Digital infrastructure: Lender considerations on fibre roll-out financings

Lender considerations on fibre roll-out financings

Over recent years there has been a growing focus from infrastructure funds and other investors on digital infrastructure as a distinct asset class, which has in turn lead banks and other financial institutions to follow suit. Initially, this was primarily related to towers, but over recent years we have seen a broader application to fibre/broadband investments, data centres and other digital infrastructure opportunities (such as cable and satellite).

With the impact of Covid-19 combined with a growing governmental focus on improving connectivity, this is expected to accelerate. Digital assets will become increasingly important in order to support the growth of smart, sustainable cities; the shift towards remote working; increased connectivity; and the digitisation of company operations such as supply chains.

As part of this series of guides, we set out below some key considerations for financing fibre/broadband investments based on our extensive global experience advising infrastructure investors, developers and lenders on such matters, including CityFibre, Community Fibre and Airband in the UK, PT MNC Kabel Mediacom in Indonesia, Bahrain Bay development in the Middle East, Texan City fibre roll-out in the US and the Australian Government and National Broadband Network Company in Australia

Facility structure

Developers and operators require loan facilities to fund expansions and maintenance of their fibre network, as well as working capital needs. A typical loan structure is a primary term loan facility for capex development together with a supporting working capital facility. The working capital facility may be required for general cash flow needs but may also have a particular use such as providing an element of bridge funding in anticipation of subsidy/grant payments from government. An uncommitted accordion is also typically included in order to establish a framework for additional debt capacity.

Maturities vary depending on the underlying business model, but it is not unusual to see an availability phase of three to four years to fund development, with an overall debt maturity of five to seven years. Repayment is very often structured on the basis of a bullet repayment at maturity, with an element of a cash sweep post availability phase. Sweep structures vary but can be set at a fixed threshold or can ratchet up towards maturity - particularly so if flexibility for distributions is sought by the sponsors.

Sizing of the facilities is tied to the financial model and a gearing ratio, with gearing limitations typically requiring equity contributions of between 30 per cent and 45 per cent of the total spend, although more traditional gearing ratios can be distorted to a degree by an ability to include historic (equity or retained earnings funded) capital expenditure as part of the equity component. In this regard we have seen look back regimes for equity contribution but with a cut-off date beyond which no account can be taken of historic expenditure and in some cases an agreed hardcoded amount for historic expenditure so as to avoid any debate as to relevant sums and manipulation of covenants.

Security package

Security will typically include all assets of the borrower/operating company (including key contracts, insurances and account balances) and all shares of (and shareholder loans into) the borrower/operating company. In terms of shareholder security, it may be beneficial (for both lenders and sponsors) to introduce an intermediary holding company between the operating company and the sponsors so as to allow sponsors to trade their equity position (subject to typical change of control restrictions) without interference with the security package or a requirement for security accession mechanisms and other ancillary requirements, such as capacity opinions in relation to the incoming shareholders.

Borrower subsidiaries may also be expected to provide guarantees and security. Lenders will typically require an all assets security package across the borrower group. A primary operating entity may have subsidiary entities performing discrete aspects of the operations, and/or may acquire other corporate interests as part of expansion/diversification and market consolidation opportunities. Sponsors are naturally keen to avoid unduly onerous requirements of guarantee/security provision in relation to immaterial subsidiaries and as such it would be typical to see material company thresholds tied to overall contribution to the borrower group (in terms of EBIDTA, turnover and/or asset value) and a guarantor coverage threshold (typically entities contributing 80-90 per cent of borrower group EBITDA, turnover and/or asset value).

As sponsors will be keen to preserve flexibility for the borrower to make acquisitions and enter into joint ventures, it is important to recognise that the security will need to attach to material acquired assets, including assets of material subsidiaries and shares in those subsidiaries. Whilst some flexibility may be afforded, lenders may seek to impose limitations on a single asset operating company becoming too acquisitive, both in terms of nature of business, location and quantum of investment.

Financial covenants

Financing arrangements for fibre to the home (FTTH) roll-out will typically have two sets of financial covenants. One set will be applied as conditions to utilisation of the primary term loans and the other on a continuing maintenance basis with event of default consequences for breach. A third category may be introduced as distribution tests.

Conditions precedent

• In addition to gearing limitations, primary term loans will typically include conditions precedent to funding tied to penetration levels (homes connected measured against homes passed) and also monetary based KPI thresholds with values attributed to completed work including homes passed, homes connected and amount of fibre installed. It is important to carefully define concepts such as homes connected and homes passed and apply appropriate testing periods so as to ensure that the borrower is developing an effective and marketable network with an appropriate level of market risk, whilst ensuring that the borrower is able to access funding to develop its business plan. Considerations for lenders may also include the level of independent verification of reporting by the borrower – is borrower certification sufficient (following a leveraged finance model) or will lenders require verification by an independent technical adviser on the basis of a more project style financing?
• Homes passed is essentially a measure of physical deployment of the fibre (and establishing that a network is sufficiently close to a home in order to legitimately consider the homeowner as a potential customer), whereas homes connected is typically measured by reference to actual customer subscriptions (although sponsors may argue that a ready for service connection in cases where there is no existing competition or overbuild risk should count as a connected home). Definitions will be bespoke including variations for B2B, wholesale contracts and multiple dwelling units, and the specifics will be carefully tied to the technical elements of the business plan in terms of whether a home is passed or connected, including by reference to poles, cabinets, site lines and trenching requirements. Lenders will want to see not only that the business plan is being developed from a technical/physical perspective but also that the expected take-up of subscriptions is proportionate to the physical deployment of fibre and meets business plan expectations (with suitable degrees of tolerance) so as to assist with forecasting of the borrower’s ability to service the debt.
• Sponsors will typically seek to have significant headroom (and indeed we have seen examples of full grace periods in early ramp-up phase months) on the relevant conditions precedent by reference to the base case model, so as to avoid a scenario where a slow ramp up unduly fetters the ability to deploy the physical infrastructure in accordance with the business plan.

Maintenance covenants

• Maintenance covenants should only apply following the utilisation/availability phase, which is typically when the business can expect to become EBITDA positive. Since the lending terms typically cater for a bullet payment on maturity (perhaps with cash sweep in advance) an interest cover ratio and a leverage ratio can typically be found on loans in this sector. In addition, lenders may also seek to have more granular visibility on the operational and financial performance of the roll-out and include a continuing covenant linking debt to homes passed and/ or connections.
• Sponsors will endeavour to maximise their rights to cure breaches of maintenance covenants with equity injection, however lenders will seek to limit these rights to avoid a papering over of systemic problems in the business case and in this regard lenders should be wary of net debt tests (as are common on such financings) as any equity injection ahead of the calculation/testing date would then not count as a cure and not be subject to any limitations on such cures. There are also likely to be limitations on distribution rights in scenarios where an equity cure has been required to avoid breach of a maintenance covenant.

Operational covenants

The nature of the operational track record and level of maturity of the borrower’s business will dictate the extent to which lenders perceive the operational covenant package to require prescriptive project finance type controls or be better suited to a softer, more corporate lending based capex financing (or a hybrid between both ends of the spectrum). Some key issues include:

• Controls over accounts, and whether the borrower should have flexibility to operate accounts without interference or payment waterfalls (with security being on the basis of a floating charge type arrangement) or whether lenders require prescriptive controls including reserving for debt service or maintenance obligations.
• Controls over key contracts, including construction contracts, operational contracts and material revenue generating contracts. The nature of the contracting structure will impact lenders’ views in this regard - particularly if there are aggregated arrangements (such as a key wholesale revenue contract, or a framework operation agreement across the portfolio) which may influence lenders to categorise these arrangements as material contracts which will be subject to detailed due diligence and controls in the loan documentation (such as restrictions on amendments, waivers and terminations, default triggers for breach or termination and requirements for borrower to enforce its rights in relation to the same). In the case of a key anchor wholesale agreement, lenders may also consider a regime whereby credit events (e.g. insolvency proceedings) affecting the counterparty constitute an event of default, given the importance of the credit standing of such a counterparty to the sustainability of the borrower’s business case. In each case this will then prompt discussion regarding levels of materiality, cure periods and replacement rights amongst other flexibilities, with sponsors likely to push downside scenarios to distribution lock up events or cash sweep triggers rather than events of default.

• Ability of the borrower to manage disposal and insurance proceeds in the ordinary course of business without lender’s control or whether specific regimes will apply to require prepayment of proceeds unless lender-approved reinvestment plans are developed by the borrower. Flexibilities for the borrower might include a window of time to redeploy without controls, or a de-minimis level below which no prepayment/controls will be triggered, noting that any proceeds not applied in prepayment may need particular treatment for the purposes of financial covenants or gearing ratios.

Lenders may also seek to carry out due diligence and apply relevant controls and protections in relation to third party infrastructure, depending on the borrower’s reliance on the same. FTTH networks typically rely on third party infrastructure, such as poles and ducts (particularly if they are only providing ‘last mile’ connectivity) or other infrastructure such as electricity or sewer networks which may be used as routing conduits. Lenders will need to understand the adequacy of arrangements with relevant third parties in terms of tenor and access rights for maintenance, repair or upgrade of the fibre, cost implications, triggers/risks of termination by the third party, the impact should termination arise, and what alternatives or possible replacements exist. Lenders may seek to introduce information undertakings, covenants, events of default and prepayment events to deal with various scenarios.

Government subsidies

Government subsidies can be a material component of a FTTH operator’s business plan, including the voucher scheme run in the UK by Building Digital UK. The extent to which the borrower relies on such subsidies requires consideration, as do the terms and conditions of the relevant subsidies and consequences of failure to meet conditions. Lenders may seek to introduce notification or default triggers linked to breach, although operators will seek to argue that, provided financial covenants continue to be met, a more granular breach linked to a particular subsidy should not collapse the facility.

Lenders may also be sensitive to providing funding, particularly term loan funding, for amounts that are intended to be financed by subsidies. There may be a reluctance to bridge any funding gap pending subsidy receipts on a long-term basis, although a revolving working capital facility could be utilised to provide cash flow support to developers awaiting payments.

Foreign investment controls

The emergence and growth of controls in relation to foreign investment is pertinent in the context of fibre and other technology companies. Investors will need to be cognisant of restrictions in terms of planned exit strategy, but lenders should also be aware of these in the case of any enforcement of share or physical asset security.

Consistent with a global trend for more intervention in and scrutiny of national security issues, the UK Government published the National Security and Investment Bill on November 12, 2020 which seeks to introduce a wide ranging notification and government approval regime for foreign investment into sensitive asset classes (and not just limited to mergers and acquisitions but covering a much broader range of deals including minority investments and acquisitions of voting rights). Communications is listed as an asset class, thus capturing any public or private electronic communications network or service.

The retrospective call-in power afforded to the UK Government means that parties currently considering transactions in this sector should consider whether it is advisable for them to approach the UK Government, and indeed a UK Government email address has been set up for notification of such deals. Importantly, the UK Government’s ability to retrospectively call in a deal for review once the Bill comes into force will be limited to six months in the case of a notified transaction, instead of five years if the deal is not brought to the UK Government’s attention.

If a deal requiring mandatory notification is not approved, the transaction will be legally void, and in addition there are civil and criminal penalties for breach.

Final thoughts

The importance of fast and reliable fibre connectivity cannot be underestimated, and the Covid-19 pandemic has underlined the critical nature of this asset class. Globally, government targets in respect of FTTH are only likely to increase in light of Covid-19. Consumers working from home require more data and better coverage which, together with the rollout of 5G, Internet of Things and focus on smart cities requires wide scale availability of fibre connectivity.

Financings in this sector are certainly far from commoditised, however there are key themes and issues underpinning sponsor and lender considerations. An understanding of these issues and the various options, flexibilities and alternatives available is vital in order to arrive at an appropriate and balanced position that addresses both borrower and lender sensitivities.