The former Pop Idol judge confessed that before he met the Australian star he was adamant he would not work with him.
"We were making a lot of money and records with Kylie, love Kylie and always have done from the first moment we met, I loved what we did," Waterman told Smooth Radio.
"The thought of signing Jason Donovan horrified me, to the point where it could not be mentioned within PWL. This was a 'no no' - everyone don't mention to Pete Jason Donovan, he'll rip your head off. It was an absolute 'no no'.
"I went to Australia and the Australians had promised me if I made Kylie number one they would give me the holiday of a lifetime and their present to me was a trip round the barrier reef on a private yacht for three weeks.
"We went to a place called the Hayman Islands and Kylie popped up and wanted to take us for a Chinese!
"She turned up with this young guy, charmed the pants of me, who was one of the nicest men I have ever met, charming bloke, great fun, he was an absolute heartthrob, and I went, 'How can anyone not make this guy into a star?'"
He added: "He was and still is one of the nicest blokes. I had that moment when I suddenly realised that Jason could be a pop star, different from Kylie.
"I just said to Mike we need to write a particular song and we sat down and the song we came up with was 'Too Many Broken Hearts'."
Pete Waterman will showcase all of his PWL acts - including Donovan, Minogue, Steps, Sinitta and Dead or Alive - at his Hit Factory Live concert at London's Hyde Park on July 11.
The full interview with Pete Waterman will be broadcast on Smooth Radio on Sunday, June 24 at 2pm.
Watch the music video for Jason Donovan's 'Too Many Broken Hearts' below: