, which oversees about $90 billion in local debt.
“When they come to market, they have to issue debt with higher rates just to sell their bonds,” McNamara said.
Water and sewer project bonds returned 4.59 percent on average the past 12 months. That compares with an overall muni-bond average of 4.7 percent, according to Barclays index data.
These water pacts differ from recent pay-for-performance PPP agreements in North America. Deals in Pittsburgh and New York with Veolia that peg performance to peers followed a 2011 agreement in Winnipeg, Canada. Veolia helps find efficiencies, such as installing meters. In New York, Veolia identified $108 million to $130 million in annual savings.
“In New York and Pittsburgh, it’s shorter-term contracts,” Laurent Auguste, who runs Veolia Water Americas, said in an interview. “We’re not talking about 30 years, we’re not talking about the private company taking over day-to-day operations, which are still run by the city.”
Concessionary structures are common outside the U.S. from Europe to Asia. Customized arrangements are needed in the U.S. because each municipality has different rules. Veolia “absolutely” expects to see more arrangements like Bayonne and Rialto, Auguste said.
Concession agreements, called such because of tax rules, tend to fall apart in the first two years and raise rates more, said Mary Grant, a researcher at the Washington-based advocacy group Food & Water Watch. In operating deals, a municipality keeps responsibility for improvement funding. Private agreements often put the burden on companies.
“Our primary concern is the loss of local public control over water resources and management,” Grant said. “That affects the cost of service and the quality of service.”
Gary La Pelusa, a former Bayonne councilman and commissioner for the city’s previous water authority, opposed the deal and rate increases, saying Bayonne gave up too much.
“The city could have done all these things on their own,” he said in an interview. “I live in this town, I get a water bill just like everybody else. I just felt like it wasn’t worth it.”
The water-advocacy group opposed a measure in Allentown, Pennsylvania, that on April 2 awarded a 50-year, $220 million water-system lease to Lehigh County Authority, a nonprofit that outbid United Water and American Water Works Co., the largest publicly traded water company in the U.S. Allentown sought to plug a $170 million budget hole from underfunded pensions, not an overhaul.
“We looked at a lot of things, and I thought, ‘OK, here’s an asset we can actually monetize,’” Mayor Ed Pawlowski said in an interview. “And we’re doing profit-sharing on any future expansion of water sales.”
Concession agreements don’t offer the 20 percent-plus annual returns of typical corporate private equity deals, unappealing for short-term investors, said Megan Matson, a Table Rock partner who negotiated the Rialto transaction. Her firm wants to do more and is talking with several cities.
“Long-term secure returns are really difficult to find right now,” Matson said in a phone interview. “The overall equity returns are in the 15 to 19 percent range, which isn’t wild, but we understand it, it’s solid for the long term. It might be harder up front than a lot of companies want to pursue but for us it’s really satisfying.”
The private sector has shouldered more responsibility in recent years, executives, city officials and bankers said. With all the calls to upgrade U.S. water and water-treatment systems, firms see potential for annuity-type cash streams.
Municipalities also have much to gain from pursuing such agreements, said Lewis D. Solomon, a George Washington University professor who wrote “America’s Water and Wastewater Crisis” and gave public testimony on Allentown’s deal.
“There’s a lot of capital available, with private equity, infrastructure funds, there’s a lot of investor interest,” Solomon said in an interview. Since Atlanta, “a decade has passed. People have learned. Municipalities are more sophisticated. The private partners are more sophisticated.”
For Bayonne, the deal already eased one concern: Moody’s on March 6 raised the city’s debt outlook to stable. Bayonne’s $262.3-million general obligation bonds are rated Baa1, the third-lowest investment grade.
That’s boosted the interest level, said Hadley Peer Marshall, a Goldman banker who worked on the Rialto transaction.
“Private placement is investing more time in this asset class,” Marshall said in a phone interview. “There are more of these opportunities popping up.”
Private-equity funds have been used to build new facilities, including a wastewater plant in Santa Paula, California. The Bayonne pact is significant “because one of the biggest issues with water systems in the U.S. is that there’s been a lot of deferred maintenance,” BNEF’s Gao said in an interview. “It was really interesting to see a new model of investment on the O&M side.”
In the Bayonne arrangement, KKR made 90 percent of the equity investment via its infrastructure fund and United Water the remainder for a total initial investment of $172.5 million. Bayonne owns the assets, with the new venture leasing them.
The agreement also commits to capital investment in the water, sewer and stormwater system of about $110 million over 40 years, a slide presentation from KKR, Bayonne and Suez shows.
According to the agreement filed with New Jersey Board of Public Utilities and Gao’s report, about $125 million of the upfront payment went to extinguish debt owned by the old Bayonne Municipal Water Authority, backed directly by the city.
About $7 million will be used for capital improvements within two years, up to $2.15 million in each of the next two years and about $2.5 million for additional improvements yearly after that if needed.
The intricate structures and negotiations in the Sopranos’ home state show water companies learned from past mistakes, mostly around funding mechanisms and initial capital investment, United Water Chief Executive Officer Bertrand Camus said.
“They want to have control over rates,” Camus said in a phone interview. “This is what we tried to bring to the table with this model.”
“We didn’t guarantee anything other than a revenue stream,” said Joseph P. Baumann Jr., a lawyer who worked on the transaction for Bayonne’s municipal water utility. That helped assure city officials investors weren’t getting “a windfall.”
Robb Steel, Rialto’s redevelopment director, said city officials realized they needed help running and funding their system, which had lost about half its employees without replacing them. And Veolia already ran Rialto’s wastewater system.
“Most cities have a certain amount of bravado that they want to manage these things themselves,” Steel said. “Water and sewer is something that we didn’t view long-term as something we were very good at. That’s why we cut and run.”
To contact the editor responsible for this story: Reed Landberg at email@example.com