The Financial Domain and its Purpose

Investment banks usually have a portfolio of activities they take care of on behalf of their clients. These activities may include advisory services for specific mergers and acquisitions; assisting and executing capital market transactions such as privatizations;

and more general advisory services for structuring a client’s finances, including the optimizing of asset, investment, and tax strategies. In principle, the goal is to enhance the value of a company in terms of shareholder value.

Besides investment bankers, financial consultants within the management consulting domain also offer their services, which comprise strategic advice for enhancing investment and shareholder value strategies, but also more operational activities, such as optimizing the distribution of financial benefits and risks among contracting parties, as is the case in mergers of neighboring water utilities.

A major difference between the financial consultants and investment bankers is that the advice from the former is a combination of management and finance advice and is remunerated through a consulting fee, while the latter hopes to close a deal at some point, which will lead to receiving a percentage of the transaction volume as remuneration. The advice from a financial and management consultant also differs in that the client receives financial advice that is ‘flavored’ with management advice, while the investment banker is more focused on optimizing the client’s capital and finances and to prepare, assist, and execute financial transactions.

“Water utilities as enterprises are still very close to the municipal administration and…the municipality has very heavy decision-making power in the investments, the strategy, and the direction for the water company. The owner thinks more about profitability and about keeping the investments at a minimum…there has to be found a solution that satisfies the owner’s profit needs and the investment need of the utility…for example by raising the tariffs, and…more productive ways to provide the services.” (Financial Consultant)

“From this concept’s point of view, it is the same whether it is the water or electricity or whatever that is integrated. It does not make any difference.

And the value of these networks is huge in Finland…we are talking about millions.” (Investment Banker)

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In the case of investment bankers, financial advice represents a step into the direction of assisting or executing a financial or capital transaction, of making a deal so to speak.

When that is happening, a sometimes year-long effort pays off, through earning a percentage of the transaction volume as a fee for the investment bank. In some cases, the client approaches the investment bank on the basis of a concrete need to receive advice in the restructuring of an asset. As in a concrete case in a Finnish town, the discussion with the investment banker shows that the city expected to solve its financial problems by restructuring some of its assets with the help of the investment bank. The investment bank has been advising this municipality also in previous matters concerning the restructuring of their energy utility.

“The original idea came for the city, because they need money…and want to avoid paying corporate taxes on the energy company…we recommended doing that transaction….there are several benefits concerning that transaction. The most obvious is that they pay less company taxes through that transaction…the value of assets of the water utility increases fourfold through using their present cost value instead of historic cost value…and there are also some synergies they can get through that transaction.”

(Investment Banker)

The financial actor’s clients’ or municipalities’ policies and requirements represent important guidelines for the financial consultant. In most of the larger Finnish municipalities, ownership policies have already been developed, or their development is in progress. Ownership policies are sometimes developed independently, by the municipality and its politicians or officials, but it is common to use private sector consultants and financial institutions that assist in the process as well.

“Regarding energy and water sector the primary issues we have seen in [municipal] ownership policies are risk appetite, quality of service and price of service in the city, competitiveness, decision-making, employment issues, capital injections, value of the assets and the development of the value, and these fiscal issues like tax effectiveness…it is difficult to find real differences in them.” (Investment Banker)

The restructuring of municipal assets, such as water utilities, can be a lengthy and time consuming process because this field is politically charged, and the power is dispersed among numerous actors in the field. This also means that the investment banker has to carry the risk of the deal not going through, for example when the municipal council rejects the plan to restructure the energy and water utility.

Especially at times when private ownership is rejected in a sector, such as it is the case with the Finnish water and sewerage sector, the work of an investment bank takes on an additional meaning and purpose. Here, the investment bank is not merely a service organization that is hired once it is needed to execute a financial transaction. Instead, it is a rather proactive player that is involved in an organizational field through constant

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interaction with some of the actors, which is a role that makes the investment bank an important actor itself. In organizational fields where the power is dispersed among actors, it is a time and resource consuming negotiation process in which the investment banks and financial consultants keep generating new solutions and concepts that could be accepted by the relevant parties, to finally come to the decision to approve a deal. That means to constantly develop new concepts and to test and suggest them to those actors which have been identified as the most powerful ones. It also means to adapt to the logic of these actors and to the circumstances, for example when noticing that the municipalities do not plan to sell their utilities, a different concept needs to be suggested to stay in the game.

“I have been trying for three years to sell private money as a representative of the private sector to the municipalities but they are not very keen because they can release the capital in other ways and they are not planning to sell the water works…and because they don’t want to privatize, so we made a concept that they are regional water companies under a limited company…fully owned by the municipalities.” (Financial Consultant)

“We took the initiative…there was a new major…and I knew him very well, and we discussed already before…about this concept…I didn’t recommend anything, I just said which options he has…both the major and the financial director…felt this is from the owner policy view much easier politically to sell in the city than selling the whole utilities. [Our] point was that we have to create a concept which actually is...somewhere in the middle…not to keep it all as it is today, but also not to sell it all away… if we can’t create new concepts like this, nothing happens in the market. And if you create this type of new businesses, those parts of these businesses where competition is possible may be sold later, and we will be there doing it.” (Investment Banker)

Those strategic questions of restructuring municipal water utilities clearly start out on the owner level and not on the water utility level. In some cases, the utilities oppose the strategic changes proposed by the municipal owner.

“Actually, I had approached the energy and the water company already earlier…and now they [water utility] signed an agreement to pursue this change but they were not willing to do that actually, they were very reluctant and they almost had to be forced to do it.” (Investment Banker)

What the municipalities’ and financial actors’ plans for restructuring the water utilities have in common is that the main concern is of a financial nature, whether from the municipalities’ perspective or from the financial actors’ perspective. However, while the municipalities’ criteria for effectiveness as a service provider comprises also a large variety of non-financial measures, the financial actors’ criteria for effectiveness speaks a clear financial language that is a result of the client’s objectives and the investment bank’s own perception of effectiveness, as is shown in the paragraphs below.

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From a financial actor’s point of view, the major criteria for effectiveness are how effective an organization is managed and how effectively it uses its resources, which of course also affects profitability. In terms of resources, the fixed assets of a water utility represent the major share of capital investment and therefore the effectiveness with which these infrastructure assets are used is of major importance to the financial actor. Here, the water utilities are criticized for ‘wasting their resources’ for example through constructing pipelines whose diameters are larger than needed.

“They have forgotten the financial side totally, when they are constructing the pipelines, if there is no financial aspect, the pipelines are twice as big as they should be.” (Investment Banker)

Such seemingly inherent lack of effectiveness is explained with the culture of the water sector and its professionals, who have been ‘too independent in the past’ and were able to design and execute projects that were mainly focused on technical aspects, but left economic aspects underemphasized. Here, the water sector professionals are regarded as professionals when it comes to technical aspects, but they lack financial thinking and the ability to perceive their water utility as a business organization. Increasing the private sector participation, for example through selling a part of the water utilities’ shares to a private company (which would mean to get managers from the private sector onto the management board as well), is regarded as a possibility for improving the economic effectiveness of these water utilities.

“I think that the financial thinking is missing [in the water sector] and if the private sector is involved, the financial thinking is immediately in the business, and that is the benefit.” (Investment Banker)

“I think the lack of financial thinking in the water utilities is the major difference [between them and the energy sector]. If you think about business, the most important thing is the capital employed but now the key driver is the technical aspect, not the financial aspect. If they would have also thought about the financial aspect, I think the capital employed would be only half of what it actually is now.” (Investment Banker)

The private sector is regarded as more effective than the public sector water utilities not merely for economic effectiveness but also regarding management skills. Comparing the public sector to the private sector, the former is lacking the accountability for delivering economically viable results because its organizations do not cease to exist once they became unprofitable, while a private company needs to be efficient in order to stay in the game and maintain stakeholder and shareholder support. Here, a reason for being ineffective is one of ownership, public or private, and not whether markets, such as monopoly markets or competitive markets, are affecting the behavior of the organization through creating incentives and disincentives for economic effectiveness. Effectiveness, therefore, is mainly seen as a function of ownership rather than as a function of market conditions.

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“The private sector, the way I see it, in terms of management skills and in terms of financial or economic sense or understanding, is more sophisticated.

Efficiency of operations is also better, because in public organizations you always have slack, because there are always guys who are, you know, lean against the wall, and in the private sector you can’t afford that because you are accountable on what you make on the bottom line. So, you have to make it more efficient by default.” (Investment Banker)

When the municipality is the consultant’s client, the municipal owner clearly states that a certain return on the capital invested in the water utility is expected and that it should preferably rise in the future while at the same time, other challenges need to be mastered as well. Those challenges include reacting to the legislative pressures coming from the European Union, such as stricter health and environmental standards for water and sewerage, the increasing shortfall of labor through large scale retirement in the coming years, and the increasing need to invest in the construction and rehabilitation of water and sewerage networks and infrastructure. These challenges affect each other as they also affect the profitability of the water utility in times where higher returns on the capital invested in the water utility is expected by its owner, the municipality.

“The water utilities do not have enough money to make the investments they need…the municipalities cannot raise the tariff too much because they compare it to other cities [and] in the next five years, [water sector]

investment needs will grow and if regulation comes…quality factors will be supervised and investment…which will help the utilities. The municipalities want to increase the profits and it means for the water companies to produce more…but also from the ownership side it is not wise when these assets are in bad condition and there will be some problems with quality, which can affect the profit to the company as well.” (Financial Consultant)

“The water companies are producing money for the municipal budget, and the total costs for the municipalities will increase in the future and one part of how to finance these costs is to take the revenues of the municipal enterprises, such as waste management, water, energy, and some other services. This part is 25% of all municipal income and…this is a very difficult situation for the water utilities [in the face of] personnel, investment, and legislative challenges.” (Financial Consultant)

The fact that municipal budgets become tighter does not necessarily mean that the municipalities are willing to sell off their water utilities. The continuous revenue flow from the utility to the municipal budget helps to finance other municipal services. In addition, if the water utility switches its legal form from a municipal business enterprise to a limited liability company, its assets become re-evaluated. This can increase their value fourfold just through switching from valuing them at historic cost to present cost.

Therefore, the municipal owner is able to receive a lump sum payment as well. The municipalities’ option to release capital by re-evaluating the assets of their water utilities

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is a major reason why financial actors started to believe that it is not yet time for privatizing the municipal water works.