Last November Miejskie Wodociagi I Kanalizacja w Bydgoszczy (MWiK), the municipal water company of Bydgoszcz, Poland's eighth largest city, became the first in eastern and central Europe to use revenue bonds to finance an infrastructure investment programme. The PLN920 million ($287 million) Bydgoszcz Water Project includes up to PLN600 million of the bonds, which despite a long history of use in the US have yet to take off elsewhere.

The bonds are tied to the company's future revenue stream rather than its assets. Bankers involved in the deal – the EBRD, Citigroup and Bank Pekao – say the bonds allow MWiK to raise three to four times more debt than it could through corporate bonds. The flipside is that the project leaves MWiK highly leveraged. However, sustainable financial ratios coupled with MWiK's position as a natural monopoly and a robust security structure allowed Fitch to give the project a BBB- rating – equal to that of the City of Bydgoszcz.

The project involves improving the city's water quality to conform with EU standards; increasing security of supply within the system; diverting raw sewage that is currently discharged into local rivers; improving the sewerage network; refurbishing the water network; and expanding the network into neighbouring communities.

Work is divided into two capex programmes. The first of these totals PLN257 million and was begun in 2002, with completion due in 2007. The EBRD provided a PLN108 million corporate loan in 1999 that was used by MWiK, along with a PLN111 million grant from the EC Instrument of Structural Policies for Pre-Accession, to finance the first progamme. The revenue bonds will partly refinance the roughly PLN50 million that remains outstanding from that debt. The second capex programme costs PLN642 million and the work runs from 2006 to 2009.

Poland passed an amendment to the 1995 Bond Act in 2001, legislating for the use of revenue bonds. The EBRD decided to explore the revenue bond option as a means of developing new financial instruments for eastern Europe. For the EBRD, MWiK was a good sponsor to work with because of their previous relationship on the 1999 project, and the company's subsequent good track record in implementing the first capex programme.

The EBRD played a key role in the project's design, but once Citigroup and Bank Pekao were awarded the arranger mandate it switched from a de facto advisory role to one of anchor investor in the project. It has an option to purchase bonds worth up to 40% of the total, with the remainder distributed as a private placement.

The rest of the project financing comes from a European Cohesion Fund grant for Eu100 million (PLN382 million, but valued at PLN460 million at the time of the EU decision). This is subordinated funding with a 20% tail-end payment only redeemable after the work is completed. The other 80% is only repaid if the proceeds are used incorrectly.

There are two tranches of bonds, with a first tranche of PLN400 million to be issued in four separate series, and another that can be used to fund future programmes, giving MWiK some slack to expand the project if it needs to. MWiK would have to conduct feasibility studies and meet certain tests before it could issue the second tranche, which would most likely be used to cover expansion into neighbouring areas beyond the city.

The first series of bonds, worth PLN100 million, was issued in December and was oversubscribed at the book-building stage, attracting bids from Polish pension funds, banks, insurance companies and two foreign institutions. The EBRD purchased 30% of the bonds, which is its target take-up for each of the series. The 15-year notes priced at 130bp over the six-month Wibor.

The deal's success hinged on a strong security structure with two main features: a credit enhancement from the City of Bydgoszcz, in the form of a municipal support agreement (MSA), and a flow of funds mechanism that ensures the ring-fencing of revenues needed for repayment.

Many of the MSA provisions have been in place since 1999, when the first capex programme was born. It is a covenant between the city and MWiK in which the city undertakes certain obligations, such as not to interfere with the company's management and ensure appropriate tariff levels, laid out by Poland's Water Act. Moreover, the city will inject capital into the project if the debt service coverage ratio drops below 1.2x or the collection ratio drops below 95% (base-case ADSCR is 1.8x).

Under the flow of funds mechanism, revenues from the project first flow into a restricted account from which MWiK cannot make withdrawals unless it leaves behind 12 months' debt service obligations. MWiK also makes monthly payments into a coupon account that collects 50% of the next semi-annual payment before the payment date. The company has to transfer the remaining 50% 15 days before the payment date.

The project works well for the municipality because the alternative of a bond secured on assigned receivables would be ambiguous, in the eyes of Polish law, in the event of a bankruptcy. Revenue bondholders have prior claim over the asset, enabling the issuer to raise more cash than it could with commercial debt.

Poland is the only country in eastern Europe with legislation that specifically refers to revenue bonds, meaning it could be a while before the transaction is replicated elsewhere. However, since the CEO of MWiK also chairs the association of Polish water companies and is actively marketing the idea, it might not be long before another such Polish deal appears.

Bydgoszcz Water Project
Status: Closed 21 November 2005
Location: Bydgoszcz, Poland
Description: Financing of improvements to the city's water supply system and refinancing of existing EBRD debt
Size: PLN920 million (Eu235 million)
Debt: PLN600 million (Eu157 million)
Arrangers: Citigroup, Bank Pekao
Anchor investor: EBRD
Lender counsel: Clifford Chance
Sponsor counsel: Soitysinski Kawecki & Slezak