Sponsored & written by: John Marciszewski, Director, Business Development, Echologics & Anthony Festa, Senior Director, Alvarez & Marsal
It is no secret that the U.S. water infrastructure is aging rapidly. In its latest 2017 infrastructure report card, the American Society of Civil Engineers gave an overall grade of D+ to America’s infrastructure, and graded drinking water a D. Many water system assets, both vertical and buried, are in desperate need of renewal; many water systems have assets dating back to the late 19th century. Repairing and replacing crumbling infrastructure isn’t cheap; in its 2013 Drinking Water Needs Survey and Assessment, the U.S. Environmental Protection Agency estimated that $247.5 billion would need to be invested in transmission and distribution systems over the next 20 years. Broken down, the price tag can easily be tens of millions of dollars for small townships, and into the billions for major cities.
“What’s it worth?” is a question many decision makers ask about their assets or business
prior to, during, and after a transaction or restructuring. Water systems are no different, given the climate of public private partnerships (P3) and private equity transactions combined with municipal restructurings, and state and local mandates to get an appraisal, e.g., Water Infrastructure Protection Act (WIPA) in New Jersey. The list of parties that need to know what water systems are worth is ever growing, including tax payers, 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 an appraisal that will withstand scrutiny and will provide a figure that makes sense.
So how are aging water systems valued, and how does their condition come into play? With any appraisal, an appraiser should consider three approaches to value: cost, market, and income. All three approaches are not necessarily required, in fact a combination of two (or even just one approach) may be quantified and applied given the needs of a specific transaction.
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 market 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 by discounting future cash flows to a present value, using an appropriate discount rate at a required rate of return.
With a water system, it would be typical to primarily 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. Due to the uniqueness of the asset, the market approach typically would not be applied. As an example, think of a car – there are many comparable cars to yours…but for a water system? Lastly, an income approach can and should be considered and used, especially if the system has a customer base where the contracts have a quantifiable and measurable income stream. For purposes of this discussion, this blog will detail the cost approach to value.
The starting point of a cost-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 replacement/reproduction 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 replacement or reproduction 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 lives as determined from asset accounting lists, invoices, or purchase orders.
However, true condition can be quantified based on non-intrusive acoustical tests, such as Echologics’ ePULSE® condition assessment approach, that can quantify the deterioration level of buried pipeline assets. This is critical, especially as 75 percent of the total replacement cost of a system is buried. Knowing the condition of the pipes not only helps drive the valuation, but is crucial for planning future capital expenditure (CAPEX) investments.
Once physical deterioration is determined, adjustments are made for any forms of functional and/or economic obsolescence that are identifiable and measurable. In most water system valuations, buried assets are assumed that service life has expired.
The largest challenge in valuing a water system is understanding the inventory of assets, especially as most of the system is buried! It is important to perform an appropriate level of due diligence when conducting the appraisal, this would include meeting with system operators, engineers, CAPEX planners, and accounting personnel who understand the history, design, and operational capacities of the system. Also, it is important to collect additional data points such as maps, diagrams, current costing data, historical asset records, etc., and work with other third-party contractors with specialized areas of expertise that can provide critical inputs for the appraiser.