Once the staple of US power projects ? the combination of Enronitis and FASB Fin 46 changes to accounting standards have effectively killed the US synthetic power lease and spawned a return, albeit small, to standard US leveraged leases as parts of hybrid deals.

Interest has now turned to the US municipal water sector where, for the first time, US leveraged leases look set to have an impact in both greenfield development and maximising returns on existing assets.

Leveraged leasing has long been standard practise for European water treasury managers. US municipalities are now following the European lead and looking to the leasing market for funding both wastewater and freshwater assets. Estimates put potential dealflow at around $11 billion in the short term, and a number of counties are currently considering lease deals ? notably New York for its $2 billion water tunnel project.

The move is timely given the pressure US municipals across the board are feeling on their budgets and balance sheets. As Chris Whitman, managing director at Allco Finance in the US, says: ?The benefits that can be gleaned out of these transactions could be very significant to some of the agencies and cities with water and wastewater deals to be done. Wastewater facilities, in particular, offer a good asset to be done on a lease-to-service contract.?

The City of New York deal, mandated to Dexia and believed to be valued at around $2 billion, is for a new water tunnel being built by the city. In conjunction with ongoing construction on a Water Tunnel project now going on in the city itself, a lease-to-service contract is being evaluated for a new aqueduct project further north.

The New York City Municipal Water Finance Authority confirms a lease transaction is being considered for the water tunnel construction, but no decision has yet been made. But ?at the current time, the transaction remains in the discussion stage, and therefore there is no information available publicly.?

In addition to the New York City transaction, there is a wastewater transaction already mandated by the LA County water authority and two other deals are in the works in New Jersey. Both North Hudson and Jersey City are considering leasing deals for wastewater assets.

Europe tapping heavily

The move represents the re-export of US financial engineering back across the Atlantic. The market for European water lease deals has long been strong: Germany has been awash with transactions since the first in 2000, with the leasing market being dominated by wastewater transactions.

So sophisticated has it become that last year the German market even saw a club deal for a mixture of wastewater and freshwater assets. The deal, put together by boutique Global Capital Finance, included $92 million of freshwater asset for Stadtwerke Schwerin, $269 million of wastewater assets for the City of Schwerin, and a third, unnamed lessee. Global Capital Finance also has an outstanding club deal ? mandated by Stadt Sankt Augustin and Gemeinde Neunkirchen-Seelscheid ? for wastewater treatment plants with a collection network. The deal is valued at $325 million in total.

In addition to German lessees, both Belgian and Austrian municipalities got in on the act last year. Belgium has seen the most interest with four cities working on deals: the cities of Sint Niklaas and Brugge are close to completion and the cities of Leuven and Antwerp have deals in the works.

The first Belgian wastewater transaction is expected to close soon, and another mandate could be on the way. Brussels is believed to be considering a sewer system deal, although the city's complex water authority structure suggests that will be some time in coming. In Austria the big deals are a $350 million wastewater transaction put together by Babcock & Brown for Innsbrucker Kommunal Betriebe (IKB), and a wastewater deal believed to be in the works for the City of Vienna.

The UK has also seen some interesting leasing transactions over the past year, most particularly the innovative tax lease/securitisation launched by Dwr Cymru. The Welsh water company closed a £295 million ($470 million) UK tax lease transaction in conjunction with a £2 billion overall securitisation transaction. The tax lease part of the deal included three tranches of long-dated lease finance of water assets for Dwr Cymru. It was arranged by Dresdner Kleinwort Wasserstein. And in Norway one municipality ? thought to be Asker ? has a mandate out for a service contract on a waste and fresh water plant.

US waiting on first deal

With all these European deals in the works, it appears US municipal lessees have started to sit up and take notice of the benefits. However, it could still be some time before any of the prospective US deals reaches completion. Says one market participant: ?Because this is a new market space, lessees are wary of going forward with deals. No one wants to be the first in the market because they are the ones that have to sound out what works. It will take some time to work everything out and sort the best structure for US water assets, but once a deal does close, there are a number of other transactions that could follow quickly. As yet, it is unclear when the deals currently out there will reach the equity stage, or close.?

He says that most of the interest so far has been for wastewater assets: ?But that does not mean that leasing is not a good option for freshwater assets ? freshwater deals will certainly be done.?

Whitman at Allco adds that although no deals have yet gotten to the point of bringing in equity, interest in this new asset class should be strong: ?There will definitely be investor interest, although no deals have yet reached that point. There is no reason why there should not be investor interest ? these deals offer the same advantages as other leasing transactions.?

Being a new asset class in the US market, one thing the US does offer is portfolio diversification. For those investors keen on water deals but with portfolios filled with German transactions, it offers a new market with high quality assets to invest in.

The question now on many a European lessee's mind must be whether the attraction of home-grown assets in the minds of investors outweigh the benefits of cross-border deals, and thus whether the development of a US market for wastewater and freshwater leasing deals could cause a waning of investor interest in water assets abroad, especially with many of the best assets already leased in more established markets, such as Germany.

According to Whitman, there is room for deals in both markets: ?There will be interest in US deals, but that does not mean it will take away from the markets in Europe, those markets will continue to be strong for water deals. There will be situations in both markets where it makes sense to use leasing for municipal water assets and those deals will go forward.?

Whether there are assets or investor interest to support growth in the market remains to be seen, but what is becoming ever-clearer to US local government lessees are the advantages of lease transactions. Leasing offers municipality's flexible financing with an NPV benefit to boot.

Structuring hurdles

However, there are still obstacles that need to be overcome before a US water deal will come to market. As with any municipal leasing transaction, water deals must still go through the process of getting Environmental Protection Agency approvals, which can be a long, drawn-out process.

In addition, there is the tax-exempt bond analysis. The difficulty arises in balancing state and federal requirements. In order to have a tax-exempt lease as lessee, the lease contract must satisfy both state and federal law. Under state law, the questions relate to the authority of the municipal entity to enter into the lease contract and compliance with restrictions on incurrence of indebtedness. Most, if not all, states put limits of some sort on the amount of indebtedness a municipal entity may incur. So, Municipal Lease Purchase Agreements must comply with those state restrictions on the incurrence of debt but they must also still maintain the character necessary to keep tax-exempt status for federal tax purposes.

From a federal perspective, tax evaluation looks at whether the lease contract constitutes an instalment sale contract ? which should make the interest component of the rent tax-exempt for the lessor ? or a true lease. To get tax-exempt status, the agreement must constitute an instalment purchase agreement. But distinguishing between a true lease and an instalment sales contract for federal income tax purposes is a difficult process. And balancing that with debt requirements under state law makes it even more complex.

However, that is just what legal advisers are now working on. Once the structure is worked out, it will be replicable at the very least in each state where a deal is completed, and certainly the structure will have cross-application and make the deal process easier in most states.

Adds Whitman: ?There can also be other state and local issues that may arise in particular jurisdictions.? However, even with the complex regulatory environment, most jurisdictions are pretty friendly to this type of transaction, and any obstacles should be overcome.

He says that the growth of leasing transactions in the US water market is poised for growth: ?There has been a lot of water and wastewater deals done in Europe, but we have not seen that transfer over to the US as yet. It will happen, but it will take some time before we see that crossover.?

Adds one arranger: ?This asset class will grow in the US, and I expect we will see some deals done in the coming year. A number of possible transactions are being discussed. It is a slow process that is just beginning, but there are a few deals being actively evaluated and it is only a matter of time before they come to market.?