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Turbulent Waters: Raising Capital for Subsea Systems …….or: What Lenders Really Want

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Glenn S. Gerstell is the managing partner of the Washington, D.C. office of Milbank, Tweed, Hadley & McCloy LLP, and heads the firm’s global communications practice. He represents sponsors, lenders and equipment suppliers in projects involving fixed-line and wireless telecom installations, submarine cable systems, satellites and the Internet, as well as telecom operators and financial investors in cross-border alliances, acquisitions and financial restructurings. A partner since 1985, he has served in the firm’s New York (1976-80), Washington (1980-88), Singapore (1988- 89) and Hong Kong (1989-96) offices. A frequent speaker at legal and business conferences, he is the general editor of Telecoms Project Documentation, published by Euromoney. He served as Adjunct Professor

• f Law for several years at Georgetown University in

Washington, D.C. He is a graduate of Columbia University School of Law (Harlan Fiske Stone scholar).

GLENN S. GERSTELL Managing Partner gerstell@milbank.com +1 202 835-7585

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New Challenges in 2010

• Development and financing of subsea cable systems

still faces traditional inherent challenges:

Complexity - multiple jurisdictions involved Complexity - multiple jurisdictions involved Uncertainty due to permitting schemes (environmental issues and landing sites) General operational risk – both installation and cable breaks All leads to uncertain revenue generation

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• And now, a new problem: the economic downturn of late 2008

and 2009 and continued financial markets volatility coincide precisely with the subsea industry needing more financing for capital expenditures and new submarine cable projects

New Challenges in 2010

(continued)

• Debt financing from banks and the capital markets dried up,

resulting in tighter credit requirements and overall increased risk aversion

• Problem is exacerbated because as subsea projects

increasingly focus on the developing world, there are greater risks and uncertainty for procuring financing

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The Necessity of Debt Financing

• Global and regional demand for bandwidth means upgrades or

new construction of cable systems, but the cost is substantial and typically requires financing Debt is preferred form of financing where available: it Debt is preferred form of financing where available: it leverages equity, avoids shareholder dilution and interest is tax-deductible Even top-tier operators (who may be able to fund such expenses out of cash flow) prefer to leverage their cap-ex and keep debt off their balance sheets through limited recourse financings For lesser operators and all sponsors of investor-owned (as

• pposed to operator-owned) submarine cable systems,

debt financing is crucial

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Why Do Lenders Worry?

• Complexity: Subsea cables share differing characteristics from

traditional infrastructure for a multitude of reasons:

Multiple jurisdictions involving differing of legal schemes (involving permits, acquisition of landing rights, revenue taxing and environmental regulation) High degree of technical prowess to ensure a working system (e.g., High degree of technical prowess to ensure a working system (e.g., demand surveys, desktop routings, actual laying of the cable) Overall management of the system: including acts of nature, a reliable network ops center, careful negotiation of backhaul and interconnection rights, and intelligent marketing/selling of capacity

• Great Reliance on Management: A power plant does not put a

premium on management’s ability to market the project. By contrast, an owner of a subsea system must deal not only with a complex operation but also constantly shifting market forces

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Why Do Lenders Worry?

(continued)

• No Accepted Model: There is no one successful

“blueprint” for a submarine cable system and each project is structured uniquely

• The most common model, the consortium, is difficult

to finance.

Consortium allows risk and costs to be shared among numerous

• perators (who can sell capacity to third parties or utilize it for their

networks)

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Why Do Lenders Worry?

(continued)

Each participating carrier invests an equity share in exchange for a proportional allocation of bandwidth, with the capital contribution covering construction costs and consortium members liable for future O&M costs BUT…consortia are often not financed at the project level because: (i) lenders are hesitant to lend to a partnership, (ii) lenders are concerned about their ability to recover in an enforcement scenario from multiple parties and (iii) many

• perators/sponsor can fund out of cash flow

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Why Do Lenders Worry?

(continued)

• Many Legal Jurisdictions Involved. Sponsors also

generally try to limit tax liabilities by placing the owner in a tax haven (however most nations now insist on granting landing rights and licenses only to their own granting landing rights and licenses only to their own domiciliaries)

This leads to a multitude of corporate entities as sponsors try to place different aspects of the submarine system in separate jurisdictions

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So, What Do Lenders Want?

• Notable new or tougher requirements are being placed on new

subsea cable systems as a result of the tightening of credit committee review and approval

• 1. Strict scrutiny on the demand forecast, revenue projection and the
• 1. Strict scrutiny on the demand forecast, revenue projection and the

business case

• 2. Minimization of permitting, construction, operation and management

risk and the requirement that this burden be shouldered by the

• sponsors. Lenders will not accept risk of being stuck with an incomplete

project.

• 3. Significant equity component required to cover cost overruns or

revenue shortfall

• 4. Tighter transaction documents (more financial covenants, stricter

general covenants, greater attention to collateral security)

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What Lenders Want: The “Base Case”

• For lenders evaluating a project, the base case is the most

crucial aspect; for the most part, it is easy to predict project cost, but revenue generation creates projection problems:

In areas not previously served by cable systems, the new project’s demand forecasts have no comparable precedent,as Internet take-up rates in developing countries are largely an unknowable factor This problem for lenders is compounded by dropping prices (and the potential for consolidation in crowded telecom markets to further push down prices for capacity), unlit fiber on existing networks and alternate capacity solutions (e.g., satellite) Result: Lenders will sharply discount or “haircut” the sponsor’s base case, resulting in diminished projected debt service coverage ratios and concomitant need for more equity

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What Lenders Want: Minimize Permitting and Delay Risks

• Permitting and environmental risk are already established

risks; however it becomes magnified in emerging markets as more time and effort must be utilized to understand inchoate legal and regulatory schemes

Result: lenders are becoming more intrusive in the permitting process, insisting permitting risks are adequately addressed in the conditions precedent or through other milestones. Sponsors need to actively manage the communications with lenders in this regard. Lenders will require that the sponsor have sufficient funds to cover costs arising from permitting and compliance with environmental regulation and attendant delays Lender concerns multiply when multiple sponsors/owners are involved due to: (i) questions of joint and several liability and (ii) varying creditworthiness among the group

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What Lenders Want:

Sponsors to Assume More Risk

• Lenders will scrutinize the experience and expertise
• f the owners of submarine cable projects – ideally,

seeking an experienced operator as a equity owner

This often requires smaller or novel projects in the This often requires smaller or novel projects in the emerging markets to focus on turn-key construction Overseeing the equipment installation vendor becomes a critical function (and sponsors will often find it necessary to hire consultants for this role) Lenders also invariably hire their own consultants, with the cost borne by the sponsor/operator

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What Lenders Want: Tighter Financing Contracts & Collateral Security

• With the focus on emerging markets, lenders and sponsors

must move beyond the typical governing law and remedies issues to focus on dispute resolution Nascent legal systems in emerging markets may often not Nascent legal systems in emerging markets may often not be predictable and lenders and sponsors must come to a consensus on the proper approach for the particular situation Lenders will generally insist on New York or English law to govern financing documents and ideally, IRUs and shareholder arrangements. Dispute resolution forum is

• ften a commonly accepted legal center (e.g., London,

Singapore, Geneva)

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Collateral and Financing Contracts

(continued)

• Collateral security and the enforcement/liquidation of

collateral has become paramount in the minds of lenders

Result of bankruptcy situations in the past two years where collateral was unenforceable or inadequate and they were collateral was unenforceable or inadequate and they were forced to sue in unfamiliar jurisdictions Lenders prefer to make the loan directly to the project company so they can lend to where the assets are located and create liens on such assets

Even then, the project company may not be the actual recipient of

• revenues. In many cable systems, separate sales entities book the

revenue with the project company providing the service -- creating additional complexity.

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Collateral and Financing Contracts

(continued)

Alternatively, loans can be made directly to the sponsors or a newly formed JV by the sponsors But in such a case, lenders will insist on unimpeded access to the revenue stream to such sponsor or JV. Gets complicated if not all of the sponsors are willing to Gets complicated if not all of the sponsors are willing to have liens placed on the revenue stream. In any case, Lenders likely to insist on “up the chain” security, with pledges of stock of all subsidiaries and affiliates, as well as liens/pledges of all assets of those entities This creates enormous complexity in projects involving many jurisdictions and entailing many corporate entities.

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Collateral and Financing Contracts

(continued)

Local counsel needs to be retained – often separate counsel for each of the sponsors and the lenders – and local mortgage and pledge requirements must be satisfied Such requirements may be costly (e.g., stamp taxes)

• r impose substantial delays in negotiation and
• r impose substantial delays in negotiation and

recording of collateral. Sponsors should be prepared for the fundamental desire to trap cash and preserve value through liens on all bank accounts and contractual acknowledgements of their lien from all material contract counterparties, including customers and vendors to the project. Sponsors should anticipate this at the inception of contract negotiations with such counterparties.

2010

enabling the next generation of networks & services

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Pacifico Convention Plaza Yokohama & InterContinental The Grand Yokohama 11 ~ 14 May 2010 www.suboptic.org The 7th International Conference & Convention

• n Undersea Telecommunications