November 15, 1998, Issue: 313
Section: 1998 Annual Report
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Hard Times for Hard Money
John T. Mulqueen, Contributing Editor
Service providers may not find coal in their Christmas stockings, but they aren't likely to find bundles of cash either-especially if they're one of these new-fangled startups with precious little track record to attract investors. The frost that hit international financial markets in August and September will continue to chill demand for debt and equity offerings throughout the holidays and into spring. And what money is available in the meantime is going to be more expensive than ever.
Ultimately, the funding squeeze isn't the result of a lack of capital. There seems to be plenty of money to go around. Some venture capital telecommunications funds are even loading up for new investments. The problem is getting that cash out of the hands of investors, who are more cautious than ever.
The debt and equity markets haven't been particularly receptive to telecom issues in the last few months. When these markets have responded, the result is usually stock issues being floated at lower share prices than expected, or bonds being offered with higher interest rates. Venture capitalists, for their part, claim they are still interested in the telecom sector, but they're seeking larger equity interests in investment targets. They're also looking for healthier service providers to invest in, companies that either carry lower debt loads or can prove they are able to shoulder their debt burdens.
"This is not like it was in 1997 or early 1998," says Kathleen Mayher, senior vice president and division manager of media and telecommunications financing for Key Corp. (Cleveland). "You will never see that again. Deals were done with very low spreads, and credit structure deteriorated. High-yield debt was sold with 8 percent interest rates. Those are not high-yield rates."
Bob Nicholson, a partner with Spectrum Equity Investors (Boston), agrees that the days of easy money are long gone. "A lot of the high-yield debt that was sold took risks that venture capitalists are paid to take," he says. "Now the markets have pulled back too much. It will be at least the end of the first quarter of 1999 before markets settle down."
Nicholson notes the downturn in funding is in part tied to the recent performance of some competitive local service providers that have missed their targeted revenue goals. But he adds that the market pullback "had less to do with the domestic economy and more to do with an international flight to quality investments."
Even though several banks report they are actively lending to carriers, bank loans don't seem as abundant or as generous as they were earlier in the year. Data for the telecom loans is not available, but an overview of all types of syndicated bank loans in the third quarter of 1998 shows a downturn in lending. During that time $225.6 billion was issued through syndicated loans, down by 15 percent from the previous quarter and off by 25 percent from the third quarter of 1997, according to market research company Loan Pricing Corp. (New York).
"A lot of the big money center banks have problems with their own liquidity because of their exposure to hedge funds or trading losses," says Mayher. "A lot of banks are reluctant to underwrite credits if they are not going to place them."
Another industry executive who requested anonymity was blunter in explaining why cash can flow freely one month and suddenly dry up the next: "Bankers are manic-depressives."
The Capitalist Gang
Conversely, venture capitalists, especially those following the telecom market, are said to be bursting with funds and ready to invest. The problem for service providers is that these investors only want strong businesses with healthy cash flows, solid customer bases, a sound business plan and a lot more equity on their books than new companies had earlier this year. One venture capitalist, requesting anonymity, claims these firms have raised about $2 billion in recent months.
Spectrum Equity is putting together a fund of between $550 million and $650 million aimed at the media, entertainment and telecom markets, says Spectrum partner Mike Kennealy, who notes that almost $190 million of an existing $250 million fund is already committed. Nicholson says Spectrum is concentrating on these industries because they are placed in rapidly growing, multibillion-dollar markets that entrepreneurial companies can leverage.
Regulatory mandated competition, technology and new cost structures also allow new companies to enter communications markets more quickly than legacy companies, he says. "This all makes this segment very attractive over the next 10 years," Nicholson says. "We believe in the fundamentals of the business regardless of what the capital markets are doing," adds Kennealy.
Spectrum followed through on this commitment by helping CTC Communications Inc. (Waltham, Mass.), an emerging competitive local service provider, raise $100 million. Goldman Sachs & Co. (New York) and Fleet Bank (Boston) took part in the deal. "They are funded for the foreseeable future," Nicholson says.
Other venture capital firms are lining up as well. John Baker, general partner of Baker Communications Fund (New York), reports his firm has almost $500 million earmarked for Internet service providers (ISPs), competitive local service providers and suppliers of network management software and other applications. As yet, however, Baker has not found a competitive carrier or an ISP worth investing in, although he has put an undisclosed amount of money into equipment and software manufacturers.
"Generally the firms we're looking at can't get money from banks because the banks' terms are more stringent," Baker says. "They are more capital-intensive businesses and have to be managed very carefully."
The tight financial conditions and new demands are creating more than an inconvenience. It may force some smaller competitive local service providers and wireless companies, such as USN Communications (Chicago) and Advanced Radio Telecom Corp. (Bellevue, Wash.), to cut back on their expansion plans or even sell themselves to larger concerns, according to one securities analyst who asked for anonymity. USN earlier this month saw Standard and Poor's drop its credit rating from "B minus" to "triple C" following the announcement that the competitive local service provider is having trouble raising cash to meet near-term business needs.
Advanced Radio is in something of a similar fix. It received a commitment for vendor financing from Lucent Technologies Inc. to help build its wireless networks, allowing it to move from a lower-margin resale operation to a higher-margin facilities-based service. Unfortunately, the Lucent commitment was based in part on Advanced Radio's ability to raise capital elsewhere.
The wireless carrier was planning to do this through a high-yield offering of between $100 million and $200 million. But those plans changed when the market turned sour, acknowledges David Gould, director of investor relations for Advanced Radio.
The carrier is now looking at more expensive options like bank loans, private equity financing or vendor financing, says Gould. "We think we can manage our way through," he adds, although he admits that the squeeze could force the carrier to rethink its expansion plans.
Vendor financing can be particularly attractive in this market because it is both available and relatively cheap. Lucent Technologies last month offered up $2 billion at 8 percent interest to WinStar Communications Inc. (New York), which is building a fixed wireless network and buying ISPs.
In another deal, L.M. Ericsson AB (Stockholm, Sweden) increased financing available for RSL Communications Ltd. (Hamilton, Bermuda) by $100 million, to $175 million. RSL is building an international network aimed at carriers and small to midsize businesses. Some RSL board members contributed another $85 million in loans, which includes warrants to buy RSL stock.
"We have got plenty of money,'' says Jacob Z. Schuster, RSL's executive vice president and chief financial officer.
Debt Makes A Comeback
Amid the gloom are some signs that the financial markets are softening up. Long-distance service provider IXC Communications Inc. (Austin, Texas) recently received $600 million in credits from a syndicated bank loan managed by NationsBanc Montgomery Securities (San Francisco). IXC will use the funds primarily to buy switches and optoelectronic equipment on the national network it is building.
Even high-yield debt, mother's milk to many upstart service providers, was in demand late in the fall. In public transactions Nextel Communications Inc. (McLean, Va.) sold $300 million worth of 10-year notes yielding 12.25 percent in interest; and ISP PSINet Inc. (Herndon, Va.) sold $300 million in notes with a 11.5 percent interest rate. In private deals competitive local service provider McLeodUSA Inc. (Cedar Rapids, Iowa) sold $300 million worth of debt, and Qwest Communications International Inc. (Denver) announced plans to sell $750 million in notes paying 7.5 percent. Sprint Corp. pulled back a $604 million initial stock offering for its wireless operations late in October, announcing instead that it will sell $2 billion to $3 billion worth of debt. It will use some of the proceeds to reduce debt levels at Sprint PCS (Kansas City, Mo.).
Banks claim they are equally interested in lending to carriers new and old; Mayher cites Key Corp., parent of Key Bank, as one example. But the loans will cost at least 1.5 to 2.5 percent more than in the past-especially if the borrower is also using some high-yield debt to finance its operations. "We do see an upward shift in pricing and see it as logical that if deals are done with some component of high-yield debt and some component of bank debt, then banks should get paid," she says.
In this market, investors and lenders all want to get paid, and service providers are faced with footing the bill.
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