Yesterday’s blog talked about finding partners for telecom ventures. Today I want to talk about a specific kind financing. Commercial companies have often complained that municipal telecom ventures get an advantage because they can borrow with bonds instead of normal commercial loans. And this makes me laugh because having worked with a lot of ventures financed in both ways I can’t see any particular advantages to bonds over commercial loans.
It has always been generally assumed that because bonds normally carry a lower interest rate that they are a far better deal than a bank loan. But let’s look at the realities of bonds used for telecom projects:
- Bonds do generally have lower interest rates. But looking back over the history of commercial versus bond financing, the spread between the two interest rates in has usually not been very big. Certainly when we hit market conditions where there is a big benefit for tax-free bond interest rates then bonds can be a really great deal, but this has generally not been the case.
- Bonds require that you borrow all of the money up front, meaning that everything you borrow goes into escrow and you begin paying interest on the money from the day you close on the bond. Commercial loans generally start projects with construction financing, meaning that you only take the cash as needed by construction and only pay interest on the money that has been borrowed.
- It generally takes around three years for a new telecom venture to get a positive margin, and so a normal aspect of bonds financed for this purpose is capitalized interest. This means that the borrowing must include the funds required to make the interest payments, and often principle too, for the first three years of the project.
- Many bonds have required the borrower to have a debt service reserve fund. This is essentially self-insurance to hedge against a default and normally this would mean doing something like borrowing an extra amount of money equal to a year’s principle and interest and keeping it in escrow against a time when there might be a full or partial default on bond repayment. And this money accrues interest expense for the entire term of the bond.
- Depending upon the bond credit rate of the borrower, some bonds also require bond insurance. This is similar to the debt service reserve fund and has the borrower taking out an insurance policy that will guarantee one year’s payment on the bond in case of default. These policies are paid in full upfront at the beginning of the bond. I have seen bond issues that have both a debt service reserve fund and bond insurance.
- Bonds have longer terms. It is not unusual for bonds to have terms of at least twenty years and I have seen bonds as long as thirty years. This is a mixed blessing. While having a longer term lowers the payments a little each year, the new business is saddled with debt for decades. In the long run this keeps the pressure on a bond-funded venture to always perform to a pretty high level. However, once any business is debt free they can perform at a lower level and still be quite successful without having to cover debt payments.
- There are significant fees to be paid up front to sell bonds. There are bond sellers who specialize in finding buyers for bonds, but they charge a significant fee up front. The legal expenses requires to issue bonds are generally also much higher than the costs needed to borrow commercial debt.
- When taken as a whole, these various items add costs to a bond issue and it’s not unusual to see the size of a bond issue be 20% to 25% higher than an equivalent commercial loan. That extra borrowing generally more than offsets the savings from interest rates and in reality I think that bond financing is generally more expensive than commercial financing.
Because of this there is a big opportunity for public private financing. If a venture can get funds from both sources through a public private partnerships then you can benefit by the best of both worlds. Consider, for instance a financing that is 1/3 bonds and 2/3 commercial. It would have the following advantages:
- The bond money could act as equity and mean that no other equity is required for the project.
- The smaller bond size means relatively small capitalized interest and other bond costs.
- Some of the project is spread long-term with the bulk being medium-term, making it easier to make debt payments in the early years.
- The bond can be used to cover the early debt payments on the commercial loan, eliminating the need for capitalized interest.
- Construction can be done using normal construction debt financing.
I recently looked at a structure like this for a client and this public private financing looked to be superior to both normal bond and normal commercial financing. So there is a strong financial incentive for telecom partnerships between commercial and public entities.
In my next blog I will talk about what it takes to be good partners. It’s not always easy.