MARKETWATCH Deal Analysis

High-yield funding for telecom markets Telecommunications analyst Pam Friedman of Dresdner Kleinwort Benson explains why telecom companies like Energis plc are issuing high-yield bonds.

K based Energis Plc, an alterna- What are high-yield FIGURE 1 tive telecommunications compa- bonds? Uny, is one of a long list of UK and High-yield bonds are European companies that have raised bonds rated as ‘below long-term funding in the high-yield investment grade’ – bonds market. rated below BBB or Baa3 Telecom sector dynamics have driven by Standard & Poor’s and many telecommunications operators Moody’s Investor Services, like Energis to the high-yield bond mar- respectively. These bonds ket. The structure of the bonds provides offer long-term, bullet telecom companies with long-term maturities and flexible funding that involves fewer restrictions structures. than other types of financing. Emerging telecommunication Why use high-yield companies represent over 70% of the bonds? e 35bn European high-yield market. Energis used high-yield in (see Figure 1). Other rapidly expanding order to achieve two high-yield issuers in the sector include important objectives. First, COLT, Global Telesystems, Jazztel, Tele1 long-term flexibility as it Europe, and KPNQwest. moves into new markets on the continent, and sec- The need for funding ond, maintenance of its target debt to the development of the company's oper- The need for long-term, flexible funding equity ratio. ations on the continent (including the from the high-yield market is clear. Last autumn, for example, Energis development of EnerTel), and to further Emerging operators face long lead used the proceeds of a bridge loan to its network in the UK. times for costly network construction. acquire EnerTel, a telecommunications Energis could have continued to bor- More established alternative players like network backbone operator located in row under its £500m senior loan facili- Energis require financing for the contin- the Netherlands. The company repaid ty but chose instead to raise funds in the ued development of their business, both the majority of the bridge via an equity high-yield bond market. High-yield organically and through acquisitions. offering shortly thereafter. The high- bonds offered long term funding and The telecom market environment is itself yield offering took place two months fewer constraints. This financial flexibili- relatively unpredictable, shaped by con- later. Proceeds were used in part to ty is required given the highly dynamic stantly changing technologies and regu- repay the small amount remaining out- nature of the sector and the company’s lations. Recent merger and acquisition standing under the bridge loan, to fund development plan. Flexibility is fur- activity means there will be a rapidly thered by keeping the loan available for changing competitive landscape. But future opportunities. there is no doubt that these new telecom companies have long-term merit. The High-yield bonds How are high-yield bonds exploding demand for the internet and offer longer term structured to be more flexible? other advanced, bandwidth-hungry High-yield bonds are routinely struc- services is expected to drive future rev- funding and fewer tured as long-term bullets with principal enues and profitability. covenants. This paid at the end of the term. Typically High-yield investors have been willing high-yield bonds have a ten-year matu- to provide the long-term liquidity these flexibility is required rity but can be structured for less. Call companies need. The Energis transaction given the highly features permit the company (issuer) to was increased from an initial £200m to refinance halfway through the bonds’s £300m due to overwhelming interest in dynamic nature of life at par plus half the coupon. In con- alternative telecommunications and ris- the sector trast, senior lenders favour amortisation ing demand for high-yield bonds. (repayment) over the last few years of

14 The Treasurer – April 2000 MARKETWATCH Deal Analysis

the loan. Most loans can be voluntarily Europe. Given Energis’ track record, the repaid without call premiums. There is no doubt agencies were increasingly confident High-yield covenants are more flexi- that management could take the UK ble when compared to bank debt. They that these new business model into Europe and that are generally limited to ‘incurrence’ telecoms have long- they would continue to manage funding covenants, principally tested when the and growth to improve risk. The higher company wants to incur additional term merit. The credit rating increased the pool of indebtedness or sell assets. Senior loan exploding demand for potential investors and was a factor in facilities from banks require ‘mainte- boosting demand for the issue. nance’ covenants – covenants that are the internet and tested monthly, quarterly or semi-annu- other advanced, Who are high-yield bond investors ally. Maintenance covenants require and what are they looking for? financial predictability, a condition that bandwidth-hungry Investors in the European high-yield few emerging telecommunications services is expected market include commercial banks, companies can meet. The security pack- insurance and pension funds, and retail ages required by bank lending to drive future funds. Simply put, investors are looking covenants further hampers the ability of revenues for additional yield. Equity investors may companies to grow opportunistically in buy high-yield bonds to participate in the this dynamic market environment. This growth of these companies while taking restrictiveness does matter – missing a two primary rating agencies (Moody’s less risk than buyng equity – especially as covenant sends a bank facility into tech- and Standard and Poor’s). Once a com- share prices continue to rise. nical default and impacts the company's pany issues public debt and is rated by Like equity investors, high-yield bond future ability to raise funds, equity or the agencies, the percentage of total investors in telecommunications buy debt, in the capital markets. debt borrowed under bank credit facili- ‘the story’ and rely on the expertise of The trade-off for flexibility is cost (see ties must be managed. management and sponsors to drive the Figure 2). Like other emerging telecom Secured senior lenders routinely business forward. For Energis, investors companies, Energis has been willing to obtain what is called ‘structural subordi- believe that management will be able pay the higher spread on its bonds nation’ of the high-yield relative to the to take the expertise it developed in pro- today for the long-term liquidity needed loan (see Figure 3). This provides com- viding telecommunications services in to address its markets. The coupon for fort that the banks will be first in line for the UK to successfully launch services on the recently issued £300m bonds was repayment if there is a default or liqui- the Continent. 1 9 ⁄8%. dation. High-yield bond investors have Energis is further along the line in its been willing to accept this condition so How do investors measure relative development than other high-yield long as the company maintains a pru- value and credit improvement? bond issuers in the telecom sector and dent level of borrowing under its bank Market capitalisation is one measure its UK operations generate sufficient loan. If borrowing goes beyond a investors may use to assess relative cash to cover interest payments. In con- desired level (relative to business risk) value. Energis’ market capitalisation at trast, most emerging telcos are only at investors will view such borrowing as the time of the offering on 7 February the start up phase. High-yield investors ‘cramming down’ their interests. this year was over £11bn. have been willing to fund these early Investors are liable to then sell their Pro forma net debt represented less stage companies, but in the absence of bonds, causing bond prices to than 4% of the company’s total strong support from established telcos, fall (and spread to widen). This the cost is high. in turn will impact both the For example, last February Jazztel companies ability to issue FIGURE 2 issued $200m of bonds with a coupon bonds, and the cost of issuing Greater flexibility of 14% and warrants for 10% of the them in the future. company. Jazztel's equity funding at the Energis has been committed time was a mere $70m. As an early to improving its credit quality. stage company, Jazztel was not expect- The company maintains an ed to generate cash sufficient to cover appropriate balance between its interest payments for three years. To bond and bank borrowing in provide assurance to investors, Jazztel addition to an appropriate put $72m of the $200m of proceeds in balance between equity and escrow to cover the first six semi-annual debt. At the time of the most interest payments. Atlantic Telecom, recent offering, its overall Tele1 Europe and Carrier1 have also Higher financial and business risk had Senior High Convertible Public cost used this structure to attract investors. improved sufficiently to war- credit yield bonds equity facilities bonds Anti rant a Standard & Poor’s rat- Dilutive How will a credit rating impact ing upgrade from single B to dilutive Disclosure future financing decisions? Public single B+, despite the limited to disclosure The public debt markets routinely increased business risk of investors demand that issuers are rated by the moving into continental

The Treasurer – April 2000 15 MARKETWATCH Deal Analysis

FIGURE 3 Structural subordination

New high yield bond £300m Equity placement £303m Existing high yield debt £250m Energis plc

Energis Business Energis Broker-to- EnerTel Carrier Online AG Holdings Bank facility £500m Broker Services (74.9%) Limited Networks Inc (11%)

GEO Worldpay/ Energis MetroHoldings Nevada Planet Online Datarange Interactive Media Freeserve plc Supernet Communications Limited (50% tele.com Ltd. Limited Limited Group (1.75%) Group Limited joint venture) (50% joint venture) (5.3%) (16.6%) Corporate structure at time of bond offering.

enterprise value (market capitalisation Who should use the high-yield tradable. To assess whether high-yield plus gross debt, less cash not held in market? bonds should be part of funding, poten- escrow for interest payment or Because of their long-term structure, tial issuers need to plan for the degree otherwise), meaning that bond investors high-yield bonds are most attractive of leverage, financial flexibility and had a 96% equity cushion to rely on. where recurring revenues and cash credit rating desired at every stage of Given the magnitude of the company’s flows are present – or anticipated, as is development. market capitalisation, even if the share the case for emerging telcos. High-yield price were halved investors would still funding tends to fail where revenues are Pam Friedman is a high-yield have a 93% cushion. deemed to be variable or may weaken telecommunications analyst at Dresdner To measure credit improvement, over the longer term. Size is also impor- Kleinwort Benson. She covers the high-yield bond investors monitor an tant. $100m is the minimum amount for European telecommunications and issuer’s coverage ratios over time – such investors to view the bond as liquid and media sector high-yield team in London. as the degree that earnings before interest, taxes, depreciation, and FIGURE 4 Recent high-yield telecoms funding amortisation (EBITDA) covers interest expense. However most As on 23 March 2000 Coupon Maturity Rating Size(m) Launch YTW emerging telecommunications companies have negative EBITDA, Energis 9.5% 6/15/2009 B1/B+ £125 Jun-99 9.2% and coverage is meaningless. 9.8% 6/15/2009 B1/B+ $200 Jun-99 9.4% Instead, high-yield telecom 9.1% 3/15/2010 B1/B+ £300 Feb-00 9.1% investors use relative liquidity. Investors feel that liquidity miti- Colt Telecom 7.6% 12/15/2009 B1/B 1 320 Dec-99 8.4% gates default risk. Well funded 7.6% 7/31/2008 B1/B DM600 July-98 8.5% business plans have lower default probability and higher relative Global Telesystems 10.5% 12/1/2006 B3/B 1 225 Nov-99 11.6% value because they are better pre- Europe BV 11.0% 12/1/2009 B3/B 1 275 Nov-99 12.0% pared to cope with changing busi- ness and market conditions. Jazztel 13.25% 12/15/2009 Caa1/CCC+ 1 400 Dec-99 12.9% 14.0% 4/1/2009 Caa1/CCC+ $100 Apr-99 13.3% Unlike other telecom issuers, Energis has EBITDA that can cover KPNQwest 7.1% 6/1/2009 Ba1/BB 1 340 May-99 7.5% its interest. How much coverage 8.1% 6/1/2009 Ba1/BB $450 May-99 8.0% improves, and when, depends on the progress of its new ventures Tele1 Europe 11.9% 12/1/2009 B3/B- 1 150 Dec-99 11.4% and its ability to address sector dynamics. These uncertainties Viatel INC 11.2% 4/15/2008 B3/B- DEM 178 Apr-98 12.0% drove the need for long termfund- 11.5% 3/15/2009 B3/B- 1 150 Mar-99 12.0% ing without many restrictive 11.5% 3/15/2009 B3/B- $200 Mar-99 12.8% covenants and thus a desire to use Source: Dresdner Kleinwort Benson the high-yield bond market.

16 The Treasurer – April 2000