Vendor financing is becoming increasingly important in a cash-strapped telecom sector.
It involves telecom equipment suppliers extending credit to their customers, the network operators, thereby assuming their credit risk. Many market participants predict that it will play a big part in the development of third generation (3G) services.
Having committed themselves to the massive costs of acquiring 3G mobile phone licences, mobile telecom operators are desperately considering their scarce financing options to complete the roll-out of 3G networks. The established funding routes for operators, in particular bank lending and investment-grade and high-yield bond issues, are both temporarily out of favour, as lenders and investors reassess their overall exposure to this troubled sector.
Vendor financing structures vary widely. They include operating and finance leases, provision of guarantees for bank financing, project financing, securitizations and credit-enhanced structures. The risk to equipment suppliers stems at least in part from the fact that telecoms operators, including Deutsche Telekom, France Télécom and British Telecom, are pressuring them for increasingly favourable terms, after having themselves accumulated substantial debt burdens. And therefore, as suppliers scramble for a share of the 3G development programme, they may be pressured into offering potential risky financing terms.
The market perception of vendor financing is becoming increasingly realistic as this financing route takes off in Europe.
When Moody’s Investors Service put telecoms equipment maker Ericssons’s A1 rating on review for a possible downgrade at the end of January, vendor financing risks were identified as a contributory factor. At the time, Moody’s commented that with Ericsson’s customers debt-strapped, the company’s policy would need to comprise favourable pricing, firm delivery schedules and generous customer financing arrangements.
Doubts notwithstanding, there are clear advantages to vendor financing for both operators and equipment suppliers, as David Morley, managing partner of the banking department at London law firm Allen&Overy, goes on to explain: “For operators, it provides access to urgently-needed funding.
For equipment suppliers, it provides an opportunity to increase sales; to win market share in an increasingly competitive sector; to open new markets where traditional bank/capital markets finance is unavailable; and to boost buyer demand by stimulating the roll-out of 3G services.”
Because equipment suppliers need to maximize their own financing capability, as well as limiting their on-balance sheet credit risk, these deals need to be bankable. In other words, vendor financings must make commercial and legal sense not only to the suppliers of equipment but also to the banks which lend to these suppliers as well as to the network operators.
The banks already have substantial exposure to telecom operators and yet for them the risks of new generation mobile businesses are a complete unknown. Having already put up billions to fund the licences purchased by operators in last year’s fiercely-contested government auctions, they will need substantial reassurance before considering subsequent exposure to vendor finance risk in the same sector. Successful sell-downs of vendor financing risk by suppliers to the banking and capital markets in the future will depend on financings being structured to internationally acceptable standards.
A key issue for the suppliers is to ensure that, in providing vendor financing, they carry out adequate credit analysis and legal and commercial risk assessment of their customers. Failure to structure deals with the these critical factors in mind might, Morley warns, undermine the whole financing/security structure, wipe out the commercial benefits of the equipment supply and, through inability to sell down debt, create balance sheet stress.
For suppliers seeking to build up market share against the clock, the commercial benefits of vendor financing must be weighed carefully against the risks. “By adopting a banking role, suppliers are also exposed to banking risk,” says Morley, “especially where they are lenders of last resort.”
It is essential that the commercial and legal issues in vendor financing are understood from the outset, both to protect the deal structure and to facilitate the eventual removal of the financing from the balance sheet, whether through sell-down to banks, or via securitization.
This brings lawyers to the centre of the stage. The problem is, of course, that in a highly competitive market, the customer finance teams at equipment suppliers are often under pressure from their sales teams to put these deals together rapidly.
For suppliers considering vendor financing, the key commercial issues to be aware of include the following.
? Credit exposure. The supplier assumes the risk of the customer failing to pay. Suppliers need to consider enhancing the underlying credit through parent guarantees, taking security, obtaining contingent funding support and subordination arrangements. Failure to enhance the credit – or to take the credit risk off balance sheet – can be a high-risk strategy for the supplier.
? Intercreditor issues. In some structures, the vendor financing will sit alongside a parallel bank financing. How does the supplier rank against the banks? Whose finger is on the trigger? Can the supplier accelerate for non-payment? Does the supplier share pro-rata in any security, or on a subordinated basis, or have a separate pool of security?
? Customer relationships. What happens to the customer relationship if the credit relationship is poorly managed? There is a real risk that the underlying customer relationship will be damaged, or destroyed. The importance to suppliers of being able to offload the vendor finance risk cannot be overstated.
This gives rise to further questions. Can the supplier sell the deal down to banks or securitize it in due course? Are there transferability or confidentiality restrictions that might impede a sell-down? Will the financing structure prove acceptable to capital markets investors?
The banks will need to be satisfied that there is adequate security and that the deal works from a regulatory and a legal perspective. Specifically, suppliers must consider the following issues.
? Regulatory. What banking or other regulatory controls govern financing in the relevant jurisdictions?
? Credit exposure. Guarantees and security can enhance these deals. Have the appropriate technical requirements been satisfied – for example, due registration requirements?
? Legal due diligence. Have the complex legal requirements governing these deals been observed? For example, what is the telecoms regulatory regime in the relevant jurisdiction and does it allow security to be taken over operating licences? What are the exchange rate controls, the change of ownership restrictions and the withholding tax requirements?
? Security. What security is available and how can it be provided in the relevant jurisdiction?
The role of lawyers in these deals can only increase. Allen&Overy’s Morley concludes: “As the trend for vendor financing escalates, so banks will focus on techniques for taking these deals off balance sheet – and their preference will be for robust, tightly structured financings”.
