TDC’s Uncertain Future Under New Owners

1. TDC’s 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. TDC’s 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 • TDC’s 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 • TDC’s 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 • TDC’s 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 won’t 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-arm’s 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.