Tuesday, September 16, 2008

From the ashes of disaster...

The U.S. government has clarified its stance on "moral hazard" by allowing a major investment bank to fail. The International Swaps and Derivatives Association is so focused on orchestrating an orderly unwind of Lehman's positions that it held a special trading session on Sunday and has even canceled its own members conference, which should have taken place today (perhaps they were afraid that the offer of a free lunch might trigger a riot).

AIG now appears to be on its knees, and apart from the human consequences for its 100,000 employees and consumers of its more conventional insurance and re-insurance products, its demise would make the credit derivatives market significantly more complicated. Sparing readers the tedious technical details, this is significant because: a) the market is huge - Moody's estimated credit default swaps at $62 trillion back in May (that's the nominal, but replacement cost, which they think is more relevant, was a mere $2 trillion - in any event, as CDS has evolved to be a speculative trading, rather than commercial hedging, instrument, the contracts outstanding outstrip the underlying assets many times over, which may bring some problems of its own in time), and b) transactions are off-market, with limited visibility as to who's doing what, and with whom. So it's only when the music stops that we learn which counterparties are exposed, and I assume an AIG implosion would cascade through similarly positioned insurers, hedge funds, and the remaining prop desks in a very ugly fashion.

We're now more than $500bn down the road in the inappropriately named "credit crunch." I say inappropriately named because, to me, "crunch" implies a sharp, ephemeral episode of pain or distress, but this is more akin to a pandemic wasting disease, and I think it represents a fundamental realignment of the way capital will be sourced and allocated in future. Why should the denizens of Telcoland care? Well, because, as with most crises, there will be huge challenges and opportunities ahead.

First, the challenges.

1) Confidence, be it within the corporates (as we can see in the spike in inter-bank lending rates) or among consumers, is firmly in the toilet, ready to be flushed. Prepare for an aversion to spending, and for some of your customers to disappear.

2) Liquidity, where it exists at all, is going to be more scarce and costly. Given where LIBOR is at the moment, this could get very ugly indeed - in desperate cases, say where the margin over LIBOR is 1000 basis points or more, companies will be staring down the barrel of 17% annual interest rates. For the more creditworthy, things won't be so dire, but it still will be a noticeable uptick. I trawled quickly through some Bloomberg data on debt maturities for six telcos (Vodafone, DT, FT, Telefonica, BT, and Telecom Italia), and it is interesting to note that the average fixed coupon for this group's current debt is just over 6%, i.e., below the level where banks are currently willing to lend to one another, let alone anyone else. However, these six companies combined have EUR37.5bn in debt maturing in 2009 - 10. It will get refinanced, but every 100 basis point increment above where coupons are now adds EUR375m in interest payments. Not crippling, but not trivial either. Do you grow dividends at the expense of capex?

3) Speaking of capex, a friend earlier today described it as the elephant in the room. If we assume that the industry globally needs a $1 trillion access overhaul, as some are already under competitive pressure to provide, then something's got to give. Do you play "squeeze the vendor" as your only card, defer certain projects, or find creative alternative structures to keep it off your balance sheet in the near term? Do you suddenly find that the municipal broadband "hippies" are worth talking to afterall? Some of them might have access to cheaper finance...

4) Back to liquidity more generally. It seems clear that those investment banks which do survive are likely to be constrained by commercial and financial realities, and possibly by regulation, to a narrower mandate in future. So those with a business falling outside the "suitable for widows and orphans" category probably won't be able to reach out to the principal investing units of Wall Street nearly as easily as they could before. Hedge funds with dry powder can always fill that gap, I suppose, but it won't be cheap money. And the hedge funds themselves aren't exactly setting the world on fire as a group (keep in mind that this table may look different depending on when you read it, but at this writing, the Credit Suisse/Tremont AllHedge Index is down 6.07% year-to-date as of the week ending 8th September, i.e., before the most recent round of carnage). There's always private equity, but as I pointed out yesterday, we might actually find a bias towards disposal of assets here in some cases, and in any event, with the markets in the state they're in currently, it is inconceivable that PE firms will achieve the kind of exit IRRs they might have envisaged two or three years back (I'm thinking here of some of the European cable deals which got done at eye-watering multiples - in some cases they're very decent companies, but I can't see an easy exit for any of them.). And it's probably really bad if you're an early-stage company. Everything I hear tells me that there is not that much happening in early stage among the VC community, particularly in Europe, and those who are active can be extremely selective. I expect a good number of the later-stage venture-backed companies may also struggle to attract fresh capital, especially if their funding is premised upon the promise of a traditional exit. It ain't gonna happen, at least not at 10x revenues, unless you've got something really special. I should think that the outlook is particularly poor for companies created to speculatively build large communities, in the hope of finding a revenue model down the road. Don't get me wrong, I love the value and benefit that these sites bring, but in a time of severe capital constraints, it's going to be a hard story to sell. That pretty much leaves sovereign wealth funds (I don't know about the IMF, but I think $3 trillion is a lot of money) and family offices, but they will know that they are in the driver's seat and can be highly selective.

Okay, I think that's a sufficient dose of pain on the challenges side. What about the opportunities? I know times also seem hard in Telcoland, but let's face it, your margins are still at a level other industries would kill for, and it is not uncommon for even relatively small companies to produce EUR2 - 3bn in free cash flow annually. In the land of the broke, the man with one euro is king, so how might you deploy some of your relative wealth in a way that might really make a difference?

1) People - The collective stupidity of Wall Street should not obscure the real talent and intellect that rests with some of its individuals. As these firms implode, they will release some very bright people, some of whom have an intimate knowledge of their own industry and industries they have covered/invested in/done business with. Take this chance to diversify your telco DNA, particularly if you really have aspirations of competing with the likes of IBM.

2) Assets - Clearly, there is going to be a lot of distressed selling of assets. Fancy a Bulgarian incumbent or a Dutch cable company? I might just have the deal for you. But it won't just be big iron assets. As I pointed out earlier, I think a lot of venture-backed companies are going to end up in distress, and some of them may possess technology platforms and/or communities that you as a telco actually can monetize. However, you may need an outside perspective to do this (going back to my previous point), or you may need to radically change the way you think about where to take your business and how to get there. There will be huge opportunities, but it will require something other than conventional telco thinking, because the best answers will not be the obvious ones.

3) Engagement - Rather than simply waiting for companies to end up here before acting, why not partially fill the void left by the capital markets? I'm not suggesting that telcos should play the pure VC role, but I do think there is a great case for aligning strategic development goals with equity investment in companies that have something you can't (or don't want to) create yourself. There is some of this going on in the industry, but not nearly enough, in my view. Some of the companies which can help you reposition yourself are too small and young to be considered as suppliers - they typically can't get in the door of corporate HQ. What might you be overlooking? Encourage your workforce and your customers to find and evangelize interesting companies, and create a framework for vetting them, finding operational sponsorship for the suitable ones, and create a side-pocket for equity investments to let them develop.

All the evidence suggests that we're all in for a fairly brutal couple of years, with the possible exception of talented distressed investors. Next spring may be short on roses (lyrics here), but they will come in time. Now go and start planting your garden.

UPDATE 17 Sept.: Since posting this, AIG has been effectively nationalized, bringing us back from the brink temporarily. However, that this was the final outcome is a symptom of just how dire things are, and does not fundamentally change the dynamic in the market, in my view. We dodged a bullet this time, but there will be more similar situations which do end badly, and my central thesis still holds.

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