The water industry has been one of the UK's more successful privatisation stories. Significant operating efficiencies have been achieved while delivering price cuts to the consumer. But despite the improvements that have been made, the industry still faces a capital expenditure requirement of £10 billion to £15 billion over the next 10 years. The improvements brought about by operating efficiencies have for the most part been realised and the sector is now bracing itself for the next phase in its development. ?The UK water sector is on the cusp of change. There are a number of different business models that the various companies may want to pursue, including greater leverage in the balance sheet than has been deployed in the past ? observes David Dubin, Managing Director of the European infrastructure and utilities group at monoline insurer MBIA in London. And this change means the adoption of two or three very different business models across the industry.

The genesis of these latest changes was the UK regulator (OFWAT)'s pricing review in 1999, which set stringent restrictions on the prices that water companies can change their customers. It decided to impose a blanket 12.2% price cut on supply businesses from April 2000 and turnover at many companies fell by as much as 30%. That review covers the period from 2001 to 2005 and has therefore had a serious knock-on effect on water sector share values.

The water and sewerage companies (WSCs) have, therefore, been diversifying into other businesses and examining non-equity forms of finance in order to improve yields. But they are not agreed on the way forward, with opinion broadly falling into two camps: the highly leveraged business model and the underleveraged business model. From the project finance point of view the former has so far generated a more interesting set of deals and structures.

Although last year's Glas Cymru transaction has been widely lauded (and was winner of Project Finance's Water Deal of the Year for 2001, see Project Finance, February 2002, page 19), it was not the first UK water company to adopt securitization financing techniques. One problem that UK water companies face is the capital intensive nature of their business. They will always have huge capex requirements and face the question of how to meet them while maintaining credit ratings and managing their leverage. The imperative to raise long-term capital will always be there.

For some WSCs the costs of servicing the debt burden in the past have been higher than the operating costs of the business. ?Over the last 10 years the water companies have achieved huge efficiencies representing a substantial windfall from privatisation,? notes Richard Bartlett, head of corporate securitization at Royal Bank of Scotland in London. ?But the last OFWAT review took out the last of these gains and the companies are now looking at eking out efficiencies of one to two percent a year rather than the substantial gains that have been achieved in the past. The businesses have effectively become ex-growth.?

So what can they do? Operating efficiencies have been achieved and consolidation within the industry has been ruled out by successive regulators and the Monopolies and Mergers Commission. ?Any normal business [in our position] would be looking to expand in its home markets by offering better service at lower prices to more customers but as a regulated water business we can't do that,? says Chris Mellor, chief executive at Anglian Water Group (AWG). ?This is despite the clear benefits for customers to be had from an industry comprising just three or four large, successful, competing operators.?

So the obvious route left to achieve further efficiencies is financial restructuring. The WSCs are under pressure to reduce their cost of capital, take capital out of the low-yielding water business and put it into higher-growth areas and to attract a diverse range of investors. Yorkshire-based Kelda Water was the first to examine some form of restructuring following the 1999 OWAT review, and looked at mutualisation. Pennon Group (formerly South West water), Kelda Group and AWG were the only independent water companies left from the 10 WSCs that were created at privatisation (in 1989) and were thus under the greatest pressure to restructure.

At the time, Kelda group chairman John Napier was fiercely critical of the restrictions imposed by the regulator, saying that an equity-based model for fundraising cannot work without a dynamic rate of return ? which the industry clearly does not have. So the alternative has been the development of a debt-based model for fundraising which has seen the water industry embrace the concepts of securitization with gusto. ?These structures would have been impossible five years ago,? notes Charles Morgan, managing director, Global Debt Origination at Dresdner Kleinwort Wasserstein in London. ?They are only possible now because the rating agencies have been convinced of the merits of the cash flow model.?

But things are not that simple. ?Securitization has become a massive red herring in this sector,? says Morgan. ?The debt levels of these companies mean that it is simply not suitable.? He describes the types of structures that have so far been used as ?corporate finance with elements of securitization and project finance?. Indeed, true securitization, which would involve first ranking security over the cash-generating assets, is illegal under UK regulations covering the water sector.

The first water company to adopt a securitization-like structure was Sutton and East Surrey Water (SESW) which undertook a £100 million senior secured bond issue in March 2001. The bonds were rated triple-A with a wrap from FSA and the deal was lead managed by Royal Bank of Scotland. ?This deal represented 75% of the company's regulated asset value (RAV) and in addition to allowing them to repay existing facilities it freed up £30 million to £40 million of capital to invest in alternative activities,? explains Bartlett at RBS. Thus, not only can using this type of restructuring lower the WSC's cost of capital, it can also enable them to buy into higher-yielding businesses. SESW used the extra capital to acquire a gas distribution business in Northern Ireland with potentially higher yields than the company's core water activities.

But what this relatively small deal did was road-test the financing elements that would be used to great effect in later deals. These include the separation of different parts of the business (into assets and operations) and subsequent ring-fencing with a view to exploiting the generally low-risk nature of the asset generating company. In this deal, SESW was ring-fenced from parent East Surrey Holdings Group and achieved a higher rating than it would have done otherwise.

But this type of structure does not come without some fairly tough covenants. Anthony Flintoff at Standard & Poor's explains that for a ring-fenced company to achieve a higher credit rating than its parent, it must be created as a special purpose subsidiary, have a tightly drafted covenant package including dividend tests, negative pledges and restrictions on asset transfers. Also, the debt would need to be fully secured by a pledge of nearly all the assets of the subsidiary, either directly, or through security over the shares in the company.

Not surprisingly, these types of covenants prove hard to stomach for some WSCs and are the basis of the split between the equity and non-equity business models that are being pursued. The template for the non-equity model is the Glas Cymru deal, which was completed last year. While this deal was highly innovative and has been hailed as a blueprint for the industry, it was also addressing a unique set of circumstances. ?Our strategy is unique and most people's thoughts are that [the] Glas [deal] will remain unique,? Chris Jones, finance director at Dwr Cymru (Welsh Water) tells Project Finance. Jones, together with another ex-Hyder director Nigel Annett, structured the transaction, which involved the establishment of a ring-fenced not-for-profit company (Glas Cymru) which would assume the assets of Dwr Cymru from Hyder. As such it was a whole business securitization structure.

The £1.9 billion bond issue refinanced £1.85 billion debt assumed with the transfer of the company (for £1) and represented 93% of the RAV of the company. The senior bonds were wrapped to triple-A by MBIA. The deal was arranged by RBS and Citibank Salomon Smith Barney. ?The debt markets are the only way for these companies to refinance going forward and the debt markets love structures like Glas,? says William Cumming, managing director, securitization at Citibank in London. He notes that while Glas has an A? rating it trades tighter than other WSC paper with A or A+ ratings. The success of the deal has also afforded the company a wider range of funding options. In March this year it closed a £120 million 30-year finance lease on a portfolio of water assets with Lombard Leasing.

This has certainly not escaped the notice of AWG, which is now putting the finishing touches on its own restructuring ? one which follows the Glas template very closely. In November last year the company announced that it was to split the group into a ring-fenced, debt-financed company known as Anglian Water Services (AWS), which will run the water and waste water businesses and be separate from AWG's other infrastructure management activities. The structure will allow AWS to support up to £3.4 billion in secured debt within the regulated business and the plan is to transfer the majority of existing capital markets debt and lease finance to AWS and the balance will be raised as new debt. MBIA has stated its willingness to wrap up to £1 billion AWS debt to triple-A and Citigroup and Barclays Bank are in the process of arranging a Eu10 billion secured MTN programme. Total AWS debt will initially be 85% of RAV (senior debt being 73% of RAV). Clearly these gearings are slightly inflated as the company is borrowing more than it needs.

The company is planning to raise £1.5 billion new debt, which will be used to fund £205 million cash reserves, repay a £178 million EIB facility and repay short-term debt of £472 million. The transaction is expected to incur a total cost of £120 million made up of £83 million upfront cash transaction costs and £37 million net present value of future coupon enhancements.

The AWG restructuring differs from Glas in two fundamental respects: the structure keeps AWS within the group and does not make use of a not-for-profit company and the deal does not envisage the contracting out of operations ? which Glas does. The establishment of AWS as a ring-fenced SPV within the company structure is far more likely to be the precedent for future deals than the Glas situation ? which was addressing the needs of that particular set of circumstances. ?It is unlikely that the regulator will allow another not-for-profit structure,? says Fintoff at S&P. ?The Glas case was a special situation because, among other things, the company is clearly identified as being a Welsh company owned in a broad sense by the people of Wales.?

Most industry observers agree that Glas is a one-off, but Cumming at Citibank, who worked on the deal, disagrees. ?The regulator may allow not-for-profit again ? it does not select one model over another. Look at Network Rail (the not-for-profit company that has been set up to assume the assets of Railtrack),? he says. He also points out that (despite the fact that there is no dividend leakage) the structure may not be attractive in other cases. ?AWG did not want a not-for-profit structure ? there was no need,? he says, adding that ?Some investors in the Glas deal actually complained about the lack of equity ? so I've heard it both ways.?

?We have never set out to be advocates of the non-equity model,? says Jones at Dwr Cymru. ?We have no desire to thrust this down anyone's throats.? But his deal represents the extreme end of the spectrum in the debate about the importance of equity in the industry. While ? as has been seen ? the non-equity approach is peculiar to Glas, the attractiveness of Glas-type structures is prompting a thin-equity approach elsewhere ? and heated debate within the industry. ?The Glas Cymru transaction demonstrated that increased leverage is available by way of the bank and bond markets? says Dubin. ?However, further application of this structure is in part hemmed in by the natural tension that exists between debt and equity shareholders.?

But while this tension may not be there in Glas, there are many who feel that equity has a vital role to play. ?The regulator firmly believes that there is a role for equity in these companies,? says Morgan at Dresdner Kleinwort Wasserstein. ?Good shareholders are needed.? He also makes the point that increased leverage is not always bad news for equity. ?The further you increase your gearing the higher the return on equity. A high level of gearing therefore enables shareholders to maximise their return on equity ? not the other way around.? It must be remembered that the Glas deal dealt with a business that was completely unwanted and very inefficient ? a very different situation from that at, say, AWG. And Chris Jones questions the industry wisdom that active shareholders are needed to enhance performance. ?We are confident that we will be an industry leader going forward,? he says.

Several UK WSCs have tied their banners firmly to the equity mast ? most visibly United Utilities and Severn Trent. The former has pursued this strategy with some success. Its core network business gives it efficiency and it has overlaid this with a series of other businesses with different growth stories ? giving it little imperative to go down the debt route. DKW advises both AWG and United Utilities, and Morgan explains the latter's thinking. ?United Utilities has no reason to undertake this kind of restructuring. It is trading above its RAV and there is nothing to be obtained by it ? these things need to be looked at from the point of view of the shareholders, not just from what will maximise the fees to a debt origination group.? But this is not the case in some of its other equity-model stablemates. According to a report by SSSB, Severn Trent was trading at 9% below RAV in March this year and Pennon Group was trading at 12% below RAV. United Utilities declined to speak to Project Finance for this article. Morgan counsels that if the current trend of replacing equity with ?something else? continues the industry will need to develop another model of management to ensure that it does not end up where it was 100 years ago with a series of municipal water companies with no shareholders to drive performance.

But for some WSCs these debt structures must be a dream come true. By splitting their activities and taking advantage of the strong demand for high quality, low event risk, long-term debt from UK financial institutions (particularly post-FRS 17) they have been able to achieve funding at a greatly reduced cost of capital and with gearing levels that would usually make potential lenders' eyes water (in the past, the average gearing in the water sector has been between 50% and 60%). It is industry legend that the Glas structure achieved a 200bp reduction in cost of capital for Dwr Cymru, which translates to £50 million per annum ? the total employment cost of everyone who works for the company.

So what's the problem? Why are all the WSCs not rushing to follow suit? Not surprisingly ? covenants. These structures limit the WSCs ability to leverage their UK assets in order to expand into other businesses ? a key strategy for some in the industry. ?There are clearly participants in this sector that do not want creditors too close to the vest,? notes Dubin at MBIA. ?Certain of the WSCs are having to look seriously at the trade-off between greater permitted leverage combined with economic and financial ringfencing of the licensed appointee and the perceived loss of control that could entail.? But are the covenants are restrictive as some claim? There is no doubt that they were in the Glas case, but each deal presents its own story. ?Structuring is about reassuring the investor,? says Bartlett. ?But the covenant structures are only replicating many of the regulatory protections.? He adds that regulatory risk is not an issue. ?The regulatory environment is stable ? any risk comes from not understanding it.?

The inclusion of tranching in these structures has been a great advantage ? enabling the deals to be sold across the board. The triple-A tranches are attractive to investors looking for stable yields and the unrated tranche is structured to be attractive to more equity-type investors. Dubin clearly believes that the market represents good potential for the monolines and is devoting a significant percentage of his department's resources to it. ?This sector is lower in risk than most other asset classes that monolines participate in. We have committed and executed a £1 billion guarantee in favor of Glas while also committing a further £1 billion to the potential restructurings for AWS and Southern Water deal (which was pulled) ? which is equivalent in par size to 10 to 15 UK PFI deals.? Most people expect there to be three or four more deals in the next few years, with prime candidates being Kelda Group, Pennon Group and Southern Water.

Southern Water was widely tipped to be the latest WSC to be restructured along AWS lines earlier this year by parent Scottish Power ? which had made no secret of its desire to readdress its holding in this sector. It seems that a deal was fairly well underway when Scottish power underwent a change of heart and sold the company to investment vehicle First Aqua for £2.05 billion. It seems that Scottish Power had been considering a securitization-based structure but unlike AWG is understood to have been looking to treat Southern Water as an integrated company ? not split out assets and operations. ?The deal did not happen because First Aqua came along and offered a better price,? explains Bartlett at RBS ? which funded the First Aqua acquisition. The £2.05 billion bid (which was approved by the EU at the end of April) represents 104% of RAV.

The other recent high profile water industry sale ? that of Wessex Water to Malaysian conglomerate YTL Power International ? also involved a last minute change of heart. Abbey National and Royal Bank of Scotland had been named as preferred bidders for the Wessex business, which was being sold by Azurix, a UK-based subsidiary of failed US energy firm Enron. The company had entered exclusivity talks with the two UK banks when it announced that the water company was to be sold for £1.24 billion to YTL.

Recent reports that RBS is considering backing legal action against the auction process brought by another unsuccessful Wessex suitor, Cheung Kong Infrastructure Holdings, have been denied. Sources close to the deal indicate that the fate of the Abbey/ RBS bid centred on the consortium being able to complete sufficient due diligence to be able to satisfy itself that it was free and clear from any liability arising out of the collapse of Enron. The issues involved are similar to those that scuttled a similar merger in the power sector between UK-based Centrica and 44% Enron-owned New Power. That deal foundered when the US bankruptcy court ruled that tax and pension liabilities were outside its jurisdiction and it is these liabilities that concerned the Abbey/RBS bid. YTL therefore emerged successful as it not only topped the alternative bid but had completed its due diligence. Whether or not the YTL bid was looking for the same level of assurance that the Abbey/RBS one was is unclear.

Dresdner Kleinwort Wasserstein is now advising YTL on the acquisition of Wessex Water and underwrote a £545 million loan for the transaction at the beginning of April. ?We are now exploring a variety of refinancing options with YTL,? says Morgan at DKW. ?Given the levels of debt involved it may take the form of a securitization but it is very early in the structuring process.? YTL is paying £1.24 billion for Wessex Water ? or 105% of RAV. Wessex could, therefore, be the latest UK water company to adopt a debt approach for future fundraising. ?If you can raise debt more cheaply than equity then it makes no sense not to do so,? says William Cumming at Citibank. ?It is inevitable that companies will go down this route.? He reckons that they will have to, given the pressures that they now face. ?With people like the VC shops looking at the water sector, as soon as one of these companies stubs its toe there will be a takeover,? he predicts.