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TDCs Uncertain Future Under New Owners

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Title: TDCs Uncertain Future Under New Owners


1
TDCs Uncertain Future Under New Owners
  • Professor William Melody
  • CICT Policy Conference
  • Implications of Private Equity Ownership of
    Information Infrastructure
  • The Case of TDC
  • 13 October 2006
  • CICT/COM
  • Technical University of Denmark (DTU)

2
Private Equity Ownership (PEO)
  • Increasing vehicle of investment in several
    industries
  • It began in the US in 1980s in general industry
    and in the 1990s has spread to Europe and to
    telecom, and infrastructure industry
  • Private finance firms use a relatively small
    amount of their own funds and the assets of the
    target company as security for loans to buy the
    equity shares of the target company called a
    leverage buyout
  • After the purchase, the debt incurred is an
    obligation of the target company, increasing its
    debt/equity ratio dramatically

3
Why Do They Do It?
  • An opportunity to unlock capital not being used
    productively in the target company and paying out
    that which can be converted to cash in the
    short-run
  • An opportunity to reap substantial short-term
    returns by radically increasing debt and
    financial risk
  • PEOs sell off the target companies as soon as
    the unlocked capital can be cashed out
    generally within 5 years of takeover
  • PEO is not ownership to invest in the long-term
    growth of the company, but rather to disinvest by
    removing capital and selling the residual company

4
How Do They Do It?
  • By dramatically changing the financial structure
    of the company increased debt/equity ratio
  • By examining all assets and activities for
    possibilities of freeing up cash for distribution
  • Withdrawing capital as cash payments for
    financial services fees and returns of capital to
    new owners
  • By removing transparency and accountability so
    regulators, tax authorities, politicians and the
    public are unable to scrutinize the changes
    introduced and the amounts of cash removed from
    the company

5
Divergent Views on PEO Based on Experience
  • It increases competition in the financial
    management of companies, forces managements to
    adopt more efficient financial practices, and
    frees up capital to be reinvested elsewhere in
    the economy
  • It makes management more directly accountable to
    owners than widespread public stock ownership
  • Barbarians at the Gates. Vultures that raid
    the treasury of good companies, remove capital
    needed for investment in long-term growth, and
    leave the company laden with excessive debt,
    unacceptable financial risk and little ability to
    invest for expansion.
  • It is financial manipulation that bypasses
    regulation, avoids taxes and public scrutiny and
    needs to be brought in line with other forms of
    financial regulation.

6
Research on PEO Experience
  • Some evidence of companies doing well thereafter
  • Some evidence of companies doing poorly
  • Almost universal evidence that financial gains in
    fees and capital payments have provided
    outstanding returns
  • The transactions costs of making the changes in
    financial structure are high. Do these represent
    the efficiency of unlocked capital or the
    inefficiency of unnecessary costs associated with
    the transfer of capital out of companies?

7
Characteristics of Good Target Companies?
  • Highly inefficient financing structures
  • Generate a large and stable cash flow
  • Compliant management and board
  • Significant monopoly power in their industry

8
The Dilemma for Management of Takeover Targets
  • Resistance invites PEO criticism and loss of job
    if hostile takeover is successful
  • Co-operation offers rewards far exceeding normal
    pay
  • Perverse incentive is created for management and
    its financial advisors to establish an
    inefficient financing structure to invite PEO
    takeover and greater rewards them

9
TDC as a Takeover Target
  • Significant monopoly power over telecom and cable
    facilities and most services
  • Controls public resources as highly undervalued
    assets rights of way, spectrum, telephone
    numbers
  • Generates exceptionally large, stable cash flow
  • Compliant management and board
  • Highly inefficient financing structure????

10
TDCs Financing Structure
  • According to TDC annual reports, its financial
    advisors and auditors, it has had an optimal
    financing structure
  • The Annual Report for 2005 describes how TDC uses
    the latest techniques and expert advice in
    carefully managing all elements of financial risk
    and costs

11
The Financing Structure Contradiction
  • TDCs financial structure before the takeover
    (about 1/3 debt), and after the takeover (more
    than 3/4 debt) cannot both be optimal
  • Either the old structure was extremely
    inefficient, or the new one imposes unacceptable
    risks and constraints on future growth.
  • How can TDC management and its financial advisors
    support both scenarios?

12
Evidence on Efficiency of TDC Financing
Structure
  • TDCs capital structure is comparable to many
    other European incumbent telecom operators
  • When some European incumbent telcos acquired debt
    mountains with their 3G spectrum bids, investment
    rates were reduced significantly until they could
    reduce interest obligations, improve their
    credit ratings and reduce their interest rates
  • TDCs credit ratings have been down-graded
    several times since the takeover.
  • Evidence suggests that the old capital structure
    is closer to an optimal financing structure for
    TDC than the new one imposed by the PEO

13
Infrastructure Operators as PEO Targets
  • Good cash generators from large long-term
    investments in network assets
  • Stable client base and significant monopoly power
  • Undervalued public resources
  • Lower business risk than general industry
  • Conservatively managed
  • Subject to special sector regulation and public
    policy direction, but not usually on financing
    policy
  • Public responsibilities can be avoided in the
    short-run
  • Negative effects of reduced investment in
    infrastructure unlikely to have significant
    effect on earnings and cash flow in the short run

14
Assessing TDC as Infrastructure Operator under
PEO Management
  • The differences between the short-run financial
    interest of the PEO (divestment) and the Danish
    public interest in continued long-term investment
    in an upgraded broadband infrastructure for the
    future Danish economy are far greater than for
    general industry, and are likely to have far
    greater repercussions
  • One cannot pretend that a major divestment of
    capital and adoption of a debt mountain wont
    have a negative impact on the both financing
    costs and future investment possibilities of TDC

15
TDC and Public Interest Regulation
  • As TDC and other major infrastructure operators
    represent a special class of industry, long ago
    called business affected with a public
    interest, PEO takeovers should be subject to
    public interest monitoring, in the same manner as
    key infrastructure operators have been in the
    past, and in some countries still are, by
    infrastructure regulatory authorities.

16
Recommendations for TDC Public Interest
Regulation
  • Transparency is essential for businesses affected
    with a public interest. The reporting and
    accountability requirements of public
    infrastructure operators should be imposed.
    These derive from the public interest of the
    activity, not the ownership structure.
  • Non-arms length transactions involving
    significant amounts should be approved as
    reasonable by the appropriate financial or
    telecom regulatory authority
  • ITST (telecom regulator) powers over TDC should
    be strengthened to require monitoring and
    reporting of infrastructure investment and
    services development in the sector, and direct
    regulation over prices and quality of services
    where TDC has significant market power under the
    new European Regulatory Framework.
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