Jan 7, 2002 12:00 PM,

DEBT TO EQUITY GIVES CLECs NEW LIFE

Vince Vittore

After the collapse of the CLEC market, players such as Covad, Focal and McLeod opted to broker financial restructuring deals. Though usually not the most lucrative solutions for bondholders, it's better than negotiating Chapter 11. And more significantly, a financial jump-start may help prove out the CLEC business model.

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Greg Card and fellow high-yield bond fund managers are suddenly hot commodities. During the Internet gold rush that saw competitive carriers' stocks jump to ridiculous heights, bond fund managers toiled in anonymity while their stock-side brethren basked in the spotlight, becoming quasi-celebrities.

Fast-forward to the nuclear winter that befell the CLECs, and the boring bond boys have become all the rage.

In the last quarter of 2000, McLeod-USA, Covad Communications, Focal Communications and XO Communications revamped their financial structures in part by exchanging existing debt for equity. In each case, that required convincing bondholders — and, more important, bond fund managers like Card — to accept as little as 19¢ on the dollar (see figure). In exchange, they received equity in companies that at some point had been declared dead by Wall Street.

Bondholders by and large are accepting the deals because the alternative — forcing the companies into Chapter 11 — doesn't guarantee any return. More significantly, many players that have been part of the deals see them as an opportunity for CLECs to finally prove that their business model works when it's not encumbered by massive debt loads.

“For the entire sector, this is a high water mark,” said Card, manager of Safeco's High-Yield Bond fund. “We're getting closer to the end game as it relates to these CLECs. We'll find out if it's a viable model or not.”

That may be putting the best face on an ugly situation, but it's also a positive sign for CLECs.

Faced with the piles of debt that are endemic to building a large telecom network, CLECs got caught in the capital crunch like no other sector of the market. Indeed, the aforementioned carriers now look as if they'll be among a select group of CLECs — those that survived.

“It is a restart,” said John Hesse, vice president and chief financial officer for privately held New Edge Networks, which had to scale back its once ambitious plans in the current environment. “You're essentially rebooting the company in a financial sense.”

In some cases, it's more than a restart; it's an opportunity to shed debt in a market with historically low interest rates. Covad, for instance, paid about $110 million in debt interest in 2000 and would have had barely enough cash to survive through the first quarter of this year had it not restructured.

Now Covad has virtually no debt. Getting there required a pre-packaged Chapter 11 in which bondholders agreed to swap $1.4 billion in high-yield and convertible debt for $257 million in accreted bond value plus $13 million in previously restricted cash and 15% ownership of the company. Given that many of the companies have threatened to file for bankruptcy in announcing their intentions to renegotiate debt terms, bondholders often have little choice but to come to the table.

“With the state of the CLEC industry, the bondholders have to be reluctant to go into bankruptcy,” said John Laprise, an analyst for New Paradigm Resources Group. “If they're lucky they might get in that [19¢ on the dollar] range. In certain respects, the bondholders are between a rock and a hard place.”

“It behooves everyone and the management team to keep this out of court,” added Aryeh Bourkoff, high-yield telecom analyst for UBS Warburg.

Debt holders, though, are becoming familiar with the choices. In October, Focal closed a deal in which its bondholders exchanged $280 million in debt for equity representing 35% of the company's outstanding shares. At the time, Focal was thought to be one of the select CLECs that would survive.

However, in unveiling the plan back in August, Chairman and CEO Robert Taylor admitted that the carrier was feeling the pressure of its mounting debts. “We attempted to grow our data business a bit too fast,” Taylor said at the time. “And we strayed from our slow, steady philosophy.”

The move may turn out to be the smartest yet for both lenders and CLECs, according to Hesse, who takes the view that the U.S. is now in a rare deflationary economy. “If you subscribe to that view, it means even though nominal interest rates are low, the real interest rates are still high by historical standards,” he said.

In a deflationary economy, which hasn't happened in the U.S. since the 1930s, dollars used to pay off debt are more expensive than the ones that are borrowed. “It's contrary to the American psyche of using debt to acquire assets,” Hesse said.

At the same time, companies such as Forstmann Little, SBC Communications and Madison Dearborn Partners — which are investing additional capital in the revamped CLECs — are getting significantly greater equity for the after-restructuring dollars.

“It's a hard time to be aggressive and have courage,” Hesse said.

All of which makes bond-holding fund managers key to the transactions. In some instances, those managers are happy to walk away with anything and make negotiation fairly fast; in other situations, the initial proposals are viewed as table stakes in a potentially long negotiation process. For the most recent company to propose debt for equity deal, McLeodUSA, the offer of 19¢ on the dollar was in line with other CLEC offers.

“It's a good first step and probably sets the floor for what is an acceptable settlement,” said Card, who manages a fund with $500,000 in McLeodUSA debt and about $3.5 million in debt from other CLECs.

Comparing the XO and McLeodUSA refinancings, which both involved Forstmann Little shoveling in additional capital, Card said they should set the tone for the near future. “These two offers as they're finally worked out are going to be the model for how we see a number of things restructured,” he said.

More important, the renegotiations will give CLECs a second shot, Card added. “We're all going to find out if the CLEC model is going to work.”