July 23 (Bloomberg) -- Hypo Real Estate Holding AG agreed to buy Depfa Bank Plc for 5.7 billion euros ($7.9 billion) to challenge Dexia SA as Europe's biggest lender for public-sector and infrastructure projects.

Shares of Hypo Real Estate fell the most in more than three years after the Munich-based company said it will issue 67 million new shares and sell convertible bonds to help pay for the purchase. Depfa shares surged the most in five years.

Hypo Real Estate, spun off by UniCredit SpA's HVB Group in 2003, has rebounded along with a recovery in the German economy. Buying Depfa will bring it a more stable stream of revenue by adding business such as public financing and infrastructure financing for roads and railroads which is less prone to economic swings. Depfa, based in Dublin, is Europe's second-biggest provider of financing to governments after Dexia SA.

``The combined company will have a less cyclical business and can be more profitable,'' said Helmut Hipper, who helps oversee more than $138 billion at Union Investment in Frankfurt and owns shares from both companies.

Hypo Real Estate will pay 6.80 euros in cash and 0.189 of a new share for each Depfa share. It also sold 450 million euros in convertible bonds today to help finance the offer. The offer values Depfa at 16.14 euros a share, 17 percent more than the July 20 closing price.

Narrowing the Gap

Hypo Real Estate's shares declined 3.06 euros, or 6.2 percent, to 46.11 euros. The company has a market value of 6.18 billion euros, which has more than tripled since the spinoff from its former parent in 2003. Depfa's stock rose 1.66 euros, or 12 percent, to 15.46 euros.

The combined company will have about 254 billion euros in public-sector and infrastructure finance assets, coming close to the 271 billion euros that Dexia held at the end of the first quarter.

Hypo Real Estate Chief Executive Officer Georg Funke said he won't enter a bidding contest should another bidder emerge. Shares of Depfa rose as much as 6.4 percent on July 9 on speculation of a bid from Dexia.

Dexia spokeswoman Ulrike Pommee declined to comment today when asked whether the company may bid for Depfa. Eurohypo AG, a unit of Commerzbank AG and Germany's No. 1 commercial-property lender, is not considering a bid, spokeswoman Gisela Brandhoff said in a telephone interview.

``We don't see a high likelihood of a second bidder,'' Derek De Vries and Manus Costello, London-based analysts at Merrill Lynch & Co., wrote in a note to investors. ``Depfa's cost-income ratio of about 30 percent makes it difficult for a bidder to achieve significant cost synergies.''

Trains and Railways

Depfa's shares have increased about 10 percent in the past 18 months, about half the gain in Dexia shares, after the bank pulled two major projects it thought would help it expand. The bank in April 2005 abandoned the sale of its German unit, Deutsche Pfandbriefbank AG. In November of the same year, it also shelved plans to start a financial guarantee business in Europe and the U.S.

Depfa was created when Depfa Deutsche Pfandbriefbank AG split in June 2002. The other half, Aareal Bank AG, comprises the former company's real-estate business. Depfa in March acquired First Albany's municipal-bond business, gaining a foothold in the U.S., where the New York-based company has 70 bankers and traders in nine offices.

Depfa funds projects such as Portuguese high-speed trains, light railways in China and toll roads in the U.S. Depfa moved its headquarters to Dublin in 2002 to take advantage of lower taxes in Ireland. The bank is the No. 1 seller of Irish covered bonds and sells German covered bonds, or public Pfandbriefe.

New York, London, Tokyo

Hypo Real Estate has been increasing property lending outside of its home market, where rising competition has lowered profit margins, and expanding outside of real estate. The bank is Germany's No. 2 commercial property lender after Eurohypo AG, a unit of Commerzbank AG, and helped provide financing for landmark buildings including the original New York Times building in New York, the Lloyd's Building in London and the Ebisu Prime Square in central Tokyo.

The acquisition will add about 40 million euros to pretax profit the first year after the transaction is completed and contribute to earnings per share starting in 2008, Funke said. The purchase is expected to be completed by early October.

Hypo Real Estate expects integration costs of 160 million euros, of which 100 million euros are expected to be booked this year, Chief Financial Officer Markus Fell said.

The lender reiterated a target to raise return on equity after taxes, a measure of profitability, to at least 13 percent in 2009 and said it expects more than 15 percent in 2010.

Dividend Plans

The lender's dividend payment for 2007 will remain at the 2006 level, when it paid 1.50 euros a share. It aims to return to a policy of paying out 40 percent to 50 percent of profit as a dividend by 2010.

``This transaction leads to strong diversification of our business activities and geographic reach and lowers the potential for earnings volatility compared to a stand-alone basis,'' Hypo Real Estate's Funke, 52, said on a conference call. The combined company will be able to offer financing with higher margins, he added.

At least 75 percent of Depfa shareholders will have to approve Hypo Real Estate's offer at an extraordinary shareholders meeting that is planned for September. According to Irish law, Hypo Real Estate will be able to buy 100 percent of the shares should it get such an approval, it said.

Morgan Stanley advised Hypo Real Estate and Goldman Sachs Group Inc. worked with Depfa on the transaction.

Second-Quarter Earnings

In a separate statement, Hypo Real Estate said second-quarter net income, excluding the effect of capitalized losses carried forward, rose 30 percent to 137 million euros while net interest income rose 13 percent to 224 million euros. Earlier this month, the bank raised its full-year target for pretax profit to more than 710 million euros from a previous forecast of at least 680 million euros.

Depfa's second-quarter net income declined 10 percent to 126 million euros from 140 million euros, the bank said in a separate release. Net interest income fell 8 percent to 101 million euros in the period.

Hypo Real Estate CEO Funke will remain head of the management board of the combined company and Depfa CEO Gerhard Bruckermann will become vice chairman of the combined group's supervisory board. Matthias Mosler, currently deputy CEO of Depfa, ``will pursue other interests,'' Hypo Real Estate said.

Hypo Real Estate will also search for a new name to ``better represent'' the broader business, Funke said.

Fitch Ratings placed Hypo Real Estate on ``Rating Watch Positive'' following the lender's bid for Depfa, indicating a possible rating upgrade. Moody's Investors Service affirmed its ``stable'' outlook on both companies' credit ratings. Standard & Poor's Ratings Services placed Hypo Real Estate on ``CreditWatch with positive implications,'' signaling the ratings may be raised.

Depfa's long- and short-term counterparty ratings were lowered one step to A+/A-1 by S&P, citing weaker-than-expected second-quarter results as well as the impact of the merger. The outlook for Depfa is stable. The lender had been on a negative outlook since Nov. 22, 2006.

Credit ratings are important to both Depfa and Hypo Real Estate because any rating change has an effect on refinancing costs and profit margins.

Bruckermann owns about 8 million shares in Depfa, while former deputy CEO Thomas Kolbeck controls another 2.7 million shares, according to the bank's 2006 annual report.

To contact the reporters on this story: Oliver Suess in Munich at osuess@bloomberg.net; Aaron Kirchfeld in Frankfurt at akirchfeld@bloomberg.net

Last Updated: July 23, 2007 13:20 EDT