After the drought, the flood. A harsh price review from the water regulator has sent the UK's water sector into freefall for the last two years, but a rash of restructurings this year could prove to be a decisive turning point.

Glas Cymru is to restructure Welsh Water and finance it entirely through a £1.9 billion securitisation, in a deal that credit analysts are predicting will be the year's most important sterling bond issue.

But whilst bondholders are celebrating the fact that the Welsh Water business has been restructured specifically for bondholders and not shareholders, other water companies are finding themselves unable to access the sterling market.

At the start of March, Northumbrian Water pulled a £200-300 million corporate bond issue after arguments with UK investors over covenants.

United Utilities raised Eu1 billion earlier this year, and is now fully funded for the next two years ? but it avoided the cheaper sterling market, and instead tapped the euro market. The reason, say analysts, is that if it had borrowed in its domestic market, it would have had to accept investor demands for covenants.

Ofwat, which oversees the privatised water sector in England and Wales, announced in 1999 a severe reduction in prices that utilities could charge customers for 2001-2005. As a result, utilities have been attempting to combat their declining share prices by diversifying into more risky international areas. This, in turn, has pushed credit ratings downward, making debt more expensive to issue.

In the face of this problem, water companies have been taking a fresh look at how to reduce their cost of capital and cut financing charges. And the consensus from many water companies is that the best way to improve their capital structure is to increase their leverage.

When the industry was privatised in 1989, water companies were financed with just 50:5 debt to equity. But the feeling now amongst most finance directors is that this level is too cautious, and there is no need to have so much equity in such a stable and predictable sector.

But gearing up may not be so straightforward as just issuing bonds. Sterling investors, wary of a sector which has underperformed over the past few years, are demanding protection in the form of covenants. Whilst some utilities such as Glas Cymru are happy to ensure that bondholders have the protection they are demanding, others are not so keen.

This split may seriously hinder some companies' ability to borrow money in the sterling bond market.

Two utilities this year have led the way in financial restructuring. Sutton & East Surrey, a small water company in the south of England was the first. It issued a £100 million index-linked bond that gave investors strict controls over the business, and featured a triple-A wrap from monoline insurer FSA. Royal Bank of Scotland was the lead manager.

This deal, whilst lowering Sutton's cost of capital to less than the regulator's expectations, was seen as just a warmup for a much more radical deal ? the debt-financed acquisition of Welsh Water.

Glas Cymru, a non-profit making company, is funding its £1.9 billion acquisition of the regulated water company entirely through a securitisation. The deal is being arranged by Schroder Salomon Smith Barney and RBS.

The deal is expected to reduce Welsh Water's cost of capital significantly, but the structure has not received the support from all of the sector.

In particular the water regulator Philip Fletcher, who approved the restructuring, has expressed concerns about the structure. In a paper published on January 31 2001, he outlined a number of questions. First, he asked: ?would the wholly debt-financed structure be sufficiently robust to withstand cost shocks and the consequences of poor management, when compared to shareholder-owned, equity financed water companies??

Second, Fletcher queried whether the absence of shareholders ?would mean that the incentives for continuing efficiency would e inadequate??

Fletcher's final question was: ?would the complete outsourcing of its operations leave Dwr Cymru in a position to maintain proper control over its functions??

Glas causes problems for other utilities
Over the past few years, bondholders have become increasingly disenchanted with the UK water sector, as companies have diversified away from their original regulated businesses and into higher risk growth sectors abroad.

Stephen Wilson-Smith, a credit analyst at Prudential M&G, says that, ?utilities have made debt-financed acquisitions into sectors that they say are similar but might not be.?

For these utilities, such as Thames Water and United Utilities, which are committed to providing growth for shareholders through diversification, a structure like Glas Cymru's is not an option.

They do not want to give away covenants on the bonds that they issue, because it could hinder their ability to expand their operations.

Such companies still have to finance their regulated assets though ? and between 2001 and 2005, UK water companies have around £15 billion of capital expenditure to finance.

But will they have a problem? If investors start to get a taste for water bonds with covenants, then issuers who are unwilling to use covenants may experience difficulties.

Northumbrian Water, which tried to access the sterling market earlier this year, is a perfect example of this emerging tension in the sector. The water company is owned by Suez Lyonnaise des Eaux, the acquisitive French utility.

Stuart Buchanan, treasurer at Northumbrian Water, says that the cost of issuing sterling debt moved substantially between the beauty parade for the lead managers and the roadshow for its sterling bond.

?At the time of the beauty parade, our 1998 25yr bond was at 165bp over Gilts, and one month later it was 225bp over the Gilt. In addition the Gilt itself moved up 10-12bp. We wanted a coupon of 6.25%, but it was looking more like 7%.?

Because of this, Northumbrian Water and its lead managers Barclays Capital and HSBC decided not to launch a bond.

?With Glas coming, there was a lack of certainty in the market, and investors were looking for more covenants than what we were offering,? says Buchanan. ?We wanted to use the same documentation as our 1998 bond, which incorporated a negative pledge and a put option in case of a downgrade.? Investors, however, wanted coupon step-up language in case of downgrades ? an issue made more pertinent by Suez Lyonnaises' bid for Air Liquide, which could have affected its rating.

Investors have learnt from the recent poor performance in the sector, and with the expectation of a lot of future issuance from water companies, they can afford to be picky.

Wilson-Smith at Prudential M&G says: ?why should we commit for 25 years without protection, when the ratings history over the past few years has been negative??

When United Utilities issued debt earlier this year, it decided to opt for the euro market ? despite the fact that it is more expensive, and there is no long dated investor base. Paul Deehan, investor relations manager at United Utilities, says that, ?we issued in euros because it is a very deep and liquid market, similar in size to the US.? The issuer borrowed Eu1 billion of seven year paper at a rate of 6.625%. ABN Amro, UBS Warburg and Deutsche Bank were lead managers.

Although the euro market is certainly deep, the biggest advantage it has for UK water companies is really that investors are less experienced than their sterling counterparties, and so less likely to demand covenants.

Tim Butcher, an investment manager at Scottish Widows Investment Partnership, says that, ?the issue of covenants is a trade-off between what bondholders want and what companies are seeking to do. Companies will look for other options if they cannot issue bonds as they want ? and at the moment, the euro market seems to be an option.?

Glas ? a project template?
With Glas Cymru's deal coming out in May, and Anglian Water expected to announce a restructuring package in June, sterling investors have little interest at present in unstructured bonds. Stuart Buchanan at Northumbrian Water says that, ?I think the uncertainty in the sterling market will continue for the rest of this year.?

Glas Cymru has devised a unique capital structure, which has completely eliminated the need for equity. By derisking the business and outsourcing operations of the asset, Glas has been able to reach a much higher level of leverage than rating agencies would previously allow.

Glas is a non-profit making company limited by guarantee. It is buying Welsh Water from Western Power Generation, which bought the troubled utility Hyder last year after a competitive bidding battle with Nomura's principal finance group.

WPD bought Hyder for its electricity distribution business Swalec ? as soon as it won the bidding war, it set about trying to sell Welsh Water.

Because WPD was so keen to sell Welsh Water, it agreed a price with Glas Cymru that was 5% below the company's regulatory asset value, which is the company value that Ofwat sets and uses to calculate customer prices.

Glas Cymru's primary focus is keeping financing costs as low as possible. Because it has no shareholders ? just 50 Members who perform the housekeeping duties of shareholders but receive no dividends ? all savings pass through to the customer in the form of rebates.

The entity is limited to owning Welsh Water by the terms of its licence, its constitution, and bond covenants. In order to reduce risks yet further for lenders, it has outsourced all operations in two four year contracts. Glas announced at the end of March that United Utilities had won a contract to operate Welsh Water's assets, and Thames Water had won the customer billing contract.

As well as reducing risk, this model introduces an element of competition into what otherwise is a monopoly sector. Both contracts went through an EU procurement process with around 30 initial bidders.

Issuers cut costs with monolines
Both Glas and Sutton have used a monoline insurer to lower their costs of funding.

Sutton used FSA to give its £100 million bond issue a triple-A rating. Unusually, Sutton also announced that its shadow unwrapped rating would be single-A.

Charles Silberstein, head of project finance at FSA in London, says that, ?investors have two layers of security. They have the underlying rating of single-A minus, and on top of that they have the wrap.?

In the Glas Cymru deal, monoline insurer MBIA is being used to provide a triple-A wrap on £1 billion of debt. Lead managers Schroder Salomon Smith Barney and Royal Bank of Scotland compare the securitisation to last year's £1.48 billion Punch Taverns deal, where a triple-A wrap on a portion of the deal helped it sell successfully.

Monoline wraps have been used in the water sector for PFI deals in Scotland, but this is the first time that privatised water companies have used wraps. The precedent for wrapping PFI water deals was set in March 1999, when Thames Water used MBIA-Ambac to wrap its £79 million water concession financing in Stirling.

But Glas and Sutton are not really developments of the Scottish PFI template. The Sutton deal is in effect an enhanced corporate bond, and Glas Cymru is a whole business securitisation.

The Sutton and East Surrey did not require the approval of Ofwat because there was no change in ownership. There has been no radical change in structure, as the company still has shareholders. However the result of the deal is that Sutton is now geared to approximately 75% of its regulatory asset value.

Bondholders receive comfort in the following ways: credit enhancement, restrictions against diversifications, and protection against subordination.

But bondholders are still exposed to operational risk, because Sutton still operates the assets. In addition, the existence of shareholders mean that there is still regulatory risk, as there is still the likelihood of dividends being paid by the management.

But Glas' bonds, whilst still featuring a similar range of covenants as the Sutton deal, are derisked in other ways. Glas has restructured the company to align the interests of the management, regulator, customers and bondholders ? in order to reduce the risk in the business as much as possible.

Antony Flintoff, in the infrastructure ratings group at Standard & Poors, says that, ?in Glas, the derisking comes from the business side as well as the financial side. But the Sutton deal does not derisk so much on the business side.?

But Glas is a radical model, and it will not appeal to all water companies wishing to restructure their operations. Glas Cymru's deal has been in discussions for two years; Sutton took just three months to issue its bond.

For utilities just wishing to leverage up, rather than completely restructure their business, using the techniques employed in the Sutton model may be attractive. But bondholders lending to an equity-driven company will find that in five years time, at the time of the next regulatory review, they risk being hit again by harsh price cuts from Ofwat.

But Glas has done as much as possible to eliminate regulatory risk, and this will be a comfort for bondholders. Other water companies will now be working out how they can attract increasingly choosy investors.