Competing for CAPITAL

Big buildout plans but short on cash? Here are several considerations in securing financing for your next big network investment

As improvements in technology have dramatically increased the speed and variety of telecommunications options, customers increasingly expect to receive their telecom services in an integrated bundle - from one provider, on one invoice and often at one price.

Providing high-speed bundled services means making large investments in fiber optic networks, wireless transmitters and receivers, switching and routing equipment and sophisticated billing, accounting and customer care systems. These investments require enormous amounts of capital, but the opportunity for profit is equally enormous for those telecom companies that can attract capital and execute business plans.

The creditor's perspective

Debt usually represents 60% or more of the capital structure of a telecom company, so it is important to understand how creditors analyze the risk of lending to this industry. Success in persuading a creditor to commit funds to a project is related directly to the quality and sufficiency of the service provider's management team, business plan and contributed equity.

The management team. When preparing a financing proposal for a bank or creditor, it is easy for a provider to become too focused on the financial forecast and forget about its most valuable asset: its management. Even the most impressive business plan is only a collection of neatly bound paper without the right people to breathe life into it. The company's strategic vision should be identified, and great effort should be made to educate the creditor about the experience and accomplishments of the key managers responsible for realizing that vision.

The business plan. A sound business plan flows from a conservative demand forecast. It is built on realistic assumptions and has been stress tested to identify weaknesses. The version delivered to the creditor should clearly identify the most powerful drivers or projection assumptions. The creditor often willinput the business plan into its own projection model first to validate the business plan and then to develop a loan structure that fits. Management should expect the creditor to rigorously challenge assumptions related to penetration, churn, pricing, costs and interest rates. The provider should be ready to support these assumptions with actual experience and industry data.

The contributed equity. Creditors routinely are asked to provide the lion's share of a company's capital, but they typically have no upside potential, significant downside potential, and little, if any, say in the management of the enterprise to which their funds are committed. The only tangible protection to the creditor is the collateral. The creditor also must have a large portfolio to absorb potential losses. Many types of business plans, especially new projects, may include several years of operating losses and even cash flow losses. If a creditor funds these losses, it quickly will find itself with insufficient collateral, facing unacceptable losses in the event of liquidation.

Thus it is important for the borrower to have sufficient equity contributions to cover projected losses. The creditor usually will expect the equity contribution to cover much of the company's working capital needs as well. Equity may be contributed in the form of common or preferred stock and sometimes subordinated debt.

A creditor generally only will consider preferred stock and subordinated debt to be acceptable forms of equity if dividend and interest payments are accrued, rather than paid in cash, until the senior debt is substantially repaid. The amount and type of equity contributions by the investors in a project vary based on the type of project and the associated risk, but it typically ranges from 25% to 50% of the capital structure.

Different plans, different risks

In the telecom industry, capital is committed for three general purposes. Each one has a different risk profile for both the creditor and the investor.

New projects. The largest capital needs involve new projects such as building an extensive fiber optic backbone or deploying a competitive local exchange carrier (CLEC) plan (Figure 1). These plans are characterized by huge capital expenditures and often two to three years of negative EBITDA (earnings before interest, taxes, depreciation and amortization). New project financing represents the highest risk to creditors but offers the highest potential return to investors. The negative EBITDA phase means creditors cannot use their standard approaches to evaluate risk such as traditional leverage ratios and debt service coverage ratios. Many lenders have overcome this problem by splitting a new project business plan into two distinct phases.

In phase I, which should last no longer than three years, the service provider will have little or no EBITDA rendering traditional measures of risk, such as debt-to-operating-cash-flow and debt-service-coverage ratios, meaningless. In phase I, availability under debt facilities and risk is measured and controlled through statistics that are not dependent on cash flow. These may include:

- Debt/contributed capital

- Debt/subscriber

- Debt/net plant or capital expenditures

- Minimum revenue targets

- Minimum percentage buildout targets

- Borrowing base formula

Phase II occurs when the company becomes substantially EBITDA-positive - in other words, when the provider earns some money. At this point, the company can be evaluated under more traditional leverage ratios and performance-based covenants, such as the debt-to-operating-cash-flow, debt-service-coverage and fixed-charge-coverage ratios. Risk assessment focuses on capital adequacy, management and business strategy during phase I, while in phase II, the provider will analyze projected compliance with quantitative measures of operating performance, leverage and repayment capacity.

The debt for a new project often is provided in the form of a revolving loan and one or more term tranche loans or segments. The loans for a new project are structured to match the project's cash flows. An interest-only period is provided to accommodate the negative EBITDA period of phase I. In phase II, the project's cash flows generally ramp up sharply, and the term loans can be repaid quickly, resulting in terms that rarely exceed 10 years. A typical loan package for a new project might look like this:

- The package would include a revolver and one or more term tranches

- The revolver would carry a tenor of six to eight years

- The term tranche tenors would range from seven to 10 years

- The borrower would pay interest only during phase I - up to three years

- Covenants would vary for the two phases of the loan package

- Availability of funds would be controlled via a borrowing base calculation

Because new projects are risky, creditors often require credit supports in the form of parent company guarantees, equipment vendor guarantees or subordinated debt. Subordinated debt usually is issued at the holding company level and down-streamed to the operating company. Subordinated debt may represent up to 30% of the debt capital of the new project and significantly reduces the leverage to senior creditors. In addition, a new project business plan requires high levels of equity capitalization, often in excess of 40% of the total capitalization. The management team for a new project must have prior successful experience with start-ups and have excellent engineering and marketing talent on board.

Acquisitions. Acquisitions may involve the purchase of existing telephone exchanges, such as when an RBOC sells off some of its markets (Figure 2). Alternatively, a CLEC may wish to acquire a wireless company or an ISP to broaden its portfolio of services. Acquired companies usually are EBITDA-positive and require only moderate capital expenditures associated with upgrading and integrating existing facilities. Leverage initially may be high due to the acquisition-related debt and gradually will decline as the combined company grows. Acquisitions typically represent a moderate level of risk to creditors.

The average tenor of acquisition-related debt usually is longer than new projects. The combined company normally is EBITDA-positive from the outset, and the cash flows typically do not show the aggressive growth curve of a new project. A loan package for an acquisition might look like this:

- The package would include a revolver and acquisition-related term debt

- The revolver tenor would range from eight to 10 years

- The acquisition loan tenor would range up to 15 years

- The borrower would pay interest only for some periods if large upgrades are needed

Because the combined company often is EBITDA-positive at the outset, guarantees generally are not required for strong companies. Subordinated debt may still be used to reduce the high initial leverage to senior creditors.

The equity component of the capitalization of an acquisition-related business plan typically is lower than a new project and is highly dependent on the nature of the acquisition. For instance, a simple purchase of an RBOC divestiture might qualify for 100% financing, while the acquisition of a fledgling CLEC might require an equity component as high as a new project. Much of the value of an acquisition is derived from cost savings obtained from the consolidation of back-office operations and operational and marketing synergies. The management team should be rich in financial and operations management. Prior experience with integrating companies is highly beneficial.

Modernization. Modernizing the physical plant of an existing telecom company involves only modest capital expenditures associated with upgrades to specific facilities (Figure 3). For example, an LEC may wish to upgrade its plant to deploy DSL service to its business customers. Modernization plans always are EBITDA-positive. Leverage is low initially, then rises to moderate levels as funds are drawn under the debt facilities as the improvements are completed.

The added cash flow derived from a modernization normally is far less than a new project or an acquisition, and the risk to the creditor also is much less, which leads to longer average loan tenors. A loan package for a modernization might include the following:

- The package would include a revolver, term revolver or just a straight term loan

- The tenor would match the life of the improvements - usually no more than 12 years

- The borrower would pay interest for only certain periods only if large upgrades are done all at once

Credit supports in the form of guarantees rarely are required, provided the collateral coverage is strong. Likewise, subordinated debt is not needed because the much lower capital requirements of a modernization plan gives senior creditors a comfortable leverage ratio. Often, no additional equity contributions are required for a modernization. Existing, competent management is sufficient but should be strong in engineering because modernization plans usually have a technical focus.

How creditors value collateral

Telecom equipment is costly and difficult to repossess. The individual pieces of equipment often have little value once uncoupled from the network. Soft costs, such as engineering and software, often represent a major component of total costs. Intangibles, such as goodwill associated with acquisitions, have no value on a stand-alone basis.

To deal with these issues, creditors focus on the enterprise value of a company when valuing its collateral. The enterprise value is the fair market value of the company as a going concern. A creditor can assesses enterprise value in several ways:

- Discounted cash flow analysis

- EBITDA multiples

- Revenue multiples

- Access line or subscriber values

The most commonly used technique is discounted cash-flow analysis. In discounted cash-flow analysis, the creditor calculates the value today of a stream of cash flows that could be derived from the ongoing operation of the company during some specific holding period, usually seven to 10 years. This stream of cash flows also includes a terminal value at the end of the holding period, which represents the creditor's estimate of the fair market value of the company, if it was sold at the end of the holding period.

The projected cash flows and the terminal value are discounted to arrive at a present value, based upon the creditor's estimate of the rate of return that investors and creditors will demand over the holding period. The combined present value of the terminal value and the projected cash flows is the enterprise value of the company. The enterprise value then is compared with the outstanding debt to assess collateral sufficiency. Therefore, discounted cash flow analysis relies on good financial projections. This is one reason why competent forecasting ability is highly regarded in a solid management team.

Competing for capital is a dynamic process. It does not end when the loan is closed. Advances in technology, shifting demand patterns and deregulation provide new opportunities for service providers every day. Maintaining close relationships with major creditors is fundamental to ensuring continued access to the capital needed to exploit these new opportunities. Understanding the perspective of the creditor is the first step toward forging such mutually beneficial relationships. The companies that become experts at understanding how their creditors think and anticipating how their creditors will react to various proposals will be in the best position to attract and keep capital in today's information era.