Expenses for interest on debt used to finance the projects are also covered, usually without much debate, since they are easily quantified. Still, regulators like to see that "we are getting the best possible borrowing rates," says Smeltzer, making it important to maintain strong credit ratings and to mine opportunities for tax-free or low-interest-rate borrowing through towns and counties. Aqua America's weighted average cost for the $917 million it carries in long-term debt is below 6 percent, thanks to about $300 million borrowed tax-free at 5.2 percent and another $80 million at a 2.1 percent interest rate funded through the Pennsylvania Infrastructure Investment Authority. That's down from 7.4 percent in 1999.

At Connecticut Water, CFO David Benoit says that "virtually all our debt has been issued through the Connecticut Development Authority as tax-free debt," making for a weighted average cost of 4.9 percent on its $77 million in long-term debt.

Floating New Shares
But rate hikes that just cover operational expenditures and interest costs are not enough, since that would bring a water utility only to the break-even point. A crucial element in making a profit is to have equity in the mix, since most state laws allow for a "fair" or "reasonable" rate of return on equity, or the cash that companies use for projects.

"The purpose of the equity return is to compensate investors for taking a risk," says Smeltzer. While the definition of "fair" is debated, it usually translates into about 10 to 11 percent on the cash portion of the investment. "Private water utilities are not going to be allowed to earn outrageous returns," says the NAWC's Cook. Indeed, Connecticut Department of Public Utility Control commissioner John Betkoski says all of a company's expenses, from executive salaries to T&E budgets, are rigorously scrutinized by auditors before any decisions about returns are made.

With the equity return the sole opportunity for profit, at least in terms of the regulated business, a CFO's ability to work the capital markets can be the lifeblood of a water company. Aqua America has done eight equity offerings in the past 10 years, with the last one for $80 million using an innovative structure known as a forward sale. That structure means that Aqua America's banking group, led by UBS Warburg, converts a set number of shares to cash, which it turns over only as the company needs it, thus minimizing share dilution. It also helps Aqua America's debt ratings, says Smeltzer. "We've got the money sitting there, so if S&P asked how we're going to finance the $51 million acquisition of New York Water, I could say I've done it already."

Clearly, American Water's giant impending IPO could saturate investors' demand for water stocks, making it harder for other companies in the industry to raise funds. Smeltzer says he's hoping the $80 million from the forward sale lasts until 2008 so that he won't be in direct competition for capital. Connecticut Water's Benoit says he has managed to avoid a secondary offering for more than 11 years and doesn't foresee the need to issue stock, although with a 45/55 debt-to-equity ratio, he would likely have to tap the markets again in order to do a major acquisition.

So far, though, it seems investors can't get enough of water. California Water, another publicly traded utility, initially filed to float 1.8 million shares for its October 2006 equity offering, according to CFO Marty Kropelnicki, but since the deal was "well oversubscribed," the company ended up issuing a total of 2.3 million shares.

For water companies, growth options beyond capital investments and rate hikes are limited, since most customers aim to conserve water, not use more of it. Hence the race to acquire companies, ideally in areas that adjoin existing operations to provide economies of scale.

Both Aqua America and American Water say they aim for between 20 and 30 acquisitions per year. Smaller players are more targeted. California Water looks at 30 to 50 potential deals per year, Kropelnicki says, but pulls the trigger on only 1 or 2. The targets are usually other private companies, mostly nonpublicly traded, that are perhaps too small to make infrastructure investments (some mobile-home parks have their own water utility) or that have been poorly run. In a highly fragmented industry, such targets are easy to come by, say water CFOs, giving acquirers growth potential for years to come.

However, "we'd like to consolidate the municipals as well as small private companies," says Wolf. Indeed, if the municipally owned waterworks that serve 85 percent of Americans were to open up to privatization, the horizon for private water companies would expand exponentially. Such privatization deals are rare but not unheard of. For American Water, taking over municipal systems represents less than 1 percent of annual growth, according to Wolf.

Enter Private Equity
Publicly traded water companies are not alone among the private entities vying for the public systems. A private-equity arm of Macquarie Bank has already added Thames Water in Britain to its utilities portfolio, even as it awaits approval to take over Aquarion, which operates in four New England states. Highstar, an AIG private-equity fund, acquired Utilities Inc. with a similar strategy in mind. "We have long considered water infrastructure as an attractive investment opportunity and an excellent complement to Highstar II's existing energy-infrastructure portfolio," said AIG Global Investment Group chairman and CEO Win J. Neuger in a public statement regarding the purchase.

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