Perspectives on the Financing of Submarine Cable Projects
As published in the March Issue of SubTel Forum Magazine
By Chris van Zinnicq Bergmann
March 29, 2022
This article will provide some perspectives on the financing of submarine cable projects. The first part will cover the broader picture, followed by some specific insights into the consortium and project financing. As this is a very broad subject with many different tangents, the following paragraphs can of course only scratch the surface here and there.
As is commonly known, the global generation and consumption of data and the resulting demand for evermore bandwidth is continuing with unabated force, driven by the ever increasing demand for online video content (at this point roughly two thirds of all traffic) and the growing share of cloud computing. As the primary mode of intercontinental connectivity, submarine cable systems carry an estimated 95-99% (depending on whom you ask…) of all data traffic between the continents. In 2021, there were 428 active subsea cable systems connecting to 1,245 landing stations around the globe (source: TeleGeography).
The continuous construction of new systems will be crucial to support this trend in the coming decades. Over the past years, a significant number of investments in new submarine cable systems has taken place in connecting the continents of Africa, Europe and Asia, but many projects are also underway or planned in the Atlantic and Pacific Oceans. Investments are driven by the fact that broadband connections are becoming more affordable in an increasing number of developing markets, which in turn drives the demand for international and intercontinental connectivity. For the period up to 2024, more than $8bn has been earmarked for subsea cable investment. Also, the situation that a lot of systems which were built around the turn of the century are reaching the end of their economic and design lives is a contributing factor.
In many respects, the development of a submarine cable system can be compared to the development of any large scale infrastructure project. However, as an intercontinental system will cover thousands of kilometers and can touch multiple jurisdictions, the implementation process has a number of distinguishing characteristics which have significant commercial and legal consequences. This is certainly applicable to financing the development and construction of such systems and as such there is not really a blueprint for how to successfully accomplish this. Each individual project will have its own characteristics, driven on the one hand by the geographical landing points which the system will touch and on the other hand by the markets in which the financing is to be raised. From a perspective of return on investment and tax minimization, debt financing (at a sustainable level) can play an important role. The ability to access commercial bank loans or the corporate bond market will be determined to large extent by the creditworthiness of the borrower. Also, the ownership structure of the ownership of the system will of course have a major impact on the way it is being financed. The variety of structures range from the traditional consortium approach to the joint build model (with individual fiber pair ownership enabled by the open cable model) and single private ownership.
One conclusion that can be drawn in general is that over the past two decades the financing of submarine cable systems has become significantly more disciplined as a consequence of the “dotcom” crash in the early 2000s, when a lot of speculative projects that had been launched prior to the bursting of the bubble were forced through restructuring and bankruptcy proceedings. Following the crash and prior to the big content providers/hyperscalers coming to the scene around 2010, the commercial banking sector had become much more risk averse, and the traditional equity and debt capital markets were more or less closed for the financing of new systems. In the past decade, this picture has changed substantially for the better. Quantitative easing by central banks and their low interest policies have created a lot of liquidity in search of returns and digital infrastructure in the broadest sense has been a focal point for investment, particularly also by the private equity sector.
As mentioned above, the dynamics in the subsea cable industry have also been changed profoundly by the appearance of the large content providers. According to TeleGeography, the content provider share in the traffic profile has surged from 10% prior to 2012 to 66% in 2020. As they overtook the traditional operators as the largest consumers of international bandwidth, these players have become direct investors in new submarine cable systems, either through the consortium approach but increasingly also through single or limited multi-party ownership. Google, Facebook, Microsoft and Amazon are usually listed as the main actors, whereby it should be noted that Google and Facebook have been more active than the latter two (for example Google at this point has invested in at least 15 systems globally).
Multilateral institutions (such as for example the World Bank and its affiliates, the Asia Development Bank and the European Investment Bank (EIB)) also play a role in financing new projects, particularly in situations where the business case for a new system may be challenging but it will provide connectivity to remote and not densely populated regions (see for example various projects connecting island territories in the Pacific). However, to get access to financing by these institutions can be very time consuming and as such cause considerable delays in the launch of a project.
A recent development triggered by the Covid-19 pandemic has been the launch of large governmental economic stimulation funds, such as the European Union’s €720bn Recovery and Resilience Facility (RRF) or the recent infrastructure bill in the U.S. which will put $550bn in new funds into transportation, broadband and utilities. The U.S. funds will probably remain mostly out of reach for new submarine cable projects (the focus appears to be on expanding terrestrial broadband connectivity in underserved regions). The EU fund will be distributed through individual governments, which may make domestic subsea cable projects eligible for subsidies (provided that they meet the criteria as set by the national governments and the European Commission). Even a system connecting two or more countries in the EU might qualify but would require tight co-ordination of the application processes in the relevant countries. The coming months and years should show whether this manner of funding can play any role in the development of new projects.
Of course, it will have to be seen how the current political and economic developments impact the subsea cable sector. Increasingly (and worryingly as demonstrated by the current conflict between Ukraine and Russia and the tensions between the United States and China), geopolitical developments can now be an important factor in the risk assessment of new projects. However, it is probably not a controversial bet to conclude that the macro trends described earlier will remain on their projected growth paths for the longer term.
Some aspects of the consortium model…
For a long period, the dominant approach to successfully launching an intercontinental submarine system has been the consortium model (and this model was in fact the only option before deregulation and liberalization started in the telecommunications industry) as the sharing of the risks and costs among a number of participants made it attractive to telecommunications operators. Each participant invests in the project as a co-owner and receives an allocation of capacity on the system in proportion to its equity interest.
In some consortia, each member provides its own financing, whether from its own balance sheet, an equity raise or from corporate debt. In other cases, the financing is at the level of the joint venture company, the SPV. Debt financing for a consortium project could be provided to the SPV with recourse to the members of the consortium. In such an approach, differences in creditworthiness of the members become important because lenders to a project will be concerned how to hold each member liable (either jointly or severally for the full amount or just severally liable for a specific member’s proportional share of the debt).
…and some on project financing
When it comes to a system being funded through project financing, one particular characteristic of a submarine cable project is the fact that it usually shows a cashflow pattern in which a large part of the total cashflow is generated immediately or soon after the RFS date of the system. Typically, the capacity on the system is sold as an IRU and the fees are paid as a lump sum when the capacity becomes available (a portion may even be paid as a down payment upon contract execution between the customer and the system owner). For the duration of the IRU term (usually 10, 15 or 20 years), the customer will then pay the system owner an annual amount for “Operations & Maintenance”, but this fee is typically equal to 2.5-4% of the IRU fee.
Using project financing with a long term tenor, such a cashflow structure creates interesting issues for system owners and lenders to consider, as the majority of the (cash) revenue is generated at the outset of the project’s operational period. Naturally, the system owner(s) would like to see such revenue to be distributed (to the extent it is not required for short term debt service or operating expenses), but on the other hand – as the debt is to be repaid over a longer period of time – lenders will consider the system’s ability to generate future revenues to repay the debt, also in the light of projected price erosion in the particular market in which the system operates. Standard project finance ratios such as DSCR (Debt Service Coverage Ratio) and LLCR (Loan Life Coverage Ratio) are difficult to apply to front loaded revenue models. Senior debt prepayments linked to shareholder distributions and locked cash reserves being included in financial ratios can be a way to mitigate the project financing risks in this particular context. Of course, refinancing the debt once the system is operational can be another option to improve the financing structure in line with changes in the risk profile of a project. This can enable the system owner to replace a more restrictive and costly initial debt instrument which may have been critical to get the project launched but may no longer be necessary once the system has become operational (as the ability to generate revenue has become more certain).
Project finance lenders will often require that the planned system has at least one anchor tenant signed up, preferably with a strong credit rating. This will give the lenders some comfort that a certain amount of the system capacity (nowadays often at fiber pair or spectrum level) will have been pre-sold at the time of the initial debt and/or equity funding. On the other hand, a system owner may have an interest in more limited pre-sales of capacity as capacity sold after the RFS date usually avoids the discounts required for anchor tenants to sign up in the early stages of a project. The right balance of course also depends very much on the competitiveness of the market in which the system will operate.
Project risk on any specific new submarine cable system is still not insignificant in view of the increasingly stringent environmental, permitting and other regulatory requirements. Also, constraints on the supplier side – such as the availability of cable-laying ships – can be a challenge with the current cycle of high investment in new projects.
Submarine cable systems come in many flavors in terms of ownership and financing structures. The good news is that in the coming years the outlook for the subsea cable industry as a whole seems to remain positive. However, each individual project will have its own set of challenges when it comes to successfully funding it. But as the saying goes: “if it was easy, everyone would do it.”
Chris van Zinnicq Bergmann is Investment Development Manager for WFN Strategies and has been in the submarine cable sector for over twenty years, working in Europe, the U.S., and Asia for Global Crossing, Pacnet and Global Cloud Xchange. Since 2020, he is an independent consultant in Amsterdam, The Netherlands, and is involved in the financial and commercial development of new subsea cable projects.