Dexia and the Tlalnepantla Water Company have closed a first for municipal ? and water finance ? worldwide. The bookrunner and sponsor have adapted the solutions of the UK water industry, and exploited the growing Mexican bond market, to create a useful solution to the funding crisis in emerging markets' water infrastructure. This $10 million deal will not have made any of the principals rich, but provides the template for a slew of forthcoming mandates.

Water has presented so many obstacles to project finance bankers that it would be unsurprising if they were unwilling to look at the sector ever again. While the securitisations of UK water companies have made several banks, or at least their principal finance groups, a tidy return, concession based deals elsewhere have for the most part led to heartbreak. In Asia, Maynilad and Thu Duc have been cancelled, while in Latin America, Suez has abandoned Aguas Argentinas, which is in talks with the Inter-American Development Bank on restructuring its debt.

Water infrastructure is most frequently cited as the most pressing concern for developing countries looking to raise quality of life and make a major contribution to industrial development. So far, however, it has been extremely difficult to structure a concession in such a way that the private sector makes sufficient returns to entice investment. Too high a tariff level, and water riots and cancelled concessions ensue.

Municipal-level finance offers far greater potential, especially when combined with the assumption that local governments retain control of water assets, and have a strong hand in setting tariffs. The importance of dealing with local governments has been the key to the emergence of European public finance banks such as Dexia and DePfa in the Americas. The sector brings with it its own set of obstacles, however.

The municipality of Tlalnepantla is located within the State of Mexico, the largest and most populous of the United Mexican States. The federal government has until recently had a strong hand where fiscal affairs are concerned, and traditionally takes charge of public works. Federal participations usually finance investment and a municipal bond issue will usually rely on these central government credits.

Tlalnpantla has until now lightly treated its sewerage and let it flow into a drainage canal of the Rio San Javier. But the new wastewater treatment plant, the first in Tlalnepantla, will recycle untreated residential and industrial wastewater for industrial reuse. The use of the recycled water will also free up drinkable water to meet the growing drinking water demands for residential and business customers. This is a long overdue step for a municipality that accounts for 23% and 2.9% of state and national GDP, respectively.

The new plant will have a capacity of 200 litres per second and uses proven technology. While the contract for the plant is still in the final stages of negotiations, it will contain a detailed schedule of works and be tightly monitored, as will disbursement. The municipal water company, a small-scale concern, has already been forced to improve its management and controls in preparation for the new project.

The treated wastewater will be sold to industrials ? a mixed but relatively healthy bag of credits. These form the backbone of the deal's credit and the payments, made to local banks, will be transferred to the Trust under order of the municipality. The deal, therefore, relies upon the ability and willingness of the municipality to maintain this arrangement.

One of the key drivers of the municipality's willingness to honour its obligations is the involvement of the International Finance Corporation (IFC). The IFC exists to aid the private sector's involvement in emerging markets but, aside from construction work, there is little direct private investment in the project. The IFC, however, appears to be realising, much as some bankers have, that the subsovereign sector offers more promise in getting infrastructure off the ground.

The IFC guarantee backs $3 million of an $8.2 million letter of credit from Dexia Credit Local, one of the new breed of infrastructure banks that actively lends at this level. Despite the interest of monolines in backing local currency offerings, they were not serious contenders for the mandate because by paying for a wrap, an issuer pays to bring the rating of a bond up to the AAA level on an international scale, a level of enhancement far beyond that required on the domestic markets. A Dexia letter of credit, essentially, is cheaper, and enough to raise the issue's rating from Mx.AA to Mx.AAA (national scale).

The issue carries a coupon of 5.5%, and is of 29,311,000 UDIs (the inflation-adjusted unit, equivalent to MXP95.9 million). It has a maturity of 2013. The bonds were issued through Deutsche Securities and Banco Santander, while Protego advised the municipality.

Such a long cast list may be surprising for a deal that scrapes the $10 million level, and attracted eight retail investors. Mexican pension funds have large sums of money to invest (and are expected to be the mainstay of the government's forthcoming road deals), and will be looking for more substantial assets in the future. But the template is ripe for application on further financings.

In one potential adaptation, many bankers want to see financings take in multiple sets of assets, in a number of different states. The north, for instance, has water infrastructure wholly inadequate to serving the needs of its growing industrial population. Provided local governments can coordinate, there is little reason why deals cannot break the $100 million mark.

However, this thinking also infused the optimism of bankers confronting the difficulties of operating in the fragmented European market. There has been little movement here because of the complex security and regulatory issues, as well as the difficulties in bundling several credits together.

Nevertheless, the deal has a future wherever there is a relatively stable municipal sector and reasonably vibrant capital markets. Brazil, for one, is a country where participants are apparently anxious to export the structure.

---

Tlalnepantla Water Company

Status: closed July 2003

Size: $10 million

Location: Tlalnepantla, Mexico State, Mexico

Description: 200 litres per second wastewater treatment plant

Debt: UDI, peso-denominated issue backed by a letter of credit and IFC guarantee

Letter of credit provider: Dexia

Guarantor: IFC

Placement agent: Deutsche

Financial advisor: Protego

Technical advisor: Halcrow

Lawyers to the lenders: Curtis Mallet