Aging System Assets Need Investment
Mary-Anna Holden is a former New Jersey BPU Commissioner and Butch Howard is a former South Carolina PSC Commissioner.
The U.S. water infrastructure is aging rapidly. It has been doing so for decades as the infrastructure reaches the end of its useful life. Many water system assets, both vertical and buried, are in urgent need of at least upgrades and quite likely, replacement.
Some water systems have assets dating back to the late nineteenth century. Repairing and replacing crumbling infrastructure isn’t cheap — the price tag can easily be tens of millions of dollars for small systems, and into the billions for major operations — whether publicly or privately owned. To be sure, water service is a capital-intensive business.
Underground pipe can range from cementitious asbestos to ductile iron to copper to galvanized steel to plastics to lead, and even in some very old but still being found cases, hollowed-out logs. No matter the original life of the pipe, over decades, due to its age, it is now all losing its integrity at about the same time, or in some cases, as in lead service pipes, its removal has been ordered for environmental/ health concerns despite maintaining its integrity for the time being.
Nationally, older communities are facing an economic and public health reckoning. In this article, while we won’t tackle why maintenance may have been deferred or suffered disinvestment for decades, we intend to address, in this first of a series, how water systems can be responsibly valued if they are seeking sale, merger, acquisition or consolidation.
What’s it Worth?
The obvious question many decision makers ask about assets or businesses prior to, during, and after a transaction or restructuring is:
What is it worth? Water systems are no different, given the reality of the age/condition of their infrastructure and the related impacts.
This climate is causing investor-owned utilities, public-private partnerships (P3) and private-equity transactions combined with municipal restructurings, and state and local mandates, to get appraisals, so they can make rational decisions.
The list of parties who need to know what water systems are worth is ever growing, including taxpayers, customers, sellers, buy-side investors, and lenders including banks and bond issuers. These parties want to have a comfort level that a credentialed, independent third party-performed appraisal may provide while withstanding scrutiny and providing a figure that makes sense.
We asked Anthony Festa, ASA (American Society of Appraisers), Managing Director and National Practice Leader — Machinery & Equipment Valuation, with Marshall & Stevens, where he begins in valuing water systems. “An appraiser must understand, first and foremost, when taking on a valuation assignment, the scope of work,” he said.
“With water systems, one of the largest challenges is understanding the inventory of assets, especially if the system could be buried. Sometimes an entire system needs to be appraised, including all the assets and infrastructure used in the sourcing of water, initial treatment and distribution, storage, sanitary conveyance once used, and wastewater treatment. For some transactions, all these components must be considered; for others — only some.”
How do you determine the proper approach in valuing a system? “Performing due diligence when gathering the necessary information to conduct the appraisal, includes meeting with system operators, engineers, CAPEX planners, and accounting personnel who understand the history, design, and operational capacities of the system,” Festa continued. “Also, it is important to collect additional data points such as maps, diagrams, current costing data, historical asset records, et cetera, and work with other third-party contractors with specialized areas of expertise that may provide critical inputs for the appraiser.”
So how is a water system valued? “With any appraisal, there are three approaches to value a water system that must be considered; the cost, sales comparable, and income approaches,” he said. “The cost approach relies on the principal of substitution; this assumes an investor would not pay more for an asset than the cost to reproduce or replace it with like-kind or similar utility, less adjustments for physical deterioration, functional, and/or economic obsolescence.
The sales comparison approach analyzes comparable sales data found in the used marketplace, making adjustments as necessary to equate each comparable to the subject asset being appraised.
Lastly, the income approach determines the value of an asset or business by discounting future cash flows to the present value, using an appropriate discount rate at a required rate of return. All three approaches are not necessarily required, in fact, a combination of two — or even one — may be quantified and applied given the needs of a specific transaction.”
With a water system, what would be typical? “Primarily, I apply the cost approach, as these assets are uniquely constructed and configured, and current costs to replace operable assets, such as pipes, pumps, and hydrants are readily available to extrapolate across the footprint of the system,” he continued.
“The starting point of a cost approach-based appraisal is the cost to replace or reproduce the asset. When developing the valuation, the appraiser needs to ultimately develop the replacement cost, based on current, direct project costs. The appraiser may also need to develop the reproduction cost, based on historical cost indexing, or ‘trending,’ as part of their procedures, and then reconcile the two. The development of the reproduction/replacement costs must include all direct costs including freight, sales tax, installation and calibration costs, as well as indirect costs such as permits and architectural/ engineering fees.
Once the reproduction or replacement cost is determined, adjustments are made to account for the loss in value due to physical deterioration and obsolescence. Physical deterioration is the loss in value due to normal deterioration, or wear and tear. Depreciation can be applied using a calculation based on the asset’s normal and remaining life as determined from asset accounting lists, invoices, or purchase orders. Additionally, engineering firms could provide condition estimates based on system testing as well as studies on the remaining life integrity of certain assets.
Once physical deterioration is determined, adjustments are made for any forms of functional and/or economic obsolescence that are identifiable and measurable. Functional obsolescence quantifies and deducts value for issues within, or internal to, a system. Economic obsolescence considers downward adjustments to value for factors external to the system.”
When to Apply Which Approach?
We found in discussing valuation with Festa that all three approaches to value are considered but not all may be applied for many reasons including requirements of state law. Due to the uniqueness of the water system assets, the sales comparable approach typically would not be applied.
He gave this example. “Think of a car. There are many comparable cars to yours. But for a water system? Probably not. It would not be prudent to individually value every asset via this approach, but as a whole, there could be a case made to compare the system to a comparable system (say, based on customer count). The only hurdle to applying the sales comparable approach in this instance is access to published, quantifiable data, since many transactions are private.”
Lastly, an income approach can and should be considered and used, especially if the system has a customer base where the contracts (or current rates) present a quantifiable and measurable income stream.
Benefits of a Certified Appraisal
With all of the data collected, once all the approaches to value are developed and applied, they are reconciled and weighed against each other to produce a final conclusion in a report that is compliant, and adheres to, the Uniform Standards of Professional Appraisal Practice, as well as state, local or federal legal requirements.
We have both experienced in some acquisitions of small, family-owned water companies, that evaluation can be extremely difficult due to lack of recordkeeping and emotional attachment to what the small water company owners think may be a fair price.
The same could be argued for larger mergers where there is serious and expensive competition for acquisition. A fair sales price for all — seller, buyer, and customers — may offer a truer value through a certified appraiser and thus may offer an easier explanation of offering price to customers, regulators, bankers, and the like.
It is also likely to reveal the reality of what the system requires over the short, medium, and long term, identifying specific future needed investments in operating systems and infrastructure. It is often the first comprehensive assessment of this reality made public for many years. In itself, that provides important value to the community served by the water system.
