When Wulf Bernotat, E.On's chief executive, said in February that he expected consolidation to leave just three dominant players left in the European utilities sector, it was not a prediction but a statement of intent. Just days later the German utility outlined an audacious Eu29.1 billion ($37 billion) cash bid for Spanish rival Endesa that has left rivals, governments and financiers in a spin.

For one thing the deal trumped Gas Natural of Spain's own Eu23 billion cash-and-shares offer for Endesa that had been in play since September 2005. With Gas Natural's board trying to work out how much it could raise to match the offer – possibly by raising Eu16 billion in debt and a further Eu14 billion by issuing new shares – there were reports that the Spanish government was trying to persuade domestic construction companies to join the party with Gas Natural.

Meanwhile, attempts by prime minister Jose Luis Rodriguez Zapatero to block E.On's bids, by giving the Spanish energy commission new powers to veto foreign takeovers, were raising cries of derision from big corporates and analysts, who accused his socialist government of blatant protectionism and of undermining years of liberalisation.

And no sooner had the market digested the political and corporate ramifications of the E.On bid, than France emerged with its own plans to create a Eu70 billion national energy champion by pushing Gaz de France into the private sector through a merger with Suez. The deal between the French gas company and the Franco-Belgian power and water company would create Europe's second biggest energy group.

France's move came just days after Enel, Italy's biggest utility, had said it was interested in Suez or its subsidiary Electrabel. French Prime Minister Dominique de Villepin and his economics minister Thierry Breton publicly declared their full backing for the Suez/GdF tie-up, leaving Italian politicians reeling and indignant at France's apparently protectionist stance. And with Italy calling on the European Commission to intervene over what it saw as France's attempt to thwart the bid by Enel, the political ramifications of the deals seem set to play on.

Banks flock to back

Bankers and financiers have been flocking to cash in on the renewed activity in the sector and although much of the new lending will be in the form of corporate facilities, speculation is that there will be more hybrid leveraged/project work in the following waves of M&A.

Supporting E.On's bid for Endesa is a Eu32 billion loan that is set to be one of the blockbuster corporate deals of 2006. Citigroup, Deutsche Bank, HSBC and JP Morgan closed the sub-underwriting phase at the end of March with a two-tranche deal comprising a Eu21.33 billion one-year facility priced at 22.5 basis points over Euribor and a Eu10.66 billion three-year facility priced at 27.5bp. Sixteen banks committed at the top ticket of Eu2 billion for fees of 10bp.

Despite the enormity of the loan and the tight margins, arrangers appear confident of selling down the debt in general syndication later in the year. And since E.On boasts a strong credit, the German utility has been able to dictate terms to eager banks.

Enel, meanwhile, has secured up to Eu50 billion from local Italian banks and institutions to fund a bid for Suez. Analysts say that funding would give Enel the firepower to bid for other European assets even if it did not gain its target Suez.

"A lot of analysts had predicted that the utilities sector was likely to hot up 2005 and 2006 and that M&A activity would start to feature," says Neil Beddall, a utilities analyst at Barclays Capital in London. "The Spanish market had been flagged as one ripe for consolidation and in 2005 Gas Natural made a bid for Endesa, with E.On also subsequently making a bid for it. National Grid made it clear it would make an acquisition in the US, but nobody had really predicted Enel would seriously consider making a bid for Suez, and nobody had really put Suez and GdF together."

The competing bids for Endesa and Suez have raised the stakes for others players in the market. And in the run-up to full-market liberalisation in Europe in 2007, more consolidation in the utilities sector looks likely. However, with few big assets left to play for, the next round of deals are either likely to be smaller in scale or trickier to put together and it will be interesting to see how much appetite there will be for the next round of deals if they are attempted on a corporate basis.

In the UK market, Scottish Power, itself recently the target of a bid by E.On, and Scottish & Southern could also be contenders for a tie-up, subject to competition issues. In the Czech Republic the restructured CEZ has been mopping up assets. In Spain Iberdrola could hold some appeal to Gas Natural should it lose out to E.On.

Germany's RWE seems in less of a hurry. It is floating off American Waterworks and its UK water business is up for sale. But with that disposal unlikely until later this year, and a higher debt burden than its rivals, the company looks likely to hold off making acquisitions in the immediate future.

France's government has made it clear that it has no intention of relinquishing control of Electricite de France (EDF). Nevertheless, given their size, both RWE and EDF could eventually emerge as strong players in a consolidated European electricity market.

Just behind the utilities groups chasing the deals are the banks. KPMG's Cox says "utilities are not finding it difficult to get funding on acceptable terms. The banks can see the market in the wider sense: Electricity prices are rising and the market is reasonably short on capacity."

Liquidity and credit quality

However, the size of the E.On deal has raised questions about whether such big deals will soak up all of the excess liquidity in the market, especially since the market is flooded with M&A deals across all sectors.

Says one London-based banker: "Banks will have lending limits for clients. But those limits will depend on the size of the company and their credit quality. Arguably that could affect liquidity overall. But you could argue, however, that consolidation in the utilities sector could focus people's mind on the sector as a whole – creating liquidity and expanding the number of ways of providing funding."

The latest round of M&A deals will be financed in the corporate loan market but that there is a high expectation that those deals will be refinanced in the bond market. "The bond market is ready and waiting to taking up the excess capacity in the second part of this year and into next" says one banker.

Writing in a recent report, Manfred Wiegand, global utilities leader at PricewaterhouseCoopers (PwC), says that the momentum built up in the electricity and gas M&A market is 2005 is going to continue in 2006. "We are seeing a new era of 'blockbuster' deals. Companies are consolidating and extending their regional footprints to attain non-organic growth in a tight sector facing high fuel prices and security of supply concerns. We are also seeing greater involvement of financial players in the market, with the rise of infrastructure funds creating a new asset class."

With new sources of funding on offer, however, question marks remain over whether the first round of deals is leaving borrowers too highly leveraged.

Aggressive moves by E.On and Gas Natural have triggered reevaluations of the major utilities from the rating agencies. In September Gas Natural was placed on credit watch by Standard & Poor's, following its bid for 100% of Endesa. S&P argued that a one- to two-notch downgrade would have to be considered should Gas Natural's bid succeed. "S&P would expect a weakening of the company's financial profile as a result of the proposed Eu7.8 billion cash-based portion of the deal and the consolidation of Endesa's Eu18.3 billion net debt."

But analysts say that the new credit ratings for the utilities should not be taken out of context. "In the last three to four years most utilities have had a strategy of selling non-core businesses to focus on their core energy activities, improving cash flow and reducing debt," says Barclays Capital's Beddall.

Ahead of its bid for Endesa, for example, E.On was sitting on a Eu15 billion cash pile.

Beddall says that following the focus on core businesses and debt reduction utilities now "think that they can re-leverage given their improved credit and ratings profile".

"If you look at a regulated business, there is no need to be AA or strong A rated. In the UK the average rating for a regulated business is A- or BBB+, and in the US it is weak BBB. Now if you look at Enel, E.On or EDF, you have to say that [having such a strong credit rating] is a pretty inefficient use of their balance sheets."

Beddall says that for some of the big players priorities have changed. "It's almost a matter of the search for size and market share taking precedence over ratings," he says.

The sector is facing pressure from politicians concerned over high electricity and gas prices as well as a potential crackdown by Neelie Kroes, the European Union's competition commissioner, to increase competition in the European utilities sector. But the big companies are rising to the challenge. Rather than returning its cash pile to shareholders E.On's chief executive and others are playing the long game.

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Infrastructure takes a toll on liquidity

The scramble for size and market share is not confined to the utilities sector. 2006 is already looking set to be a big year for toll road and airport projects with big-ticket M&A deals in the offing as well as quasi-privatisations.

In the last year BAA has gone from hunter to hunted. No sooner had the operator of the London's Heathrow, Gatwick and Stansted airports clinched the £1.25 billion ($2.35 billion) deal to acquire Budapest airport than Ferrovial was circling with a potential takeover bid.

BAA rebuffed the 810p a share bid from the Ferrovial-led consortium but the UK airport operator remains vulnerable and analysts remain confident that a takeover could add value to BAA.

In the UK, BAA's business is regulated, operated under a price cap regime set by the Civil Aviation Authority. Utilities, notably water companies, operating within a similar regulated regime have traditionally been far more highly leveraged than BAA.

Even given BAA's expansion plans at Stansted and its debt-financed acquisition of 75% of Budapest Airport, analysts say that BAA has traditionally been a very conservatively financed group and as such is vulnerable to highly leveraged bids.

BAA is likely to draw in other sponsors and private equity groups, and many were expecting Macquarie Bank to enter the frame. But Ferrovial has countered by appointing Macquarie as financial advisor for its BAA bid and giving the bank options to buy Ferrrovial's shares in the Bristol and Sydney airports.

Macquarie, Ferrovial/Cintra and a number of other European contractors/operators have already made their mark over the past year in the toll road sector. Spurred on by the successful financing of deals in the mature Spanish toll road market, companies such as Abertis, Cintra, Ferrovial, ACS Dragados and Sacyr are looking abroad for acquisitions.

The recent sale of three French state-owned toll road companies pulled in bids from all the major players. And in what appears to have been politically motivated award, after an uproar in the French press that all the roads would go to Spanish bidders, Abertis won Sanef, Macquarie and Eiffage won APRR and Vinci won ASF.
All three deals have tapped the bank market, soaking up some significant liquidity.

The Eu7.65 billion acquisition facility for Eiffarie – the joint venture between Macquarie and Eiffage for APRR – is near to close. Mandated lead arrangers BBVA, Dresdner Kleinwort Wasserstein, Ixis CIB, Royal Bank of Scotland and SG CIB have been offering sub-underwriting tickets of Eu500 million with a Eu350 million target final hold. There is a participation fee of 30bp and a 10bp sub-underwriting fee. Lead arrangers committed for Eu350 million for a Eu250 million target final hold. There is a 25bp fee upfront with a 5bp sub-underwriting fee.

The facility is split into a Eu5.85 billion seven-year term loan at 90bp over Euribor and a Eu1.8 billion seven-year revolver at 30bp. There is also a Eu1 billion one-year cash bridge that has not been syndicated.

In March, Barclays, La Caixa, HSBC, JP Morgan and Royal Bank of Scotland also signed Abertis' Eu3.5 billion loan backing the buy-out of Sanef. The deal was twice oversubscribed and was split into three tranches. Tranche A is a one-year Eu750 million term loan that pays a margin of 40bp. Tranche B is a one-plus-three year Eu2.6 billion term loan, and C is an Eu150 million one-plus-three year revolver, both paying a margin of 75bp.

And Calyon, Royal Bank of Scotland and SG have also signed 12 banks into general syndication on the Eu4.2 billion facility for Vinci. Banks have been offered tickets of Eu100 million for 12.5bp and Eu50 million for 10bp.

The sub-underwriting phase finished syndication in February with BBVA, Bank of Tokyo-Mitsubishi UFJ, Barclays, BayernLB, BNP Paribas, CM-CIC, Fortis Bank, Ixis, Mizuho, Natexis Banques Populaires and WestLB committing. The seven-year loan pays an initial margin of 27.5bp and is tied to a leverage grid.

Elsewhere, Cintra and Macquarie Infrastructure Group have been mopping up assets in the US, and were recently named as preferred bidder for the Eu3.17 billion, 75-year concession for the Indiana Toll Road concession. Cintra and Macquarie will provide Eu635 billion in equity with the rest of the funding likely to mimic that of the Chicago Skyway toll road deal, where project debt was refinanced in the bond market.

MIG's ambitions in the US look set to continue after the group recently said it planned to sell its stakes in three Sydney motorways because the assets are entering the mature phase of their life cycle, as it seeks to free up funds for overseas expansions – particularly in the US.

Says Stephen Allen, MIG's chief executive: "Significant value has been realised for MIG investors through the divestment of its investments in Transurban, Cintra, Yorkshire Link, and Hills Motorway over the past few years."
What differentiates the recent round of toll road projects in the US is the length of concession on offer and the level of debt used to finance them. Rather than a 25-35 year toll road concession offered on a project finance model, deals in North America have been highly leveraged deals with concessions of up to 99 years in the cases of Chicago Skyway in the US and Highway 407 in Canada.

Robert Bain, associate director at Standard & Poor's in London, says that the high prices being paid for such concessions are easily explained. "People have started to realise the revenue capacity of these assets over the longer term, particularly for mature, established toll roads, and the potential for tariff increases in the shorter term higher than those that might be imposed by public sector operators. For those selling the concessions the immediate attraction is, of course, the significant cash injection."

And with such long concessions on offer and on well-established roads with predictable revenue streams, it is little surprise that the prices paid for the North American assets have been so high. Chicago Highway sold for $1.8 billion, Highway 407 for C$3.1 billion ($2.7 billion at today's rates).

The upshot is that debt has increased significantly, though loan tenors still only stretch to a maximum of about 17 years. And with the natures of concessions changing, so too has the method of financing, with recent deals incorporating typical project finance with a blend of corporate and structured financing solutions – commonly with deferred payments structures.

Says Bain: "When you have these very long-dated concessions, they take on some characteristics of perpetuity. In response, financial engineers have begun to think about them as quasi-corporates and advance structured and traditional corporate financing solutions such as bullet maturities, deeply-accreting debt and so forth. From a policy perspective, these deals mirror part-privatisations, yet the concession language may be more politically acceptable."

But will such highly-leveraged deep-future concessions become the norm? Bain thinks not. "We'll probably see some more in the US, but there is unlikely to be a widespread explosion," he says. "Mature assets with a strong business profile may be suited to this type of approach, but not all roads fit that model and not all public authorities will want to relinquish control of strategically important, cash-generative infrastructure assets to private hands."