Last year's event was filled with promise, expectation and a positive outlook across the European telecoms sector. Twelve months later credit downgrades have become the norm among telco operators, with the resultant soaring fund-raising costs.

"Those operators known for their conservative practices and aversion to certain structures [for example, QTE leasing] have been seriously humbled in the post-auction fall-out," says one London-based cross-border arranger. "They need cash lump sums - now."

Gerry McGinnity, group treasurer at Eircom plc, the Irish telecom operator, and also chairman of the event, described the impact of the Universal Mobile Telecommunications System (UMTS) auctions as catastrophic. He summed up the challenge as follows: "More than $100 billion being spent on acquiring the licenses, a further $190 billion to build them, and that is in the context of unknown returns on the new technology and a trend toward declining corporate credit quality."

These over-priced licences in the UMTS auctioning process mean that operators are still trying to find ways of paying off their bids, plus finding ways of funding the network construction for the third generation (3G) of mobile phones.

The challenge is how to overcome reduced credit ratings and less favourable pricing. For example, at the beginning of January 2000, British Telecom was rated AA+/Stable. This compares to A/Negative at December 31, 2000. Similarly, for the same time period, KPN was AA/CW Negative compared to A-/Negative.

Debt levels of telecom operators became too high in relation to their ratings. To reduce it will require considerable asset sales, IPOs and lower equity valuations. Without this, more downgrades are likely, says Peter Kernan, associate director, corporate ratings, Standard & Poor's.

Core to the credit downgrades is UMTS. Rather than beauty parades with proposals accepted on their financial viability, European licences were awarded to the highest bidder. More than Eu60 billion was spent on licence investment alone during 2000. And the return on this investment is unlikely, argues Kernan. "UMTS is still only a network concept for a mobile operator service that still does not exist."

With this possible funding shortfall looming on the horizon there are several options available to the European telco operators.

Funding solutions

According to Steve Din, managing director, Morgan Stanley Dean Witter (MSDW), securitization is a natural way out of the quagmire of rising debt levels. Such a product can generate substantial cash lump sums reducing the burden of licence and build out costs considerably. A securitization deal could lead to significant reductions in the weighted average cost of capital (WACC) used to set prices as well as a corresponding improvement to equity returns.

Receivables, equipment leases, real estate, services and fixed line networks; all are eligible asset classes for combined or stand-alone transactions.

The massive telecom financing requirements means that corporate bond issuance is pushing the boundaries of market capacity, resulting in telecom bond spreads widening relative to corporate bonds. Telco operators have to pay a premium to access the corporate bond markets, he said.

In a typical structure, a telco operator would spin off the assets being securitized into a new subsidiary (See chart). The business would be paid for out of the proceeds from a bond offering. Payments made by customers (obligors) would be applied by funding from the company. It would do this by first making a payment to the telco (via a management fee and payment of maintenance capital expenditure), second to bond-holders and third (by way of a dividend), to the telco operator itself.

Din forecasts the build out costs for the 3G networks to be roughly equivalent to the licence costs. He estimates that for the 2000-2010 period, the total UMTS cost for Europe, including licensing costs and capital expenditure, will be around the Eu325 billion mark.

British Telecommunications (BT) recently announced it is looking at its options for offloading and monetizing its UK real estate assets.

Din also estimates that major European telecom companies currently own around $40 billion of real estate assets. The product is generally only suitable for strategic assets that the operator is likely to occupy for a predictable period.

In effect a deal entails the transformation of real or financial assets into securities through the creation of bond-able leases. Flexibility and bond yield, as opposed to property yield, are two key advantages that Din highlighted.

But there are also disadvantages. For example, the assets still need to be managed and there is direct competition with corporate credit for capacity in the bond market, adds Din.

Most of the capital expenditure is likely to fall in the second half of the decade, giving operators more than ample time to concoct fund-raising solutions with their relationship banks. Din reeled off a list of European operators: BT, Telefonica, Sonera, KPN, Deutsche Telekom, France Telecom, Swisscom, Telia and Telecom Italia.

He estimates the total securitization volume potential for these telco operators as follows: plant and equipment, $156 billion; land and buildings, $38 billion; and receivables, $38 billion.

Pipe dreams

One highlight of the event was the presentation given by Marc Hari, senior manager in the project and structured finance division at Macquarie Bank in London, on the world's largest single tranche lease-to-service contract.

The $2 billion deal for fibre-optic network pipe ducts took more than two years before closure.

On September 21, 2000, Swisscom AG closed the transaction. It was its second pipe ducts deal ? the first closed in December 1999 and totalled $850 million. Edison Capital was equity investor on both cross-border deals.

With the deal originally structured as a US lease-in lease-out (lilo) and then service contract following regulatory changes, and mergers and acquisitions spreading throughout the US banking sector, lining up a suitable US equity investor was a challenging process.

Despite the investor's related company ? Edison Mission Energy ? undergoing financial problems due to deregulatory issues in the US power market, Hari was quick to point out that the two cross-border leases were in no way affected by the related company's recent financial problems.

The asset class itself consists of a mixture of concrete, steel cast and plastic ducting with useful lives ranging from 60 years to 90 years, spread through a network of 95,078 kilometres with a total network value of $3.5 billion.

In July 1998 negotiations started with NationsBank to invest in the cross-border deal. In September 1998 NationsBank merged with Bank of America. In January 1999, Bank of America decided that its policy was not to invest in any type of US lilo deal.

In July 1999 negotiations began from ground zero with Edison Capital, the first deal closing in December 1999, culminating in the $2 billion blockbuster closed in September last year.

A deal with similar assets is currently underway for Telenor, the Norwegian telco operator. The Citibank mandate is expected to hit the $1 billion mark. Edison Capital, again, is rumoured to have shown interest in the transaction, as have three other equity investors. On this particular deal, though, there is the possibility that as well as the pipe ducts, the actual cables may be included.

But few cross-border lease financings ever reach this scale of deal.

Structured finance's role in the telecom sector is not core, but added value to mainstream fund-raising, says Gerry Smyth, principal at cross-border arranger Babcock & Brown. Discretionary funding is how he described the tax-based transactions that are usually able to offer net present value (NPV) benefits in the 5% range.

To date, most QTE lease transactions for telco operators have been defeased, allowing the lessee an upfront benefit. With deals having to show significant economic substance, fully defeased transactions are not as popular as they used to be. A minimum of 10% true debt has quickly become the norm.

A minimum deal size of $200 million on a 12-year to 15-year term will produce NPV benefits in the 6% to 8% range, depending on interest rates, says Smyth. And $1 million in fees is likely for the lawyers and equipment experts involved in these transactions, he adds.

That said, the so-called QTE expert can be worth its weight in gold in deciding which hardware and software assets can be categorized as QTE-able.

Non-telco asset deals -  those for assets other than telecom digital switch-gear - are becoming more prevalent, with deals for postal sorting equipment, flight simulators, air traffic control, automated revenue collection systems and train control systems having closed. The next non-telco class to be exploited is likely to be utility distribution control systems, with rumours of deals into Germany in the offing.

New business

One completely untapped QTE line of business is hi-tech manufacturing firms. The semi-conductor manufacturing plants, or wafer fab plants as they are more commonly known, can notch up appraisal values around the $1.5 billion to $3 billion mark. Taiwan is home to many of the world's leading manufacturers. Arrangers are confident that service contracts could be used for the facility assets and that QTEs could be applied to select hi-tech assets.

Companies such as Taiwan Semiconductor Manufacturing Corporation, Advanced Semiconductor Engineering and United Microelectronics Corporation, are all considered to be potential lessees. But obsolescence is a key issue with a QTE lease.

With each new generation of computer chip produced, the manufacturing and testing assets only have a life-time as long as the production run itself, between one and three years ? too short a time for a cross-border structure.

LKE

But Like-Kind Exchanges (LKE) could provide a solution. So long as the replacement assets have at least the same capability as the assets being replaced. The pre-qualification of potential LKE assets can provide asset replacement flexibility without early termination costs during the lease term.

Perhaps the numerous wafer fab plants located in Ireland could provide arrangers with an opportunity to test this idea?

The 3G auctions highlight stumbling blocks that the equivalent US market will hopefully learn from. The New York bidding process for mobile operator licences has become the centre stage for the US market. Verizon Wireless recently put together a $4 billion bid for two mobile licences - a record-breaking price.

Bids across the country are likely to total $17 billion, much higher on a comparative basis than last year's auctions in the UK and German markets.

The question everyone is asking is whether the US market will follow Europe, in that telecom operator stocks bombed as capital markets' concerns grew over their ability to recoup the auction prices paid. In total 422 licences have been on offer.

According to the local press, the New York bids are nearly three times higher than those made for the 3G licences in the UK and Germany.

The European bids were the equivalent to $4.08 for each megahertz of spectrum to reach each potential customer, while Verizon's New York bids are equivalent to $11.32.

But as the total number of licences covers secondary and third tier markets and will raise less, the overall price paid in the US auctions should be less.

Verizon, the largest bidder, has made commitments totalling $8.8 billion. Cingular and AT&T have bid more than $2 billion each.

Will structured finance figure as highly in the product portfolio of these telecom operators as it does for their European equivalents?, is the question that structured financiers are asking. And with an economic downturn predicted in the US economy, the problems in fund-raising could worsen.