Thames Water - RP2, Expectations and Returns

All,

Please find our all new analysis of Thames Water here.

Will it be worth it? The New Money certainly will, but the next round will involve three- or more likely four-way discussions and no party appears to have a clear upper hand - except KKR, who could (and will at some point) walk away - at least temporarily. The more finely balanced negotiations should therefore also give rise to more finely balanced economics for creditors, who must commit to new long-term instruments that allow for liquidity and therefore an exit. We think the opportunity is interesting, but it will be more suited to some investors than others.

Investment Considerations:

- We are not taking a position in the Class A debt (never mind Class B). The attraction of the A Class was primarily transferred into the Super Sr. Notes, which should provide the original backstop parties with ~20% returns. However, from here on out, competition with KKR for fresh equity and the demanding CapEx schedule that will likely persist into AMP9 and possibly AMP10, should make the reinstated debt little more than average attractive. Coupons for the reinstated stubs could come as tight as 6% or less, while maturities will have to be stacked, making many of them long duration and thus highly exposed to factors outside TW that we feel we could replicate with Gilts. 

- The further CapEx is pushed beyond the end of AMP8, the longer it will take for EV to approximate RCV and we fear that the significant rise in water prices in London will make it politically impossible to cram it all into time frame anywhere close enough for us or many of the participating funds. This could be an ideal instrument for a leveraged vehicle with long-term locked up capital, but we don't think the new debt stack befits the needs of a an evergreen hedge fund, which is the assumption underlying our shadow book.

- The longer term stub instruments will again have significant duration, making them more appealing to macro / multistrat investors than distressed investors.

- We are not yet sure of the exit scenario for the minority equity, which will need to be paid for in cash, in what should remain a private company.

- We calculate an Equity Return of 10% IRR for an investment today of £6.5bn, if in 2040 EV equals RCV - on the assumption that the intervening CapEx is only barely financeable. We typically look for this kind of return in credit. This would primarily rise with a lower investment today, as the future RCV is limited by permitted price inflation and resulting cash flows. We concede that only slight adjustments to our case will significantly alter the return, but we are not privy to private information, and we doubt that even private access would vastly increase our confidence ahead of negotiations. 

Key Insights:

- Even as Thames Water’s proposed CapEx plan is materially more generous than AMP7, there is "only" a £1bn p.a. gap between stakeholders (See Recapitalisation). There is substantial alignment between the Company and creditors. However, the CMA is less concerned with pragmatic arithmetic and is focused only on quality of service. CMA process is unlikely to conclude before Treasury involvement, making it probable that KKR, as a potential sponsor, gets involved before the D/E swap—diluting creditor recoveries (See RP2). To avoid insolvency, the four-party agreement (Company, creditors, Treasury/Ofwat, KKR) must be finalised by early 2026, when existing S.Sr. funding is expected to run out (See Restructuring Plan).

- A 30% debt haircut would unlock ~£6bn in equity. A further £2.5bn equity injection could fund a debt/equity swap and repay S.Sr. debt (left pocket/right pocket), while an additional €4bn from a sponsor would secure majority equity and enable a CapEx programme still £5bn below regulatory expectations for AMP8 (See Recapitalisation). Realistically, Class A creditors could be reinstated near current market levels if they inject at least £2.5bn, while Class B creditors would recover ~3p/£ (See Recapitalisation).

- A DCF is of limited use, given sustained negative cash flows during the CapEx Catch-up phase, during which around £7bn in AMP8 CapEx do not seem to accrue toward RCV. To keep the plan viable, we have removed some £2bn of it (See RP2). By the end of AMP10, elevated CapEx drives the equity ratio down to 40% of EV, but valuation may improve under lower forward CapEx assumptions. EV could begin approximating RCV, offering significant upside not explicitly captured in the model (See RP2). Discounted RCV is therefore a more practical anchor for valuation today. While peers trade at a premium to RCV, Thames Water is likely to remain at a discount as long as CapEx must remain elevated. Only long-term London water pricing could justify a premium. Significant duration in the current debt stack offers further upside if UK fiscal consolidation leads to lower rates (See DCF / DRCV).

- All scenarios presented by TW and the regulator delay significant CapEx until post-AMP8, with even the Sensitised Case showing an abrupt and unexplained increase in revenues and CapEx in 2031 (See Model). RCV only aligns with debt plus equity once CapEx is deployed and the business turns cash flow positive; the 2031 bump warrants scrutiny (See Model).

Summary:

- Thames Water was privatised in 1989 as part of a broader UK policy shift aimed at introducing private capital into utility infrastructure. Following an initial period of public listing, the company was acquired by RWE in 2001, and later sold to Macquarie in 2006. Under Macquarie’s ownership, and continuing under subsequent shareholders, the capital structure shifted decisively toward financial engineering. Leverage increased substantially, while distributions to shareholders outpaced reinvestment in core infrastructure.

- By the early 2020s, the business operated with a thin equity buffer, multiple layers of structurally subordinated debt, and material exposure to inflation-linked instruments. This left it highly sensitive to shifts in the rate environment and operational underperformance.

- At the same time, ageing assets - the Victorian pipe system underneath London, triggered rising environmental expectations, which in turn drove CapEx requirements sharply higher. Regulator Ofwat tightened investment mandates under AMP7 and projected further increases under AMP8, but raising prices to finance this CapEx proved a bigger political hurdle. Thames Water’s internally generated cash flows proved insufficient to fund the necessary upgrades.

- The combination of structural underinvestment, a highly levered balance sheet, and a regulator unwilling to allow for price rises to finance growing expectations, made the existing capital model unsustainable. When macro conditions turned—particularly through rising interest rates and inflation—the Company had to turn to its creditors and ask for a Super Sr. bridge while RP2 negotiations for its AMP8 period would take place, so as to avoid entering int Special Administration.

- RP2 Negotiations will need the CMA to broker at least a three- way agreement between the Company and its creditors (close) and Ofwat. However, the process should get escalated to the Treasury, which would certainly want the new Sponsor (KKR) to be part of the agreement. Conclusion of negotiations and therefore a restructuring plan under Part 26A of the Companies Act 2006 is expected to take place in early calendar 2026. This coincides with a likely need for more liquidity at that time.

Moving Parts:

- Creditors should do better, the longer they can avoid KKR entering negotiations. This could, however, require substantially more cash equity investment and HM Treasury might still prefer a reputable sponsor.

- A drop in inflation and rates would greatly drive value for TW and its stakeholders. - Class B creditors could be wiped out. Following their lost appeals process, recovery of 5p/£ in exchange for a smooth process sounds like an opportunity to the Bs.

- Failure to agree on a new plan and capital structure could still land TW in Special Administration - even be followed by Nationalisation. However, none of the parties involved in the negotiations wants this outcome. We have not quantified the damage from this scenario as it will entirely depend on London water pricing and CapEx requirements set at that time, but it could well be substantial and the Treasury will want to use this scenario to bring creditors to the table.

- During RP2 negotiations the point will come when the sponsor walks out.

Here to discuss this name with you,

Wolfgang

E: wfelix@sarria.co.uk
T: +44 203 744 7003
www.sarria.co.uk