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Selling High: The Equity Alternative

Posted: 06/1999

The Bottom Line

Selling High: The Equity Alternative
By Bryan Mitchell and Salman Tajuddin

As any telecom insider would tell you, telecommunications is a capital-intensive
business. The ability to execute on a business plan is predicated not only on raising the
appropriate amount of capital, but also on raising the appropriate type of capital from
the appropriate financing source.

Capital markets offer a range of financing sources, each one corresponding to a unique
risk-and-cost profile. This article is the third in a three-part series that covers
capital-raising options available to telecommunications companies. In April, Part One
discussed the general differences between debt and equity solutions. Last month, we looked
at raising private debt. This month, we’ll consider the demands facing telecom service
providers from private equity investors and the public markets.

Much Ado About Private Equity

From early-stage venture capital (VC) deals to later-stage leveraged buyouts, there is
an abundance of private equity in today’s capital markets. Excluding VC firms that invest
in startups (which require a broader discussion than this article will attempt to cover),
there are three dominant private-equity deal types: recapitalization, repositioning and
expansion.

Types of Mid-Later Stage Equity Deals
Recapitalization

Using equity and debt to replace a significant
portion of the capital structure and set the company up for a particular strategic
initiative that a reconfigured capital structure supports.

Repositioning

Using equity to start a new business within an
existing business with entirely new operations support systems (OSSs), cost structure and
capital requirements.

Expansion

Using equity, possibly in combination with another form
of capital, to drive growth of an established business model to attain a future valuation
that far exceeds the current enterprise value.

Each of these private-equity deal types typically has a coterminous investment of
additional capital in the form of senior debt or subordinated debt. Whatever the use of
proceeds, the underwriting hot buttons are consistent among many investors: management,
market opportunity, valuation and structure. In most recapitalizations and repositionings,
private-equity investors seek to back management teams that have demonstrated success and
potential to take a company to a new level.

Investors do their best to provide incentives to management through an equity
participation known as the management "promote." The promote, depending on the
particulars of the investment, ranges in terms of percentage. In addition to or as part of
the management promote, most private-equity investors require management to make a
meaningful co-investment.

Just as the promote is negotiated heavily in the first two deal types, the issue of
dilution is negotiated heavily in the last. Private-equity investors typically are control
investors or minority investors but seldom are they both. In either case, dilution will be
determined by valuation. Valuation will be determined through a mutually agreed-to level
of confidence relating to the execution of the business plan and valuations on comparable
businesses. You must do your homework to present convincing evidence relating to these two
issues; after all, it is what you come away with at the end of the day that counts.

Wind Point Partners, Chicago, has demonstrated firm support for the competitive local
exchange industry with investments in competitive local exchange carriers (CLECs) One Stop
Telecommuni-cations Inc., Lisle, Ill., and MGC Communications, Las Vegas, and an
investment made to add a local service platform to LDMI Telecom-munications, Detroit. Some
equity firms, such as Spectrum Equity Investors LP, Palo Alto, Calif., specialize in
nothing but telecommunications. That specialization gives Spectrum the ability to leverage
experiences gained from investments in telecommunications infrastructure companies as well
as service providers.

"We can evaluate a company’s OSS (operations support system) because we have
investments in OSS, provisioning and billing software companies, and the [Spectrum]
partner who closed those deals will always provide his input when looking at a service
deal," says Shawn Colo, associate, Spectrum.

Valuation and structure are two areas in which different firms take entirely different
approaches. Some firms are content to take significant minority positions while others
must have control.

Going Public, Again

There is no shortage of articles being written these days on going public. Rather than
get into a technical discussion on registration statements, quiet periods, over-allotments
and accounting adjustments, this discussion will focus on what investors these days are
looking for, what attributes investment bankers are looking for in an initial public
offering (IPO) candidate and what you should expect from your investment banker.

As any modern-day businessperson is aware, the IPO market is a fickle thing. What’s in
this month may be out next month. Matt Fremont-Smith, managing director, Goldman Sachs
& Co.’s Communications Media and Entertainment Group (CME), New York, confirms that
broadband and digital subscriber line (DSL) services providers are now the favorites of
the equity marketplace. Fremont-Smith indicates that investors "are more concerned
now with a shorter path to profitability … and want confidence that money will be spent
correctly." The high-yield market also has imposed a new discipline by focusing more
on profitability and cash flow and less on story deals.

DSL providers Rhythms Net Connections Inc., Englewood, Colo., and Covad Communications,
Santa Clara, Calif., both completed high-yield offerings last year prior to Covad’s
January IPO. According to Fremont-Smith, Covad had difficulty selling a second high-yield
offering in February, despite its hugely successful stock offering and subsequent run-up
to a $1 billion market capitalization.

Fremont-Smith also notes that investors are looking to transactions that have
demonstrated potential for scalability with respect to customer care, sales, provisioning
and facilities management. Echoing the concerns of the private-equity investors,
Fremont-Smith summed up by saying that the capital markets "place a premium on strong
management," management that has technical, managerial and, interestingly enough,
public-markets experience.

Well, now you know what the equity markets want. What is your level of interest and
does your business plan fit the bill? Assuming that it does, there are several things you
should look for in your investment banker to ensure the best possible public offering:

Pricing Ability. As this article’s title would suggest, you should only want to
sell your equity at a reasonable valuation. A good investment banker will be able to price
the offering to provide a valuation that is comparable to your peer group’s valuation
while delivering a fair price to the public. You want investors to reap some positive
return initially, thereby keeping them enthusiastic and willing to support a potential
secondary offering.

After-market support. It is important to have the support of at least one but
preferably several investment banks with strong sales, trading and telecommunications
research. It is important to have the backing of at least one investment bank with enough
capital to make a meaningful market in the stock to prevent wild price fluctuations.

And since you want your stock to actually go somewhere, you and your management team
should expect to spend a considerable amount of time promoting your business plan and
financial results to stock analysts. It is nice if you have friendly ears among those
analysts.

Corporate finance expertise. Do your best to pick a banker that has a strong
corporate finance practice in telecom. Banks that enjoy the confidence of institutional
investors can more easily accommodate your need for follow on offerings of debt or equity.
Furthermore, pick a banker whose syndication network is broad and, if possible, global.
The more widely distributed your shares are in the offering, the less likely any
particular shareholder will be able to impact market valuation or operations. Having
global distribution in the offering is important to reach investors whose return and
liquidity requirements won’t all ride in sync together.

To demonstrate the importance of having the right investment banker, picture this
disaster scenario: Stock flippers dump the shares immediately following the IPO, and since
most of the shares have been placed with a handful of institutional investors, the price
swing is great. The Federal Communications Commission (FCC) has just issued a ruling
unfavorable to your sector, so the market is already jumpy.

The ruling requires a short-term change in strategy that will cause you to miss your
first quarter’s earnings. The change in strategy will necessitate your doing a bond
offering, but your investment banker has lost the entire telecom corporate finance staff
to your competitor’s banker. The clock is ticking, you are running out of cash and the
market is yours for the taking. What are you going to do?

Clearly, the alternatives to financing your telecommunications services company are as
diverse as the capital needs your company will have over its life cycle. The
private-equity option is available for those entrepreneurs willing to trade control for
significant growth and valuation. The public offering, too, is an option, but its success
is measured not simply on its execution but on the long-term performance that follows.
Either way, a fresh slug of equity will provide your company with a strong footing for
future competitive challenges.

Salman Tajuddin Bryan Mitchell is CEO and president of, and Salman Tajuddin (pictured) is an
associate with, MCG Credit Corp., Arlington, Va., a specialty finance company
majority-controlled by affiliates of Goldman Sachs & Co. Tajuddin can be reached at +1
703 247 7520, or via e-mail at stajuddin@mcgcredit.com.

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