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Even as construction economic reports continue to paint a less-than-optimistic picture, consolidation among water and wastewater service providers, manufacturers and distributors continues to outpace that of many other infrastructure subsectors. Increased federal funding for overdue water projects, strong cash positions of major industry players and private equity interest in the long-term fundamentals of the industry have contributed to this consolidation—a trend we see continuing into 2011.
The massive capital improvement needs for America’s aging water infrastructure are well documented. In its most recent “Drinking Water Infrastructure Needs Survey and Assessment,” the U.S. Environmental Protection Agency (EPA) estimates that capital improvement of $334.8 billion is necessary over the next 20 years for water systems to continue to provide safe drinking water to the public. This figure is up from the $198.2 billion reported in 1999 and the $331.4 billion reported in 2003.
Transmission and distribution projects, specifically the replacement or refurbishment of aging or deteriorating distribution mains, have the greatest 20-year need, requiring approximately $200.8 billion. Projects related to water treatment will require $75.1 billion over the next 20 years. The EPA uses the findings of the assessment to determine how much funding each state should receive for drinking water infrastructure improvements. According to the most recent assessment, California, New York and Texas have the largest 20-year needs, requiring drinking water infrastructure improvements of $39 billion, $27.1 billion and $26.1 billion, respectively.
America’s wastewater and storm water infrastructure is not much better off. Similar to the aforementioned drinking water assessment, in May 2010 the EPA submitted to Congress its fifteenth “Clean Watersheds Needs Survey,” which analyzes capital investments necessary to meet the nation’s wastewater and storm water treatment and collection needs over the next 20 years. The survey documents total capital needs of $298.1 billion, up from the reported $254.1 billion in 2004 and $220.9 billion in 2000.
Publicly owned wastewater pipe and treatment facilities have the greatest 20-year need of the sector, requiring $192.8 billion in projects to rehabilitate aging infrastructure, meet more protective water quality standards and respond to and prepare for population growth. The EPA warns that if wastewater infrastructure needs are not met over the next 20 years, the U.S. risks reversing public health and environmental gains made over the past three decades.
Mergers & Acquisitions
Dating back to the late 1990s, investment in this highly fragmented industry was of particular interest to companies seeking to diversify their product base. Today it is seen by many global companies as a critical source of revenue given the increased spending initiatives and focus on aging water infrastructure. Many large engineering and construction firms have publicly announced their investment interest in the sector.
Black & Veatch President and CEO Dan McCarthy said, “Water is a safer haven than a lot of other markets.” Tetra Tech’s chief financial officer recently indicated that half of the company’s growth over the next three years will come from acquisitions. Similarly, Jacobs’ CEO singled out water and wastewater as a sector of acquisition interest in a recent earnings call. In addition, international firms will continue to acquire U.S. companies in an attempt to capitalize on an increasing number of federally funded projects. Examples include Netherlands-based ARCADIS’ 2009 acquisition of Malcolm Pirnie and Canada-based Stantec’s recent acquisition of ECO:LOGIC.
Beyond engineering and construction firms, the industry has seen increased merger and acquisition (M&A) interest from several other markets touching the water infrastructure space, most notably from PVF manufacturers and distributors. Watts Water Technologies has remained active in M&A, while Ferguson Enterprises, a U.S. subsidiary of Wolseley Plc, recently has expressed interest in acquisition opportunities after a three-year hiatus.
Even before the stimulus bill, private equity jumped head first into water infrastructure investment. Larger funds like Carlyle, KKR and Blackstone established infrastructure funds to capitalize on population growth and government spending initiatives. Smaller funds generally followed suit by establishing initiatives to invest in infrastructure. Examples include Frontenac Co.’s investment in SIGMA Intl. Group, described as “the culmination of a year-long pursuit of investments in the waterworks industry,” as well as Montage Partners’ acquisition of Cal-Sierra Pipe, driven by “a fundamental need for clean water.”
With the global economic downturn, many funds generally slowed their pace of investing due to the collapse of the credit markets. In the first quarter of 2010, however, these groups developed renewed interest in water and power projects, as well as in companies with strong defendable market positions. We also saw a fundamental shift of the funds interested in infrastructure investing, particularly in water and wastewater.
This shift is from a short- to medium-term investment horizon to a long-term horizon. The reasons for this shift are simple: attractive fundamentals and valuation multiples. Some funds are using more equity to finance these transactions given the continuing relative weakness in the credit markets. The message is clear. Historically this sector has had attractive consolidation dynamics with deals getting done even in economic downturns. With attractive exit options, private equity will continue to play a key roll in the immediate and long term.
Near-Term M&A Outlook
We anticipate that M&A activity in water and wastewater will accelerate again in the fourth quarter of 2010, driven by improving economic conditions. More importantly, projects that have been delayed by state and local budget constraints should start to be released as the economy improves. Companies operating in water services will seek to reduce their risk profiles by expanding geographically through acquisitions and by diversifying their portfolio of services. For global players and those U.S. companies with international aspirations, the most attractive markets are Brazil, China, Russia, the U.K. and the Middle East.