The construction of new drinking water and sewage treatment plants is lagging growing demand across Latin America, and with many international water companies taking a cautious view on new equity investments, new ways are being sought to get projects financed.

Domestic sponsors are becoming increasingly prominent in Chile, while the use of local bond market debt is on the rise in Chile, Mexico and Colombia. And the Mexican Water Funding Trust (MWFT) deal which closed last December has structured a novel way for sponsors to release equity in existing deals, and so free up equity to be recycled into new projects.

In addition to these developments, the municipalities are back in fashion as potential providers of water and sewage services.

Throughout the 1990s private sector sponsors, mainly from Europe, were viewed by multilateral lenders as the main way to get additional capacity built in the developing world. But, in the wake of the economic meltdown in Argentina, bankers now expect to see municipalities playing an important role in infrastructure developments across the region. The activities of the IFC Municipal Fund are an important element in this switch towards a more balanced mix of public sector and private sector participation.

The busiest country is Mexico, and the blueprint was laid early in 2003, when an $8.8 million equivalent bond offering was made by a private Mexican trust, with the proceeds being used to provide a loan to Tlalnepantla Municipal Water Company and the City of Tlalnepantla, to be used to build a wastewater treatment plant.

Dexia Credit Local Agency New York provided a guarantee for Tlalnepantla, together with the International Finance Corporation (IFC). This was a first for both organisations, with IFC offering a peso denominated partial guarantee of up to $3 million equivalent, and Dexia a letter of credit capped at $5 million equivalent.

These partial credit guarantees helped create a new infrastructure bond asset class for Mexican institutional investors. The partial guarantees also raised the rating from Mx.AA (the rating of the municipality itself) to Mx.AAA, and allowed the deal to become the first time that a municipal bond had been issued in Mexico without either a federal guarantee, or being backed by assignment of federal tax transfers (as has taken place in many asset-backed securities deals backed by future tax participations).

"There is a recognition that building up the credit markets that lend to the public sub-national sector is very important, and in Mexico there is a huge demand for infrastructure and large pension fund system, so there is a natural way for that market to develop," comments David Vetter, vice-president and manager, public finance Latin America at Dexia Credit Local in New York.

"The pension funds want to diversify their holdings, so for a company like Dexia that provides credit enhancement, Mexico is potentially a very good market," Vetter adds. "And all the creditworthy municipalities now have credit ratings, which helps the process."

The IFC is keen to do more deals, but there will also soon be transactions where private sector guarantors such as Dexia go it alone.

IFC and IDB pushing funding boundaries

Despite some disappointment that there has not yet been a follow up transaction in Mexico, Juan De Mollein, analyst at Standard & Poor's in New York, does anticipate more IFC-led deals this year. "Institutions like the IFC and the IDB are trying to reach out to potential issuers that can comply with the characteristics that these institutions require from potential clients, which is on one side that it brings some social benefit to the community, and on the other side that the financing structure includes some type of repeat potential," he says.

There may also be involvement from monolines as well as municipal bond guarantors such as Dexia. "The participation of the monolines would help these transactions reach a triple-A global level, though for some issuers this may be more than they need," says Mollein. "But that is not to say monolines will not participate. For example last year we saw them participate in some toll road transactions - so it will be on a case by case basis."

Over the past two years Mexican municipalities and states have become frequent issuers on the local bond markets, and the partial credit guarantee has become a well accepted structure among Mexican institutional investors, who have grown used to deals such as a mortgage-backed bonds partially guaranteed by federal entities such as Sociedad Hipotecaria Federal.

Another country where the IFC partial guarantee structure has also successfully been used is Colombia, though this time with a private sector borrower rather than a municipality. In 2003 IFC provided a partial guarantee on 180 billion Pesos ($63 million) worth of bonds issued by Sociedad de Acueducto, Alcantarillado y Aseo de Barranquilla (known as Triple A), which is a joint venture between Spanish and Colombian partners. IFC guaranteed principal and interest up to $18.24 million on the bonds.

Another innovative financing structure in the water sector closed last December, when Nord/LB led a syndicated project loan to refinance existing debt and equity participations in an existing group of Mexican water projects.

The Mexican Water Funding Trust (otherwise known as the Poseidon Water Refinancing) won the Project Finance Latin America Water Deal of the Year Award for 2003 (see March 2004 issue.)

The various loans from three existing Mexican water projects are pooled in the trust, and are cross collateralised. Once project starts generating cash after debt service, individual sponsors are free to release equity. And there is room for additional water projects to be added to the pool. This presents sponsors with a flexible way to release equity in projects once they start to generate cash in excess of debt service, and the structure is viewed as a significant breakthrough for the regional water industry.

"Of course we are interested in doing repeat deals using a similar structure, but the structure will have to be adapted to each different market," comments Bruno Mejean at NordLB in New York. "The trust structure was particular to Mexico, since it was driven by withholding tax reasons."

"In upcoming water deals in Mexico we expect to see more local currency financing, and more municipal risk," Mejean adds.

Chile retendering

In Chile the focus is currently on a round of asset sales and quasi-privatisations, but these will soon lead to new investment, which will require fresh bank lending or local bond offerings.

The structure currently preferred by the Chilean government is one where operating concessions are signed, rather than full privatisations that previously took place in cities such as Santiago. So under the latest round of deals the shares of the companies will still be owned by the State of Chile, but under the concession contract private investors have the right to use the assets and to receive payments from the customers, and also the obligation to make certain investments and maintain a certain standard of service.

Chile is divided into 12 regions, starting with Region I on the northern border with Peru and ending with Region XII which includes and Cape Horn. It is these regional authorities that are responsible for water services, rather than individual municipalities - the exception being the capital city of Santiago.

Last year bids were invited for water utility concessions in Regions I to IV, and in November the government announced that two bids had been accepted, while in the other two cases the offers were too low, and another round of bids will be necessary.

Bidders included Suez of France and Canal Sacyr of Spain, but the eventual winners were local Chilean investors. The Region II utility Essan, whose service area includes the port city of Antofagasta, was acquired for $185.6 million by Punta de Rieles, a consortium led by Luksic Group, Chile's largest conglomerate.

This means that the Antofagasta desalination build-operate-transfer (BOT) financed last year by the IDB is now providing water to a concession run by the Luksic group, rather than a state-owned utility.

In December 2003 the IDB approved a $20.9 million financing for the desalination plant, which is being built in four modular stages, as growth in demand for water increases. Desalent, which is a subsidiary of the Spanish OHL Group, has a 20-year BOT concession from Empresa de Servicios Sanitarios de Antofagasta. This loan, comprising a $7 million A Loan and a $13.9 million syndicated B Loan, will cover the first stage of the project.

"The water company in Region II that previously existed still exists, but for the next thirty years the whole operation, and the right of exploitation of the resource, has been privatised," explains John Binkley at the IDB Private Sector Department in Washington DC, who was project team leader on the Antofagasta loan. "For all practical purposes the private company that has taken over operations in Region II is now the offtaker, but the company that we are lending to has a contract to provide water and that contract remains intact," Binkley explains.

Up to now the IDB has not done any water deals at municipal level anywhere in Latin America, but the first deal may not be far off, as the bank is doing more lending to municipalities in other sectors. For example, in February the IDB approved its first ever loan to a municipality in Peru, providing $45 million to the Metropolitan Municipality of Lima to finance the first stage of an integrated, urban mass transit system.

In Chile the second bid accepted by SEP was for the Region IV utility, Essco, which was acquired for $85.6 million by a group which already controls the previously privatised Esval utility in neighbouring Region V, centred on the cities of Valparaiso and Vina del Mar.

Until recently Esval had AWG plc, the UK water company which owns Anglian Water, as a shareholder. But earlier this year AWG sold its 49.8% stake in Esval to local investors Consorcio Financiero and the Modeda Chile Fund for $92 million.

"Some international companies want to get out of Latin America, and focus on their core countries, and we are seeing a lot of local investors coming in and being more aggressive," comments a banker based in Santiago. "For example Region II is very attractive because it has a lot of mining companies - for the mining process you need a lot of water."

Brazil slow

Brazil is also looking at a mixture of private sector and municipal solutions to its pressing water needs. However, though some deals are currently being worked on, the going is slow at the moment.

Since the left wing government of Luiz Inacio Lula da Silva came to power in January 2003 there has been a lot of policy discussion about plans for more private involvement in sectors such as water.

There has however been some disagreement within the ruling Workers' Party about the direction to take. Finance Minister Antonio Palocci is a supporter of PPP, and when he was Mayor of the city of Ribeirao Preto in the mid-1990s he presided over the signing of a 20-year concession for the local sewage treatment works. But some of the more left wing ministries are keen to keep services such as sanitation in public hands, and relying upon loans from institutions such as development bank BNDES.

"Brazil has these very large intermediaries such as BNDES, but there is a shortage of capacity because they are maxed out on public sector lending," says one observer. "So both private sector institutions and players such as the IFC are trying to help get deals done in Brazil, in which BNDES may lend to a PPP, but then the private sector would come in and take part of the risk, for example by providing a Letter of Credit. The private sector involvement might just be in the form of the contractor, so the borrower would be the municipal water company rather than a privately owned water company under a BOT solution."

But a banker in Sao Paulo cautions against expecting any significant dealflow this year. "Things are very quiet here at the moment for lenders," he says. "In the water sector there are still issues over whether the municipalities or the states are responsible for the concessions, so I think PPPs are more likely to happen first in the thermal power sector."

Given Brazil's size, such an assessment will come as a disappointment to bankers, and will reinforce the feeling that the countries with the best immediate prospects are Mexico and Chile, especially since the two countries have the best developed domestic bond markets in the region.

Overall, the strategy for Latin America is diversifying away from the 1990s model of a European sponsor on the equity side, and Dollar loans from multilateral institutions on the debt side. Today, particularly in the wake of problems following the collapse of the Argentine economy, a wider variety of structures are clearly needed if the region's water needs are going to be met. Local private sector sponsors, local bond offerings and local municipalities will all play a much bigger role in the Latin American water sector in the coming years.