The most intriguing spin-off from the ongoing deregulation of the telecoms industry in Europe is the rise of the Competitive Local Exchange Carrier (CLEC). Emboldened by the requirements of the established telcos that they open up last-mile services to competitors, rival operators have stepped in to provide what they promise will be fast, broadband capabilities. The CLECs have clearly identified a niche, planning to cherry-pick the profitable city-to-city and business-to-business traffic on their fibre-optics while the state giants begin the slow process of upgrading their networks.

But entry costs are high ? sponsors backed by venture capital firms and American know-how require the funds to get their networks rolled out fast. Even where the competition is slow to respond, fixed-line operators face the imminent arrival of cheaper wireless technology as governments begin the process of auctioning off the relevant licences.

The new independent CLECs are the darlings of the high-yield market, spearheading this year's explosive growth in European issues. Some operators themselves, however, take a dimmer view of the benefits of these instruments. High yields may be the only way for a start-up operator to capitalise rapidly, but they come at a price.

No matter that the coupons attached are usually edging the mid-teens, the business strategists dislike their inflexibility. For a fast-growing network looking to expand incrementally and keenly aware of the potential gains to be made from an IPO, high yields can be a frustrating option. No early calls and no means of fine-tuning funding requirements according to how the network rolls out, in essence a fast way of building up capital stock.

December has seen huge issues from Versatel, Jazztel and Colt telecom, totalling s2.125 billion ($2.063 billion), on the high-yields, equities and convertibles markets. Expectations of increases in data traffic and merger speculation have fuelled take up. One CLEC, Irish network Esat, after furiously defending itself against hostile bids from Newtel and Telenor of Norway, has agreed a £1.5 billion ($2.5 billion) merger with BT.

The seminal performer this year, Jazztel, has gone to all three markets and also arranged financing, through Chase Manhattan, Barclays Capital, JP Morgan, Lehman Brothers, Dresdner Kleinwort Benson and local player Argentaria for its cable network rollout. Jazztel, operating alongside Telefonica in Spain, hopes to create a proprietary branded network offering the broad spectrum of services, partly because the country has low fixed-line penetration.

Jazztel's first financing was completed through a mixture of a s62 million (at the time $72 million) equity portion and a simultaneous s100 million and $100 million offering in high-yields. The high-yield offering carried a coupon of 14% ? the best terms available in February after the capital markets shock of 1998. Jazztel had even looked to vendor financing from Nortel, manager and provider of the planned E1 4U backbone fibre-optic network.

But the pace of telecoms deregulation and the exponential growth of Internet traffic intervened, meaning that Jazztel's already impressive success at the markets could be leveraged to make the network independent of the capital markets. By minimising its dependency on them, Jazztel hoped to move outside of the high-risk bracket shared by other telecoms start-ups. The Spanish group aimed at creating momentum, spreading with each transaction the net of investors that it could make comfortable.

Which is where the banks came in. Chase, lead underwriters, had been looking at openings in the CLEC market since 1998. Jazztel, wary of any drop in momentum that would threaten its investor chain, was anxious to close financing as quickly as possible prior to the IPO. The banks' main comfort came from the fact that the facility was provided at senior secured level ? far above equity and high-yields. For Jazztel's controlling shareholders, a varied group of venture capital firms attracted to Chairman Martin Varsarsky's record at Viatel, bank debt is another way of minimising their exposure and creating value quickly.

The financing was split into two tranches ? a s100 million portion to be drawn down from 2000, priced at 375 basis points over Euribor and a s200 million facility drawn down at a later date, priced at 250bps. The lower spread for the second portion represents the fact that revenue streams at this date, after the partial network build out, should be stronger. The blended margin, at 312.5bps over Euribor, points to a highly leveraged deal, but still represents far cheaper money than the high-yields market can offer.

In a sense, the CLECs approach to the banks has been refreshing ? in the words of one banker: ?They don't want to hammer the last basis point out of lenders.? The devil, as they say, is in the detail. The facility's control structures are innovative, and tight. Draw down times are conditional on the company's revenue/km levels, EBITDA, leverage levels, and network extent. Security features include a charge over assets and a pledge on shares and loans, as well as curbs on future indebtedness.

Similar pretenders in Scandinavia, France and the Benelux countries have followed Jazztel's example. Another recent deal has been the Utfors financing, funding the creation of a city-to-city network in Sweden. Similarities with Jazztel exist, insofar as both want to create a branded user-to-user network. Utfors, however, is following a different business plan, aiming to lease some of its fibre-optic network as ?dark? (unenhanced) capacity to generate revenue quickly.

The Swedish network is defiantly local ? preferring to restrict its activities to the Scandinavian urban customers and pursue alliances further abroad with the likes of Global Crossing, although it has not yet lined up one carrier in particular. And, as its president Jan Werne points out, they have deliberately avoided the use of high-yields. This isn't to say that they have avoided all forms of mezzanine debt, but they have tried to raise capital as quickly and flexibly as possible.

The Swedish carrier, recently joined by Ericsson's Sven-Christer Nilsson, may receive a useful fillip from the collapse of the merger between Scandinavian state carriers (PTT's) Telia and Telenor. Telia is without a backbone fibre-optic network, giving greater opportunities for market penetration even than in Spain, where local PTT Telefonica's network is still patchy.

Utfors' facility consists of a 364-day Skr200 million ($25 million) bridge facility and a Skr675 million revolving credit, both priced at 250 bps over Libor. The terms reflect the anticipation of earlier repayments and a belief that Utfors' model can work, even within the increasingly competitive Scandinavian market. Chase, joined here by Nordbanken and Swedbank, had a 100% strike rate with the seven banks that they invited in.

Eager as they are to play down any suggestion of a gold rush among investors, arrangers and sponsors praise the sophistication and risk-reward canniness of their lenders. Even the high-yield market has gained a reputation for level-headedness relative to the frenzied activity in equities.

And competition and the likelihood of alternative operators emerging represent a serious, and new, risk factor for investors to take into account. Tele 1 Europe is currently financing a Scandinavian wholesale network, and the European mainland is inundated with backbone carriers. In this environment relative value analysis, already in use in the US merchant power markets, increasingly comes into its own.

Jazztel admits even at this stage that its network is vulnerable to other entrants and not merely Telefonica and Renfe (Spanish State Railways), providers of much of their existing interconnection and infrastructure. Moreover, entrants may not offer a similar broadly based service, attempting instead to selectively price discriminate. Equally alarming is the potential of wireless local loop (WLL) technology, a standard whose shortcomings in performance are made up for by its low cost.

Several WLL licenses have already been awarded, for instance in France, on an experimental basis. If the CLEC's represent the third wave of activity in the wake of deregulation (after privatisation and the growth of resellers), then WLL could be the fourth. But while proven carrying ability is still low, operators prefer to see the technology as complimentary.

Norwegian CLEC Enitel, for example, used WLL to achieve a rapid expansion in coverage and by extension market share. Given the geography of Norway and the portability of the equipment involved this was a logical solution. Enitel is not strictly speaking a start-up, being formed from a joint venture of, originally, seven local power companies with the purpose of exploiting rights of way on power cables.

Enitel estimates that some Nkr1.5 billion ($190 million) will be needed to complete the rollout of its network, which it hopes will connect about 60 towns and cities in the country this year. It has augmented its operations with the acquisition, for Nkr2 billion ($248 million), of Telia's Norwegian business.

Financing for the deal has been found from a bank facility, again arranged by Chase, which has arranged a Nkr550 million acquisition revolver and a Nkr1.45 billion term loan to finance network rollout. The two sections, priced at 287.5bps and 250bps respectively, both have an eight-year life. As Ray Doody, from Chase's telecoms team, puts it ?they've migrated up the value chain?.

Enitel, rather like Jazztel, wants to be able to offer a comprehensive alternative to the local incumbent as fast as possible ? although it hopes to stay relatively faithful to its origins, for instance in using power lines to offer customers a last-mile service. The operator recently announced plans to focus on the creation of a mobile network, and has suggested forming a joint venture with an existing player. Given the dangers inherent in over-leveraging what is admittedly a strong capital base, this decision, marrying the establishment of a stronger market presence with reduced exposure, seems a sensible one.

The prime importance of being the first alternative to the established PTT's in a region is exemplified by the strategy of French CLEC Completel, which closed the first phase of its financing, lead arranged by Paribas and Goldman Sachs, last month. The s265 million facility is split into two tranches, one of s105 million priced at 187.5 bps over Euribor, and another of s160 million at 112.5bps. Banks included at this phase, taking on s25 million (scaled down from s45 million) are Barclays Capital, Citibank, Credit Lyonnais, the EDC, Merrill Lynch and Scotiabanc.

Completel is less interested in becoming a branded performer than in being a fast local competitor to France Telecom in selected regions. According to Bill Pearson, one of the founders of Completel, the operator prefers to emulate the business and high-user targeted strategy of performers such as Colt, reasoning that in its home market there is no shortage of dark fibre backbone capacity.

Completel's plans, which rely on the provision of high bandwidth connectivity, are also highly capital intensive. Completel, backed by American know-how and two US venture capitalists, Madison Deabourn and LPL, completed a high-yield issue in the US. The bank financing, at this crucial stage in the company's development, is needed both to complete construction and to fund existing losses. But speed is of the essence, says Pearson. ?The opportunity for us is to capture a minority share and provide a whole package of new services very fast,? he says.

The second phase of the French CLEC's financing should be in the market in January, although given Goldman's aggressive mandate bid, it remains to be seen whether it can repeat the success of the first phase. Completel certainly believes its expansion plans, which (common to CLECs) can be carried out on an incremental basis, will make it attractive, and says that the state regulator has generally been supportive. Completel is anxious not to miss out on the next generation of technology, having won one of the French experimental WLL licences in Marseilles, with final awards to be made in June.

The rise of the CLECs can be seen as the third wave of European telecoms financing, after the initial mobile and then cable company projects. Doody identifies four main factors in this wave: European deregulation, customers' desire to have an alternative, the ability of the CLECs to provide this, and effective price competition.

Jazztel, astonished by the success of its issue, has become more ambivalent about the future of its facility, and remains uncertain whether it will be drawn down. Christoph Schmid, strategist for Jazztel, points out that their risk profile is decreasing by the month. Doody, however, believes that, whatever the bullishness of the sponsors, it's too early to talk about refinancings, but that new projects, particularly in Germany, should hit the market this year.

Nevertheless, with funding availability on bank deals closely covenanted, there will still be operators willing to use the high-yield road to capitalisation ? if only because of the central poser facing telecoms strategists: the ideal shape of the winning company of the future. If a CLEC wishes to diversify, curbs on indebtedness and capital use may make useful acquisitions difficult. Moreover, given the present immaturity of the bank market, the high returns that can be achieved on CLEC operations and the capex hungry nature of the business, it is far too early to dismiss the importance of high-yields to the sector's development.