Case background Project Assets- Characteristics Providers of capital Organisation Structure Take-Out Finance Current Status of AJC Project

1990-1999: Global Telecom market grew at a CAGR of 10.2% pa from USD 348 bn to USD 835 bn Two media for transoceanic transmission :
Submarine Cable Systems Satellite Transmission

Submarine Cable Systems better because :

More capacity Better quality Lower prices

Background:
12,500km cable from Sydney, Australia to Japan via Guam at a cost of $520million. Key sponsors: Japan Telecom, Telstra and Teleglobe. Asset life of 15 years

Key Issues:

Limited growth potential Market risk from fast changing telecom market Obscene Technology; Risk from project delay Specialized use asset: Need to get buy in from landing stations and pre-sell capacity to address issue of Hold Up Significant Free Cash Flow in the initial periods of project life Fall in call charges to an average of 25% each year

Structural highlights:

Avoid Hold up Problem through governance structure: Long term contracts with landing stations. Joint equity ownership of asset with Telstra and landing station owners both as sponsors. High project leverage of 85% Concentrates ownership and reduces equity investment. Shares project risk with debt holders. Enforces contractual agreement by pre-allocating the revenue waterfall. Enforces Management discipline. Short term debt allow for early disgorging of cash.

Australian Demand and Supply for Capacity (Gigabits)

Primary estimate = $520 million, or $567 million if there were delays

Two 40 Gbit/s upgrades during first 5 years which should be funded by cash flows from operations Ability to increase capacity to 320 Gbit/s Cost of upgrading Money = $25 million per 40 Gbit/s Time = 12-15 months Estimated useful life = 15 years

Private carrier deal using a project finance structure to fund construction Need for long-term relationship Feasibility showed there was demand and the expected cash flows could support a highly leveraged capital structure Japan Telecom and Teleglobe signed MOU with Telstra

Q1. How would you characterize the project assets? What makes them different or unique?

Optical Fibers

Repeaters

Company Owned Assets

Connectors

Routers Landing Station Leased Assets Cable Laying Ships

Collapsed Ring Network helped save capital costs Low Cost capacity across the North Pacific Access to larger markets because of links to Asia and other cables which surfaced in Guam Could increase capacity from 40 Gbit/s to 320 Gbit/s if the demand increased All major assets under deep sea, hiring of ships for operations difficult, chances of obscene are high A kind of inapproachable & not marketable from the view of the lenders
More efficient to surface and repower the signal Could connect with other cables running through Guam

Q2. Who are the capital providers for AJC project?

Are they likely to earn an appropriate risk adjusted return on their investment?

Clubs

Up to 90 Sponsors Projects took longer time to complete Large blocks of capacity needed

Private Deals with Carrier Sponsors Private Deals with NonCarrier Sponsors

Competition increased
Small number of carriers Using as well as selling capacity The Pacific Group Built the cable and sold the capacity Atlantic Crossing-1 (AC-1)

Choice of strategic partners

Compatibility both at company and personal level Decrease project cost (Ex: using existing landing stations etc) Should be financially strong investors as well as capacity buyers Quicker execution should be possible by avoiding government clearances

Give credibility to project for raising bank debt Least financial and operating covenants from banks To leverage upon existing assets of the sponsor to further reduce project costs and meet timelines

Japan Telecom Landing Stations S & P Senior Debt Rating Sales (millions) Net Profit Margin Operating Margin RoA Int Coverage AA $3,117 1.9% 16.7% 1.4% 14.94

Teleglobe BBB+ $1,701 -2.5% 19.1% -0.7% 10.18

NTT Comm AA+ $71,591 2.2% 42.9% 1.2% 17.23

AT & T AA$53,223 12% 23% 10% 28.37

Debt Equity Ratio

1.12

0.42

2.17

1.33

Difficult to compare with cash flow streams of SCCN as there will be other cash flow streams as well
Lack of quantitative data
Capacity utilization projections for AJC Future cash flows Demand from Guam Intra Asia cable capacity demand

Australias Telecom carriers needed greater access to : Asia (Australias largest trading partner) US (80% of all Internet hosts were located here) In 1999, there were 3 cables for Australian Traffic: SEA-ME-WE3 (Access to US from West Coast)
Excess capacity Prone to cable failures due to extensive shipping, dredging, and fishing activities

PacRim East (Access to US from East Coast)

Full Capacity

PacRim West (Access to US from East Coast)

Full Capacity

ABN AMRO had led SCCN financing

Believed that AJC project could support a highly leveraged capital structure due to sufficient expected cash flows
Recommended gearing ratio of 85% for AJC Raising 2 debt tranches:
Tranche A -Secured and repaid (probably within 5 yrs) with presale commitments Tranche B -Repaid from future sales of capacity to other parties (within 5 yrs)

Q3. What potential problems could arise that would prevent capital providers to earn returns on their invested capital ?

Prioritization of the problems

Market Risk
Demand Risk Volatility in Capacity demand (Unused Capacity or Excess Demand) Price Volatility 25% decline in prices every year Mitigation strategy
Pre sales capacity contracts Collapsed Ring Configuration (Lowering of costs) Hedging Strategy (Forward contracts)

Technological Risk Introduction of newer technologies

Mitigation Strategy
Co-opetition Quick launch and up gradation of existing technology

Sovereign Risk Country wide relationships may get hampered

Operational Risk

Cable failures due to shipping, dredging and fishing activities Landing Stations Permission from govt. to build new stations Mitigation Strategy
High Expertise Level Shared Ownership with companies having stations

Environmental Risk Environmental concerns may lead to delay in project Mitigation Strategy

Prior submission of Environmental Impact Report to respective governments

Exposed Risk due to growing free cash flows Low Execution Risk since the firm is in this business for long Landing Stations Very short supply Extremely difficult to get permission to build new ones near major cities. Submarine cable operators require, for redundancy reasons, multiple connections into local networks. Mitigation To prevent the possibility of hold-up by landing station owners, Sign long-term landing party agreements with each party Joint Ownership Structure
High Project Risk due to chances of delay Mitigation Strategy To have a contingency plan

Cable ships Laying of cable and on going maintenance Highly concentrated 2 year waiting period

Mitigation By contractual means make sure funds are available for construction in case of delays due to this risk

Q4. How would you structure the project company to mitigate these problems? What are your recommendations in terms of: ownership structure, capital structure, organization structure, board structure and management compensation?

Organizational Structure
Special Purpose Vehicle Legally independent

Capital Structure
Debt to capitalization ratio

Ownership Structure
Number of owners Share allocations

Board Structure
Composition Size

Contractual Structure
Contracts with suppliers of inputs and buyers of output

Agency Conflicts
Problem
Conflicts between ownership and management Projects having large, tangible assets with high free cash flows are susceptible to mismanagement (Exposed Risk)

Solution
1. Capital Structure - Reduces free cash flow through high debt service. 2. Ownership Structure Concentrated ownership for critical monitoring. 3. Board structure - Mainly comprise of directors from sponsoring firms, gives them the ability to hire and fire senior managers and approve important operating decisions.

Problem
Conflicts between debt holders and equity holders Related to distribution and reinvestment of cash flow , and restructuring during distress

Solution
1. Capital Structure - Sponsors benefit from high leverage as it reduces managerial discretion over cash flow 2. Extensive contracting - Lenders impose stringent contractual provisions to protect their investments. Opportunities for risk shifting do not exist as cash flow waterfall restricts investment decisions.

Australia Japan Cable

Total Capital required: $567 million

Debt : 85% ($482 million) Equity : 15% ($ 85 million)

Reason for high leverage Forces project managers to disgorge free cash flow Discourages expropriation Lowers reported profitability

Telstra to have 40% stake so the remaining 60% is to be divided among others AT&T will not use any capacity NTT is a part of the presales contract Teleglobe will buy capacity, however they are not providing landing station AT&T, Japan Telecom and NTT need to have a good equity contribution to avoid Hold Up in the future as they are providing Landing Station which is critical

Strategic Partners/Sponsors Telstra: 40% AT&T: 15% (Landing Station) Japan Telecom: 15% (Landing Station) NTT: 20% (Landing Station/Capacity) Teleglobe: 10% (Capacity)

Telstra - 2 directors AT&T - 2 director Japan telecom - 2 director Teleglobe - 2 director Lending Institution 1/2 director

Board of Directors

Chief Executive Officer

Head of Administration Executive Manager

Chief Financial Officer

Technical Services Executive Manager

Operations Executive Manager

Head of Sales and Marketing

Finance Manager

Regional Operations Manager Australia

Regional Operations Manager Japan

Regional Operations Manager Guam

Chief executive & Project managers Flat pay-for-performance compensation schemes. Base salary Performance bonus equal to a relatively small fraction (0-50%) of the executives base salary Reason No high growth opportunities Involved with operational decision making rather than strategic Prevent agency conflicts

Q5. Can Take-Out Finance solve the governance structure?

An arrangement with any financial institution for transferring its latter outstanding. Parties Involved The project company Taking over institution The lending banks Types of Take out finance based on Risk weight Unconditional take out finance Conditional take out finance Income Recognition and Provisioning

Advantage To Lender
Helps banks in their asset liability management The financing of infrastructure is long term in nature against their short-term resources

Advantage to Borrower
Get finance for long term as required for a project Need not go and search for re-financer

Advantage to taking over institution

Economic and social development Faster Infrastructure creation

Hence, Take Out Finance will help to solve the Financial Structure issues in the firm.

AJC established in 2000 to design, construct, market and operate a 12,700km submarine fibre optic cable network (AJCN) from Australia to Japan, via Guam Funds - combination of equity capital and a project finance debt facility provided by a consortium of a dozen banks (the consortium now consists of 8 banks following several transfers) The construction completed under budget in December 2001, with equipped capacity of 40+40 Gbit/sec of a total design capacity of 320+320 Gbit/sec. In March 2010 an upgrade was completed on time, bringing total equipped capacity to 160+160 Gbit/sec and capacity increase to a maximum of 2.56 Tbit/sec.

Thank You