European water assets continue to generate strong demand from global infrastructure funds and private equity buyers, and M&A activity is expected to continue at a steady pace in 2008 despite the disruption in the global credit markets.

In the new lending climate banks are starting to demand some additional spread on deals, to claw back some of the basis points given away during the period of exceptional liquidity in 2006 and the first half of 2007. But this margin rise looks set to be around 20bp to 25bp, which represents a change in the cost of debt finance that sponsors can live with, rather than an industry-changing event.

Globally, project finance loans on new IWPP projects in the Middle East will feature more expensive bank debt. And in Europe, where the focus is more on secondary market sales of existing water assets than greenfield projects, sponsors and banks remain keen on the water sector and leverage will continue to be higher than it was three or four years ago.

"There is still quite high demand for regulated or quasi-regulated infrastructure assets that have a consistent income stream," comments Anne Baldock, global head of project, energy & infrastructure group at Allen & Overy, which recently advised the Greensands Investments Limited consortium on its acquisition of Southern Water in the UK.

"The strong appetite for assets is related to the growing number of infrastructure funds that we have seen coming into the market over the last year to eighteen months, and the water sector clearly fits into the kind of assets that they are looking for," she explains.

"Historically water companies have been very conservative with their financing structures, and have had quite low debt-to-RAV (Regulated Asset Value) ratios, and investors bidding in today's market are looking to push the RAVs higher," says Baldock.

UK water buoyant but shrinking

Acquisitions continue to come at a fast pace in the UK, though after some big deals over the past 12 months, there will likely be a shortage of sizeable water assets for sale during 2008, when attention may turn to continental Europe.

In October, South Staffordshire Water was sold to the Alinda Infrastructure Fund – a £1.5 billion ($3 billion) institutional fund managed by New York based Alinda Capital Partners.

The seller of South Staffordshire Water, which had an evaluated price in the region of £400 million, was Arcapita Bank, which is an investment firm based in Bahrain. It acquired the Midlands based utility in 2004. South Staffordshire Water was advised by Hammonds .
Also in October, Greensands Investment Limited agreed a deal to buy Southern Water from Royal Bank of Scotland for an enterprise value of £4.195 billion. This represented a valuation of 1.35 times Regulated Asset Value (RAV).

The Greensands consortium includes JP Morgan Asset Management Infrastructure Investments (32%), UBS (18%), seven Australian superannuation funds advised by Access Capital Advisers (18%), ex-BT pension fund Hermes (4%), and Challenger Infrastructure Fund of Australia (27%).
Bookrunners on the debt facility are Dresdner Kleinwort, HSBC, JP Morgan, and Royal Bank of Scotland, with National Australia Bank as a mandated lead arranger. The senior £290 million tranche of the financing pays a 50bp margin in the first year rising to 60bp thereafter.

These two financings follow a deal in October 2006 when RWE agreed to sell Thames Water for £3.2 billion to the Kemble consortium led by Macquarie's European Infrastructure Fund (MEIF). The first phase of the securitisation take-out of this transaction took place in August against a backdrop of disruption in the global asset backed securities markets, with a £900 million private placement.

Capital markets take-outs to slow?

According to Emmanuel Rogy, global head of project finance at BNP Paribas, securitisation take-outs will remain an important element of acquisition finance packages for European water companies, though bridge loans may be lengthened in the light of the disruption in the ABS markets seen during 2007.

"Banks are more cautious on the securitisation take-out piece because of the recent market volatility, so 18-month bridge financings may now be seen as a bit risky," Rogy explains. "These tranches might now have three to five year terms in order to give more flexibility on timing, but infrastructure transactions will definitely still be refinanced in the capital markets – the question is how quickly."

"There will continue to be plenty of M&A deals in the European water sector, which is less affected by the recent volatility on global financial markets than transactions that do not involve true infrastructure assets," he adds.

"Infrastructure funds still have money to invest, and lots of appetite for pure infrastructure assets such as water," says Rogy. "The difficulty will be in finding sellers, since a number of big UK water companies have already changed hands over the past 12 months. As a result we may see the infrastructure funds focusing more on countries in continental Europe such as France, Germany, and Italy, as well as moving into Central & Eastern Europe."

In greenfield project finance, there are some PPP projects across Europe, but the Middle East continues to be the busiest place for new business, and that is where the new pricing on bank debt will be tested over the next couple of months.

"Those tranches in the Middle East that used to be priced very thinly need an adjustment," comments a banker. "There is a need from lenders for a minimum absolute return, so a very low risk piece paying 30bp may need to go to 50bp or 55bp, whereas a piece which paid 50bp may rise less in proportion to perhaps 60bp."

He also expects a return to the situation where very large deals pay a slightly higher margin than small deals. "The curve which links debt pricing with the size of the deal is positive again – over the past few years very large transactions were paying a little bit less than smaller sized transactions, since everyone wanted to come in on those very large and visible projects," he explains.

"The dynamics of the water industry, where projects are fully contracted or natural monopolies, means that water projects are unlikely to be very adversely affected by the current credit crunch," says John Dewar, partner in the global project finance group at Milbank, who has worked on some of the largest IWPPs in the Middle East.

Pricing on the up

"We are seeing some upward pressure on pricing, but not enough to seriously impact the economics of projects," he says. "Project lenders are looking to increase pricing to take into account their internal cost of funding, which has increased as a result of the credit crunch. In the Middle Eastern water project market we may be looking at a 20bp to 25bp increase in margins for new deals."

"Project finance structures have, by and large, remained more conservative than has been the case in the leveraged finance market," says Dewar. "Whilst overall activity in the leveraged market has been reduced significantly, terms and conditions are being tightened up on those deals that are proceeding, but in the project market we are not experiencing major changes. However, due to a heightened sensitivity to syndication risk in the current, when lenders negotiate mandates they are certainly more likely to be considering flex and market Material Adverse Change provisions than was the case a few months ago."

However, bankers note that thus far in infrastructure project finance there have been no major moves by MLAs to try to renegotiate pricing with sponsors, but that they are instead looking at taking a loss in syndication on some loans that were signed before the summer credit crunch.
"No-one has called a MAC yet – though of course we may not necessarily hear about it," comments a banker, who suggests that it is better to take a loss in syndication rather than alienate sponsors on future deals.

Most affected by the credit crunch are hybrid infrastructure deals, rather than pure infrastructure plays such as water companies. To meet market demand, banks combined project finance structuring techniques with covenants prevalent in leveraged finance facilities – allowing sponsors to acquire infrastructure assets at record breaking debt multiples.

But now that the credit cycle has turned in the global credit markets, loosely structured and highly leveraged acquisition loans are looking far less attractive, and lenders are focussing more on pure infrastructure sectors such as water.

In addition, the European Union is viewed by lenders as a particularly attractive region for regulated water assets, given the overall EU guidelines within which national regulators such as the Office of Water Services (Ofwat) in the UK work.

US water complications

This contrasts well with the US, which has a highly dispersed regulatory structure with each state exercising local control over national utilities. Furthermore, the turbulence in global financial markets recently forced German utility RWE to postpone its planned Initial Public Offering (IPO) of shares in American Water. RWE announced on 14 November that in the light of conditions in the US capital market it did not expect to achieve an adequate value for American Water.

The IPO had been planned for the end of 2007. RWE acquired American Water in 2003, but after a review of its businesses in 2005 announced that it had decided to divest its water businesses in the United States and UK, saying that the limited synergies between the North American and UK water businesses and the European energy businesses were a major factor in the decision.

It said at the time that it intended to complete both transactions in 2007, and would evaluate various divestment alternatives for American Water, including an IPO or sale to a group of long term financial investors.

At the time it was thought that the American Water sale would precede the sale of Thames Water, but in the event the latter deal moved much more quickly, with a deal struck in October 2006. American Water is valued somewhere between Eu5.5 billion and Eu6.6 billion.

The American Water IPO got caught up in the local politics that governs water utilities in the United States. Before the IPO could proceed, RWE needed to get permission from pubic service commissions or public oversight agencies in 13 of the 29 states that American water operates in.

By late 2006 four states had given the green light for the sale, Hawaii, Maryland, Tennessee and Virginia, and by December hearings were underway in West Virginia, where state law allows for the Public Service Commission to rule on the sale of any utility operating in the state. That left states such as Arizona, California and New Jersey to hold hearings in 2007. But by the time the process was complete the credit crunch was underway.

The decision to postpone was made by new chief executive Jurgen Grossmann, though RWE still hopes to do the transaction in 2008. But global infrastructure fund buyers, who often hold assets for three to five years before selling them on again, may be wary of the complexities of US regulation, which will make EU assets seem more attractive.