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Financing the Telecom Industry:

Significant Hurdles for Emerging Markets

By Jeanne Castro Schmidt

At the Loan Pricing Corporation/Gold Sheet’s 6^th Annual Corporate Finance Conference the near term outlook was pessimistic for continued, aggressive financing of emerging telecom companies. Interest rate increases, increasing default rates in the high yield bond and highly leveraged loan marketplace, overconcentration of telecom paper in bank and institutional portfolios, and a flight to quality were credited with causing the decline in availability of telecom financing from the aggressive levels experienced in 1998 and 1999.

According to Meredith Coffey, Vice President and Director of Analytics at Loan Pricing Corporation in New York, the high yield bond market has been in decline since Q3 of 1998. All industry sectors have been affected by this decline, but it has hit the telecom sector the hardest since the biggest demand for funds has been coming from that segment. Rising interest rates, credit quality concerns, and increasing default rates took their toll on issuances this year. Institutional investors offering highly leveraged loan transactions (HLTs) have picked up some of the slack. Their vehicle of choice - mezzanine financing with IRR’s of 22 – 25%.

One reason for the decline in investor appetite for high yield transactions is the perception of deteriorating credit quality. Moody’s U.S. Speculative Grade Default Rates are currently at 6% -- the highest level since 1992, when rates topped 12%. They are more than 2 times the rates experienced in 1998 and 1999. Coffey also cited another indicator of deteriorating credit quality in the high yield market -- Moody’s downgrade to upgrade ratio, with downgrades outpacing upgrades since the start of this year.

Default fears become increasingly important when portfolios are heavily concentrated, as is currently the case among the telecom financiers. High yield telecom activity is at record levels, says Nancy Rochford, Managing Director of Credit Suisse First Boston. loan volume rose from approximately $6.5 billion in 1997 to $29 billion in 1999, and levels in the first half of FY 00 reached nearly $24 billion. According to Loan Pricing Corporation, telecom deals accounted for 13% of all new leveraged issuances in FY 00. Institutional investors were a major source of incremental liquidity supporting the growth in telecom lending, and they have absorbed almost $22 billion in new issuances over the past two years.

Investors in 1998 and 1999 were drawn to the telecom market by attractive yields, strong growth potential, and ready sources of equity capital which balanced the lenders’ risk. As FY 00 rolls into the fourth quarter, many institutional investors are now at portfolio capacity, and skiddish equity markets have cut off funds for IPO and secondary offerings, increasing the risk to lenders even further. As a result, there has been a flight to quality, with top tier companies still having access to capital markets, but middle tier and emerging companies getting squeezed out.

For those who get deals done, higher spreads, higher fees, and tighter terms and conditions are standard. Coffey notes that average spreads over LIBOR on B-rated telecom borrowings jumped dramatically from an average of 250 bps from 1993 to 1998, to the 320 bps range in 1999, and 350 bps now. In fact, over 25% of the B-rated telecom debt issued in Q3 00 has exceeded LIBOR plus 400. Furthermore, companies with larger transactions are paying a premium over similar rated companies with smaller transactions, due to the difficulty in syndicating to funding sources whose plates are already full. Flex pricing language – which allows the underwriter to adjust pricing to market conditions upon syndication - is now a common requirement for all telecom deals. According to Loan Pricing Corporation, nearly $22 billion dollars in FY 00 high yield transactions had upward movement in pricing under market flex clauses, and most of those were telecom deals.

Emerging CLECs and ISPs with implied C and D credit ratings, are in a particularly tough position. Execution of their plans call for large amounts of capital from both equity and debt sources. With equity offerings postponed and venture capital sources looking for higher-than-ever returns, roll out strategies have suffered, pushing cashflow- positive dates back significantly. The gap between the needs of lenders and the desires of borrowers has widened to unprecedented levels. Analysts are now generally predicting that planned telecom capital expenditures will need to be cut back. Wall Street is reacting predictably, driving down the stock prices of equipment manufacturers in recent days.

Should vendors step in to fill the financing gap? This idea is causing even more concern among analysts. Most companies seeking vendor support are looking to the manufacturers as lender of last resort. Given the lack of capacity in the marketplace, vendors may have to hold lower quality paper for a lot longer than planned, or provide significant levels of recourse, delaying the recognition of revenue and risking the wrath of wall street at a time when their own stocks are heavily scrutinized. Customers with a strong strategic benefit to a vendor, and those with a well thought out business plan, strong management team with a successful track record, and good venture capitalist support are the most likely to have access to the vendor financing marketplace. As for the others, Tae Kim, Vice President of Business Development at Allegiance Telecom comments “a lot of the “have not’s” are for sale – that fact is well known in the industry. There’s been no white knight coming in and rescuing them. Watching all the train wrecks happen will be painful in the short run, but in the long run I think it will be very healthy for the industry.” Healthy or not, it should be anticipated.