The £22.5 billion raised by the UK treasury from the sale of third generation (3G) mobile telephone licences has created plenty of excitement in Finance Ministries around the world, with other governments looking forward to a similar windfall.

But the sheer scale of the payments, coupled with the heavy capital investments to get Universal Mobile Telecommunications System (UMTS) technology up and running, raises questions about how it is all going to be financed. Even for the well capitalised telecom companies, the move up to the next level is an extraordinarily expensive process and will necessitate some of the largest syndicated bank loans, bond offerings and equity offerings ever seen.

Moody's Investor Services estimates that a total of around s150 billion will be spent on acquiring licences in Europe, with a further s150 billion needing to be invested in network construction over the next three or four years.

The next big auction takes place over the summer in Germany. Given the fact that Germany has a larger population than the UK, has a higher GDP, and that Germans are even more addicted to their mobile phones (or Handys, as they are known) than people in the UK, estimates for this auction are running above the UK figure.

One forecast suggests that as much as s120 billion may be paid for the German licences, though some observers caution that the figure may be lower, as the euphoria surrounding hi-tech stocks in general has taken a knock over the past few months. In fact the UMTS licence auction in the UK may have taken place at the very peak of the market, before the internet stock bubble burst, and hi-tech stocks in general took a tumble.

But the telecoms companies clearly believe that UMTS has a bright future, and are engaged in a game of high stakes poker. Some firms believe that they either have to get into UMTS or get left behind in the mobile market, and the view that there is a future without getting involved in this latest technology is a minority one among telecoms players.

Aggressive UMTS investment is going to increase debt levels, and will inevitably lead to downgrades from the rating agencies. The question is, as the pace of capital raising steps up, can bank lenders, and institutional and retail buyers of equities and bonds, meet the needs of the sector at reasonable pricing levels? One question now being asked is whether the prices paid for UK licences has set the benchmark for other countries, or whether the UK will prove to be an aberration, and this will partly depend on the strategy adopted by other governments. Clearly they are tempted to bring in as much money as possible from the sale of licenses, but other factors are coming into play.

In France there has been a lively debate about the potential effect of high licence prices, with suggestions that UMTS services will be so expensive as to price most people out of the market. As is the case with internet access, some people in France have said it is important to avoid creating a society of technological haves and have- nots. The French government has come up with some sort of compromise, but has nonetheless set quite high prices for licences, while also incorporating elements of a beauty parade.

?No one expected what happened with the UK licences,? comments Gerhard Thomas at Andersen Consulting in Germany, who says that the implications of the results of the UK auction for the development of UMTS in Europe are currently being assessed both by governments and potential bidders.

?There are two schools of thought. One is for the government to get as much money as possible, to plug gaps in their financing needs, but the other addresses how the mobile companies will be able to get a payback on their investment,? Thomas explains, with the French in particular favouring some sort of beauty contest, as opposed to awarding licences solely on the basis of how much money is on offer.

The prices paid for UK licences will also lead to a change in strategy on the part of some potential bidders. ?The prices were so high for the licences in the UK that companies that started with a pan-European strategy now have no chance of getting a licence in every country,? Thomas says. ?For example, Vodafone can't go after all the licences if they have to pay the same amount that they paid in the UK.?

The cable companies were also interested, but may find themselves priced out of the game. ?The cable companies all follow a pan-European strategy, and are already spending a lot of money developing cable networks, but now they can't afford to get UMTS licences, although cable and UMTS services are a good combination,? Thomas says.

So if the UMTS is spread between the existing telecoms giants, where is all the cash going to come from, and will the market be able to cope with the appetite for fresh capital?

One possibility is non-recourse or project financing of some of these UMTS units, though up to now telecoms investment has largely been conducted on-balance sheet, at least in the developed world, with telecoms project finance more associated with developing world countries such as Brazil.

?Project finance in the telecoms sector has been much more of an emerging markets phenomenon, and that is in part because the large scale projects in the United States have tended to be built out by well capitalised companies with large market capitalisations, who were able to raise money on a balance basis, either via equity or unsecured debt, and that has been cheaper than project finance,? explains Glenn Gerstell, who heads up the Global Communications practice at Milbank Tweed Hadley & McCloy in Washington DC. ?Many projects in emerging markets have been conducted on the basis of a consortium, and if you have a consortium it makes it very difficult to finance on balance sheet, and the multiplicity of sponsors pushes you towards project finance,? Gerstell explains. ?But in the United States and Europe people have had the luxury of doing sole sponsor projects, which they have had financed directly on their balance sheets, which is cheaper.?

But the sheer amount of capital available makes it possible that telecoms firms in places such as Europe may have to consider new ways of financing. ?This is an extraordinary amount of capital devoted simply to the acquisition of the licence, before any of the actual capital expenditures for the build-out are put in place, so this puts intense pressure on the building plans,? Gerstell notes. ?Most are being done on a corporate basis, but it wouldn't surprise me if some of the 3G licences ended up being financed on a project finance basis, because the sponsors do not want to carry the entire project on their balance sheet,and because the capital needs are so intense,? says Gerstell, and this will apply in particular to some of the second tier telecoms players which win licences.

But whether lending on an unsecured basis, or with licences and assets as collateral, the commercial banks are still facing a difficult task in evaluating the risks of lending into UMTS projects.

?One of the big challenges, whether you are doing an equity valuation or a credit analysis, is that though you can get a fairly good handle on the cost line in a model, you can only make assumptions about what the revenue line is going to be,? says David Wheeler, head of European Telecom at Credit Suisse First Boston in London. ?You are talking about services and applications which do not yet exist, for a market which does not exist with pricing programs which don't exist.?

?It is going to be a challenge to get all this financed in the public debt or equity market, and the commercial banks are starting to get concerned,? Wheeler says. ?The payback periods on these models are pretty long, perhaps turning cashflow positive in year eight, compared to year three for some GSM licences. Also the commercial banks have to make assumptions about exit routes, but the markets are very choppy. The high yield market is barely open, and on the equity market most European cellular company stocks are down this year.?

One solution for companies needing to raise cash for the push into UMTS may be to make asset disposals, as was the case with France Telecom selling its stake in Telmex via an equity offering in June.

?We are going to see telcos selling non-core assets either through trade sales to other industry players, or public equity offerings, and that process is going to accelerate,? predicts Wheeler. And securitisation may also play a role. ?There is no reason why you cannot take traditional voice revenues and do some form of securitisation,? he says. Future revenues to be generated from UMTS itself are certainly not suitable for future flow deals, but by parcelling up their stable revenue flows from traditional fixed line businesses, or conventional mobile accounts, the telecoms players will be able to free up other lines of credit for the move into UMTS. Securitisation thus represents a way to diversify funding sources, and tap into the fast growing base of Asset Backed Securities (ABS) institutional investors.

Telecoms securitisation has been generally ignored up to now in Europe as too time consuming and expensive to put together. But Telecom Italia is about to change all that, breaking new ground with its plans to launch a multi-billion Euro future flow deal backed by telephone bills to private customers and corporate accounts. It has mandated BNP Paribas and WestLB to arrange this deal.

In its old state-owned monopoly guise Telecom Italia would hardly have looked at such a time consuming and complex financing. But after last year's surprise takeover by Olivetti, often referred to in Italy as ?the mother of all takeovers?, Telecom Italia has become a highly leveraged and thus weaker credit.

Telecom Italia is itself not rated, but in May its parent company Tecnost, in turn controlled by Olivetti, had its BBB plus corporate credit rating put on CreditWatch with negative implications by Standard & Poor's.

Telecom Italia may be a lower rated credit than most other major European telecoms companies, but as other telecoms firms are downgraded, securitisation will begin to look less of an expensive alternative to traditional unsecured bond issuance and bank debt. And even if it is a little more expensive, it will be viewed as an important way to diversify funding sources, as a backup to the possibility that bond market investors and bank lenders may fill up on telecoms sector risk.

But one investment banker based in Spain says that the jury is still out on whether the Telecom Italia deal will spark a rush towards securitisation in Europe. ?In Latin America the alternative cost of funding is 400 bp, so if they securitise their high quality US phone call receivables and issue at 150 bp that is great,? he says. ?But a company like Telefonica is a single A credit, and they just snap their fingers and they have five banks wanting to do conventional bonds for them, while any ABS which comes out won't get that good pricing or that long a maturity.?

?All these deals get done because they look at the alternative cost, and at the moment there is a love affair between the markets and the telecoms companies,? he continues. ?Those bonds are very well priced for the issuer- though if there is a long series of large offerings perhaps the bonds will eventually not be so well priced.?

Indeed it is the expected flood of unsecured bond offerings that makes securitisation arrangers optimistic, since as more telecoms companies find themselves downgraded, the relative cost of doing a securitisation will start to look more convincing. In April Standard & Poor's placed British Telecom on CreditWatch with negative implications. This action followed the bidding for the UMTS licences. ?Pursuant to its controlled growth and diversification strategy, S&P expects that BT will bid and pitch aggressively for further UMTS licenses in Europe,? commented Peter Kernan, analyst at S&P in London.

?If BT wins further licenses this could require substantial upfront investment in licence fees and UMTS network build-out costs,? Kernan continued. ?Given that there is substantial future uncertainty about the future level of demand for mobile data services and therefore the future profitability and cash generating ability of UMTS networks, the impact of substantial debt funded UMTS investment is likely to be materially negative from a credit perspective.?

BT has a AA plus rating from S&P, and if over the next year it were to slip down two notches into the single A category, this would substantially increase its cost of funding. This would make securitisation, though still more expensive, an option worth looking at.

Vodafone-AirTouch was also downgraded at the time the EU cleared its acquisition of Mannesmann, since the EU was insisting on the sale of Orange. It initially looked as if Orange was going to be demerged to shareholders, with non of the sale proceeds being retained by Vodafone, and in April S&P downgraded the company to single A minus.

However in late May Vodafone completed the highly profitable sale of Orange to France Telecom, bringing in a large amount of cash to Vodafone and easing its debt situation. On May 31 S&P put the ratings on creditwatch with positive implications. Vodafone bid £5.9 billion for its UK licence, while and BT bid £4 billion, and as one player comments, ?Vodafone needed a high price for Orange just to be back in the game.?

Analysts point out that funding costs for telecoms companies are already increasing as a result of downgrades and concern among lenders about the upcoming capital requirements. ?In the debt market we have seen average financing costs go up by about 60 basis points across the board,? says Mark James, equity analyst at Nomura Securities in London, as investors have factored in the effects of higher leverage due to the cost of the licences.

He sees further consolidation resulting from the move towards UMTS. ?The bigger players have financial resources, among the big players they have sufficient funds to pick up the bill, and among the smaller players there is an acceleration of consolidation across the industry, as those without deep pockets partner up to try and stay in the frame,? says James.

This view is shared by Thomas at Andersen Consulting, who expects that the level of capital investments associated with UMTS will have the effect of speeding up the process of consolidation in the European telecoms sector. ?There is already a lot of consolidation going on, because of the expense of upgrading existing networks, but UMTS is even more capital intensive,? he notes.

Analysts point out that there are two basic strategies among the bidders. Some companies, notably Vodafone-AirTouch, Deutsche Telekom, France Telecom, British Telecom and Telefonica, are looking to establish a strong foothold in the pan-European wireless market, and will therefore be making substantial cross-border investments.

Meanwhile a second group, including Portugal Telecom, Belgacom, Tel Danmark, Telia and Telenor are playing a more defensive game, of remaining strong in their domestic markets, while perhaps making a few cross border investments. These and other companies are already deep into negotiations with the banks about new loans related to UMTS, but are finding it a tough sell. ?Right now we are playing a bit of pass the parcel,? says one financier. ?The bidders or operators are looking to put in a bit of equity, but are basically look for someone else to finance it. They are putting tremendous pressures on the telecoms equipment vendors, who are getting incredibly squeezed, and the vendors are in turn looking to the banks for support.?

Meanwhile he notes that some banks are wanting to have the new UMTS loans separated from existing cellular financings, particularly where second tier operators have outstanding bank loans. ?The banks are saying, ?we do not want you to put the two together, because you are going to cannibalise a good loan with predictable cashflows with UMTS'? he says.

Meanwhile it should not be forgotten that other parts of the world are also pressing ahead with UMTS, and that the services are likely to be made available to consumers first in Asia. The big Asian mobile players will also be looking for large amounts of capital to buy licences and get their networks underway.

Japan is having an auction for licences, and Korea should complete its process this year. In Hong Kong the government is currently working on its own bidding process, which may eventually include elements of both a beauty contest and outright bidding. The first round of consultation has already been completed, and there could be licences awarded either late this year or early next.

?Initially the government favoured a beauty parade, they said that they wanted to ensure that certain build-out targets were met,? explains Joe Locke, head of regional telecoms analysis at ABN Amro Asia Securities in Hong Kong, but he notes that there has been a lot of pressure from the local press to maximise revenue via an auction.

?All the operators except for one favour a beauty contest,? Locke notes, with the player with the biggest resources favouring an auction, that is to say Hutchison Whampoa which is controlled by tycoon Li Ka-shing.

Locke expects bank loans and equity offerings to be the main sources of financing in Hong Kong, where large corporates traditionally rely less upon the bond markets than they do in Europe.

Certainly the global appetite for fresh capital is going to be formidable over the next couple of years, with bond offerings and syndicated bank loans likely to set new records in size, whether in the US, Europe or Asia.

All in all it is a very challenging time for bank lenders into the telecoms sector, who are having to assess a whole new set of risks with a brand new technology.

?For the last six or so years the telecoms companies have had easy access to the debt and equity markets, but now both the equity and debt markets are getting worried,? says one player. ?We are going to see the separation of winners and losers, whereas up to now nearly everyone in telecoms has been a winner. If you look at the valuations over a two to three year period they have all gone up, but that can't be, because at some point their business plans start to eat each other.?