Australia Japan Cable: Structuring the company

Presented By: Prateek Daglia Harish Daryani Anagha Deshpande Varun Doshi Nishith Gandhi Sourav Guha Roy 15 17 18 19 21 24

Presentation Flow
y Potential Problems y Structural Attributes y Why structure matters? y Governance Framework y Organizational Structure y Ownership and Capital Structure y Organizational Design y Management Compensation y Conclusion

Potential problems for capital providers

y Prioritization of the problems
y Market Risk y Demand Risk Volatility in Capacity demand (Unused Capacity or Excess Demand) y Price Volatility 25% decline in prices every year y Mitigation strategy y Pre sales capacity contracts y Collapsed Ring Configuration (Lowering of costs) y Hedging Strategy (Forward contracts) y Technological Risk Introduction of newer technologies y Mitigation Strategy y Co-opetition y Quick launch and up gradation of existing technology

Other Significant Risks

y Sovereign Risk Country wide relationships may get hampered y Operational Risk
y Cable failures due to shipping, dredging and fishing activities y Landing Stations Permission from govt. to build new stations y Mitigation Strategy
y y

High Expertise Level Shared Ownership with companies having stations

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

Prior submission of Environmental Impact Report to respective governments

Structural Attributes
y Organizational Structure
Special Purpose Vehicle Legally independent

y Capital Structure
Debt to capitalization ratio

y Ownership Structure
Number of owners Share allocations

y Board Structure
Composition Size

y Contractual Structure
Contracts with suppliers of inputs and buyers of output

Why structure matters ? (1)

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

Solution
1. Capital Structure - Reduces free cash flow through high debt service. 2. Ownership Structure - Concentrated ownership for critical monitoring. 3. Extensive contracting - Cash-flow waterfall. Capex., maintenance expenditures, debt service, shareholder distributions agreed in advance. 4. Board structure - Mainly comprise of directors from sponsoring firms, gives them the ability to hire and fire senior managers and approve important operating decisions. 5. Governance system - For project assets rather than traditional systems designed to manage portfolio of assets.

Why structure matters ? (2)

Agency Conflicts Contd
Problem
Conflicts between ownership and management (Contd)

Solution
6. Separate legal incorporation Reduces the cost of monitoring. Instead of monitoring cash flow from numerous assets the capital providers monitor relatively simple cash flow streams from single asset.

Conflicts between ownership and related parties (opportunistic behavior) Related parties include suppliers, buyers , governments.

1. Joint ownership structures and long term contracts - To reduce opportunistic behavior by suppliers of critical inputs or buyers of primary outputs. Eg: Partnering with sponsors who owned landing stations was important in AJCs case to mitigate hold-up by landing station owners.

Why structure matters ? (3)

Agency Conflicts Contd
Problem
Conflicts between ownership and related parties (Contd)

Solution
2. Separate legal incorporation Expropriation and other forms of sovereign interference would be highly visible to the outside world. 3. Capital Structure - High leverage discourages expropriation. Even small acts of creeping expropriation will cause highly leveraged project company to default. In corporate finance expropriation can occur without default because multiple corporate assets and cash flows cross-collateralize each debt obligation. 4. Financial Structure (multi-lateral lenders) - Having international lenders like IFC,World Bank who lend to project companies and not corporations act as a deterrent against expropriation.

Why structure matters ? (4)

Agency Conflicts Contd
Problem

Solution

Conflicts between debt holders and 1. Capital Structure - Sponsors benefit equity holders from high leverage as it reduces managerial Related to distribution and re-investment of discretion over cash flow cash flow , and restructuring during Note: High leverage may lead to distress underinvestment problem but with very few growth options available in such projects problem of underinvestment due to leverage is negligible. 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. 3. Financial structure - Few classes of debt is employed as compared to corporate finance which is easier to restructure.

Why structure matters ? (5)

Underinvestment problem
Problem
Leverage-induced underinvestment (Debt overhang problem) Leveraged sponsoring firm has trouble in financing attractive investment opportunities

Solution
1. Non recourse debt - Eliminates recourse back to the sponsoring firm and preserves corporate debt capacity. Helps leveraged sponsors avoid the opportunity cost of underinvestment.

Underinvestment due to distress costs (Risk management motivation) Failing project can cause an otherwise healthy firm to fail (Risk contamination). Managers may not invest in risky positive NPV projects financed through corporate debt due to increased distress costs (Underinvestment problem)

1. Separately incorporated project company and nonrecourse debt Reduces risk contamination. Sponsors are able to share project risks with other related parties. 2. Capital structure -Sponsors are exposed to losses only as large as their equity commitments (which are a small fraction of total project cost due to high leverage)

Governance Framework
y Constitution y Shareholder agreement y Board Charter y Appointment of Board y Appointment of Chief and Senior Executives y Remuneration for Board and Senior Executives y Organizational Design y Leadership and Management Structure y Policies y Project Management y SPV Exit

Shareholder Agreement
y Scope and objective of the AJC y Capital Structure y Ownership Structure y Management and Board of Directors y Broad Principles for deriving Fair Market Value of Equity

Shares

Australia Japan Cable

Capital Structure
Total Capital required: $567 million
y Debt : 85% ($482 million) y Equity : 15% ($ 85 million)

Securities for the lenders:

Pre sales contract : 59% of the total capital Market Sales : 26 % of the total capital

Reason for high leverage y Agency Cost motivation: Discourage costly agency conflicts among participants y Forces project managers to disgorge free cash flow y Discourages expropriation y Lowers reported profitability

Debt-to-Total Capitalization Ratios: Project Companies vs. Corporations

Ownership Structure(1)
Criteria Telstra Japan Teleglo Telecom be Japan Y(1) Canada N AT&T NTT MCI World Com United States N

Country Landing Station on AJC Route Debt rating

Australia Y(2)

United States Y(2)

Japan Y(3)

AA+

AA

BBB+

AA-

AA+

A-

Ownership Structure(2)
Strategic Partners/Sponsors y Telstra: 40% of the total equity(Lead sponsor) y AT&T:30% y Japan Telecom:20% y Teleglobe:10%
10
Telstra

20

40
AT&T Japan Telecom

30

Teleglobe

Board Structure(Size of 9)*

y Telstra - 2 directors y AT&T - 1 director y Japan telecom - 1 director y Teleglobe - 1 director y Lending Institution - 1 director y Independent Directors - 3
*The research conducted by Benjamin Esty shows that the median size of board of project companies of the similar project size is 9.

Comparative study of size of Board of Directors

Organization Design
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

Roles and Responsibilities (1)

Role
Board of Directors

Responsibility
Approving pricing decisions Capacity expansion Selection of senior management Project execution Corporate governance Human resources Coordinating with bankers Financial dealing Production of financial and management reports Liaising with external auditors Managing accounts payable and receivable and general ledger

Chief Executive Officer Head of Administration Chief Financial Officer Finance Manager

Roles and Responsibilities (2)

Role
Technical Services Executive Manager

Responsibility
Specifying, procuring and testing network aspects Product development of transmission capabilities Risk Management Service Assurance Contact with Landing parties and Equipment vendors Maintenance in respective area Sales and marketing strategy Product management, development and pricing Brand direction, media and sponsorships

Operations Executive Manager

Regional Operations Manager Head of Sales and Marketing

Compensation
y Chief executive & Project managers

Flat pay-for-performance compensation schemes. yBase salary yPerformance bonus equal to a relatively small fraction (0-50%) of the executives base salary y Reason yNo high growth opportunities yInvolved with operational decision making rather than strategic yPrevent agency conflicts

Take Out Finance

y An arrangement with any financial institution for

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

Advantages of Take out finance

y Advantage To lender
y Helps banks in their asset liability management y The financing of infrastructure is long term in nature against

their short-term resources

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

y Advantage to taking over institution

y Economic and social development y Faster Infrastructure creation

What happened in reality

AJC Ltd (Bermuda) AJC Australia
10 10.1 15 15 10 39.9 MCI WorldCom Teleglobe Concert Global Networks Ltd. Japan Telecom NTT

AJC Japan

AJC Guam
Telstra

Ownership in AJC Ltd. (%)

Concert Global Networks Ltd Incorporated in Bermuda, owned by AT&T and British Telecom (50% each)

Conclusion
From the companys perspective y Structuring the project finance is a time consuming and costly affair. y The advantages such as high leverage, risk separation and single purpose motivate the company to go for it. From the lenders perspective y The only security for the lenders is the cash flows along with the project specific assets so they try to mitigate through the contractual agreements and look at the credibility of the sponsors.

References
y The Economic Motivations for Using Project Finance

Benjamin C. Esty y Project Financing: An Economic Overview Robert Bruner, Herwig Langohr and Anne Campbell y Why Study Large Projects? An Introduction to Research on Project Finance Benjamin C. Esty y www.ajcable.com

Thank You