?Fallen angel,? is an apt description of many of the competitive local-exchange carriers (CLECs) at present. Like cable companies, CLECs grew across Europe in the late 1990s on the back of an enthusiastic high yield bond market. The Telecommunications Act (1996), in line with de-regulation, decreed that incumbent local-exchange carriers (ILECs) open their infrastructure to competition. CLECs set to work, using fibre optics to cash in on profitable city-to-city and business-to-business traffic.

But the bubble has burst. Global economic slowdown and a realisation that demand estimates were highly optimistic have exacerbated a waning investor confidence in TMT. Companies such as Jazztel and Completel, that were living the high life in 2000, are now living on the bread line. In a sharp about turn, high yield and equity markets have virtually closed to alternative telcos. Bond values have crashed, their ratings subjected to a barrage of downgradings. A key industry banker was keen to point out that bank lending has been active over the last year, particularly in the 3G and cable sector. But caution and conservatism are the rule and few CLECs qualify.

Norwegian CLEC Enitel went into administration in September 2001, sending negative reverberations through much of the market. Many others are now clearly distressed, defined as when debt is trading at 80% of its value or less.

Spanish Jazztel, which successfully completed a JP Morgan, Barclays, Lehmans' and Dresdner-led bank financing in 2001 and is widely regarded as one of the stronger CLECs, was recently placed on negative credit watch by Standard and Poor's. The move was based on a revision of revenue and EBITDA projections.

?Consequently, there is increasing concern about Jazztel's ability to grow into its capital structure and, as a result, the chances of a balance sheet restructuring are now perceived to be significantly greater than in the past,? argues Peter Kernan in the analysis.

Restructuring is on the cards for many CLECs and cable companies, which have large debts and a faltering customer base. It will dominate activity on the telecoms landscape in the first half of 2002. Some have already announced plans, keen to quell the investor panic blamed for Enitel's downfall. Dutch-based Versatel and Polish Netia launched offers in the last quarter of 2001 to buy bonds back at a discount. Both had them refused under the initial terms.

Many industry players predict a settled but very quiet landscape for alternative telecoms in the second half of 2002. One analyst highlights a different point of view. ?The real question is whether CLECs are viable businesses, even after restructuring. They are high capex ventures that blossomed on the back of over-hyped and unviable projections of usage.?

What went wrong?

Exaggerated usage estimates were certainly not confined to CLECs. All TMT companies have had their fingers burnt. There is simply too much telecoms capacity supply, which has been worsened by the wider economic slow down causing demand to shrink to further. But it is the CLECs, cable companies and other small start-ups that are least equipped to deal with it. They have no solid asset or customer base and are highly leveraged on a mountain of high yield bonds.

?UMTS auctions were undoubtedly a turning point for telcos,? says Laura Cumming, vice president, JP Morgan. ?The amount of debt required to finance the licences changed the leverage profile of the encumbent.? Worries about the potential cost versus success of UMTS compounded concern. Such a situation sends investors and lenders running for safe havens. Start-ups lose out.

The fall from grace of a number of high profile incumbents has been well publicised. Saddled with debt from UMTS auctions and faced with a considerable competition base, these giants have also seen shares plummet and markets recoil. Companies right across the telecoms spectrum are restructuring but it is well-established ones that have the most to build on. For instance, as long as the fixed line is significant for UK telecommunications, BT's network is crucial. Almost all calls interconnect through it and even if the company defaulted on a debt, it is very unlikely the network would be shut down. Such assets provide comfort for lenders and investors, open opportunities for leasing and encourage vendor support. (see box)

With no such benefits to lever from, CLECs and cable companies need to find more immediate ways to reduce their debt burdens. ?Not one of these companies is fully funded,? states a London based high yield analyst. ?These companies are in distress.?

A number of CLECs have bank debt tranches in place, but these are not the problem. The typical model was first used in Jazztel's original 1999 financing. The Chase-led package combined high yield bonds and senior secured debt. ?Banks were prepared to come on the terms set out for senior secured debt,? says Laura Cumming, ?because draw down was so performance based.? Consequently, the majority of funds pledged by banks to alternative telcos has not been drawn down. It is the bonds and their powerful holders that are the problem. The pile must be reduced if funding gaps are to close.

A way out?

Completel, like Jazztel, took advantage of low trading prices in the final quarter of 2001 to purchase bonds back on the open market. Although boosting confidence temporarily, the move did not reduce debt significantly.

Completel has considerably scaled back its business plan. Along with a number of other CLECs, they were stung in Germany where Deutsche Telecom expanded too quickly to allow competitors to flourish. In the UK, operations never really got off the ground because their hosting partner pulled out. Their focus is now limited to France, where they have a foot in the door. Completel expanded rapidly in its domestic environment, becoming the first real competitor to France Telecom. But to put this in context, Completel sales are only equivalent to about 1% of the incumbent.

?Looking at overall cash requirement to fund the revised business plan, including the amount needed to service debt, the extent of Completel's funding gap will depend on the ability to curtail capex or seek some form of balance sheet reorganisation?, outlines Michael West, senior credit officer, European corporate finance, Moody's. But the company has not actually announced how it proposes to address this yet.

They have stated that all options are being considered. One possible route is attempting to syndicate a corporate loan in the bank markets. This may bridge a funding gap, but debt would still be extremely high. Moreover, bank appetite may not be sufficient.

If such a facility is not put in place, Completel may have to follow in the steps of a number of other CLECs in opting to go into distressed exchange. According to this the company puts in an offer to purchase back bonds with cash, equity or a mixture of the two. In October, Versatel announced an exchange offer for six issues of high yield and convertible bonds. It claimed this would enable continued funding from revenue streams and existing balances alone. ?We saw Versatel's proposition as attractive because it has the cash to buy back the bonds it was asking for,? says an analyst. ?The potential for Versatel to survive is undoubtedly there, but it is not a definite. Whether it can attract new customers is the issue.?

Versatel's offer, although not made formal, was refused. Carrier 1, Grapes Communication and Netia all issued formal offers to a frosty reception. At the beginning of December, Netia stated that its offer to buy back up to 85% of its Eu850 million bonds had not been accepted. Bondholders are holding out for better terms, which given lack of cash flow is likely to include a significant portion of equity.

?Equity shareholders are not happy about diluting the company through a debt to equity swap,? admits a Completel spokesperson, ?But it may be the only option.? It would at least give them a stake in a company with a chance of survival.

Grapes is considering more drastic action. Under a pre-packaged organisation, linked to a bankruptcy filing, all bonds would be bought back at a deeply discounted rate and the facility cancelled. In order to finance this, it is likely that Grapes will have to seize funds from escrow accounts, put in place to safeguard interest payments on the bonds.

The first half of 2002 will see decisions made and played out. With many initial offers having been refused by bondholders, CLECs are on thin ice. It is important they retain a degree of investor confidence to avoid following Enitel and a handful of cable companies into administration. If bondholders are not interested in saving the company, crisis is around the corner.

The survivors

Casualties over the coming months are almost inevitable. A number of mergers are possible and some operators may go under completely. The market is saturated and simply cannot support the recovery of so many distressed start-ups.

However, the future may not be entirely bleak for all. Once a company is established, capex comes right down. ?If a company has started to produce EBITDA and can then diminish interest payments, it can survive,? suggests a market player. ?For instance, in the case of Netia, 80% to 90% of outgoings are now interest.?

Those with a viable market niche may well get their heads back above water. Jazztel's SME-focused business strategy has been widely applauded. If debt restructuring is successful, it could become a viable alternative to incumbent Telefonica within its target market. Completel believes its focus on big businesses, in the nine French cities it operates, will see it through.

For some, a takeover may be the best chance of survival, a pattern already seen in a number of cable companies. Troubled cable operation United-Pan-Europe Communications (UPC) may be saved following the take over of its parent, UnitedGlobalCom by Liberty Media. Liberty purchased $1.44 billion of UPC bonds and will exchange them for United shares.

One analyst agrees that new hands could save the day. ?Some CLECs could pull through some way down the line. We might see a third owner making one work. There is certainly private equity around that could be interested in saving them.?

Banks cash in

Bondholders are bearing the brunt of current restructuring, with bank lenders escaping fairly unscathed. Senior secured tranches are very secure. Banks can cancel the facility and demand repayment before a situation of distressed exchange is declared. According to one telecoms banker Enitel is the only instance in which bank lenders have lost out. ?And that can be largely put down to an over-reaction on the part of management. When bondholders sued, they panicked and filed for bankruptcy.? Overall, there have not been many defaults on bank facilities, only a few amendments.

In fact, banks could actually benefit in the medium term from current restructuring. ?Going forward, the telcos that do survive will want more money. By then, they should be well established and banks could well lend into them,? points out West. Acquisition financings may well also arise as a result of mergings and take-overs.

?Moreover, raising bank finance for telecoms companies that do have sound business plans is actually quite attractive at the moment,? says Cumming. ?Pricing has come right up.? Popularity for well-structured telecoms deals was well demonstrated in the recent high profile successes of Wind Spa and Amena. Both went to the markets in the second half of 2001 to raise huge amounts for build out of 3G in Italy and Spain respectively. Syndication and financing structures are more conservative in the current climate, but they can be done.

Charles Pelham, managing director and head of distribution, JP Morgan, points to the Telewest syndication of 2001 as an example of how alternative telco financings can be shaped for sell down. ?The JP Morgan-led syndication was instrumental in changing lender attitudes. A club approach was taken, with a significant number of banks on board right from the start, so that risk was very thinly spread. Using this technique makes TMT much more straightforward.?

Times are certainly not good for any telcos at the moment but there is a future for some. Those that can inspire confidence can raise funds and CLECs that weather the current storm will do just that.