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Private equity plans thwarted in German cable

Market players have been discussing the need for consolidation in Germany’s cable industry for years, but antitrust issues have, so far, thwarted attempts to do so. Three years ago US-based Liberty Media’s cable acquisition plans were frustrated by antitrust concerns and more recently Kabel Deutschland GmbH (KDG) has been forced to withdraw its bid to acquire three German cable operators due to regulatory obstacles. Carol Dean reports.

Many consider the situation to be unsatisfactory, none more so than the various private equity firms that own cable operators in the country and who have been looking for ways of expanding their businesses through mergers and acquisitions or have been seeking possible exit routes.

The case for consolidation in German cable is considered to be a strong one given that the market is divided into Level 3 and Level 4 operators, a situation unique to Germany. Level 3 operators control the fibre and content and have around 30% to 50% access to the consumer market, while Level 4 operators take the cable to the consumer.

“There’s an understanding among many players that the distribution between Level 3 and 4 doesn’t make sense,” says Nico Hansen, principal and investment manager at Apax Partners who holds a seat on the board of KDG. However, private equity firms are attracted to investing in cable companies because of their stable cash flow.

Frank Herzog, director at NM Rothschild who works in media and cable adds: “The German market is highly fragmented with over 5,000 Level 4 operators in the country providing an unsustainable business regime.” It is on this level that consolidation is considered to be imperative although German politicians have commented in the past that vertical integration, between Level 3 and 4, is also required.

Against this backdrop, KDG sought to expand through the acquisition of three Level 3 operators, a move that many believed would gain regulatory approval since it would provide some cohesion to the marketplace.

KDG makes a bid for expansion

KDG, owned by three private equity firms, Apax Partners, Providence Equity Partners and Goldman Sachs Capital Partners, was formed in 2003 when the firms acquired six of Germany’s regional cable networks from Deutsche Telekom for €2.1bn. With cable valuations plummeting over the last few years, the timing seemed ripe for the Apax/Providence/Goldman partnership to buy up cable assets in Germany at an attractive price.

In April this year, KDG reached an agreement to acquire three cable companies for an aggregate price of €2.7bn. These included ish, based in North Rhine-Westphalia owned by its lender/investors; Kabel-Wurttemberg (KBW) controlled by Blackstone; and cable firm iesy based in Hesse and owned by Apollo and Blackstone.

Deutsche Bank and Goldman Sachs acted as advisers to KDG on the acquisition of ish and also advised on the takeover negotiations with KBW and iesy.

The takeover would boost KDG’s subscriber base from 10 million households to 17 million, representing the largest subscriber base in Europe. Ironically, the merger would re-unite the nine cable operations that were previously owned by Deutsche Telekom before the incumbent was forced to divest the businesses in order to reduce debt and comply with EU and local regulatory directives.

KDG was betting that the takeovers would attract content providers wanting to use the extensive network as a platform on which to distribute their products. Furthermore, the acquisitions would provide a platform on which to roll out digital cable TV and new multimedia products already available elsewhere in Europe in countries such as UK, France, Italy and Spain. German consumers currently have access to 35 channels through the analogue system but with digital, consumers could access 500.

Interestingly, of the three cable companies to be acquired, ish had already been put up for sale in 2003 by its 30 lending banks that had become the new owners of the business through a debt-for-equity swap. Callahan’s London-based Cable Partners acquired ish from Deutsche Telekom for around €2bn in 2000 in a highly leveraged deal. The company was unable to service the debt and the banks took control of the company for a mere €275m in cash and through swapping €900m of debt for equity. The banks subsequently put the company on the market hoping to recoup some of their exposure to ish.

ish provides services to around four million households in the North Rhine-Westphalia region, Germany’s most populous state and the country’s industrial heartland. iesy and KBW serve customers in the states of Hesse, where the financial capital Frankfurt is located, and the Baden-Wuerttemberg region in the south west. KDG provides cable services to the remaining 13 federal states in the country. ish has a customer base of four million households, while iesy and KBW have 1.3 million and 2.3 million respectively.

Debt syndication: a protracted affair

Once the agreement to acquire the three cable companies was reached, it only remained for financing to be put in place and for regulatory approval to be sought from the Federal Cartel office (FCO).

The financing comprised a €2.6bn senior debt facility divided into a €1.25bn seven-year tranche A paying 225bp over Euribor, a €625m eight-year tranche B paying 287.5bp over Euribor, a €625m nine-year tranche C at 350bp over Euribor. The financing also included a €100m revolving loan paying 225bp over Euribor.

In addition, there was a €1.575bn bridge loan bearing a margin of 520bp over Euribor which was to be taken out by a two stage high yield issue with the first launched in May and the second contingent on regulatory approval.

While the senior debt was underwritten by the company’s two advisers, Deutsche Bank and Goldman Sachs together with Citigroup and Morgan Stanley, syndication became a somewhat protracted affair.

The first deadline for the receipt of sub-underwriting commitments to the €2.6bn senior bank facility came and went on April 30 having generated little enthusiasm among lending banks although the tranches had been priced higher than the norm to attract lenders into the deal.

Concerns surrounded whether KDG would in fact be given regulatory approval for the takeover of the three rival cable companies that would create a larger more unified cable business. If regulatory approval was not given, then the lending banks had to seek credit approval for the company in its present form.

One senior loans banker commented: “The M&A story was more compelling than merely lending to yet another cable company. Part of the funds (up to €475m) were earmarked for a dividend payment and if the deal fell through it felt as if we were funding a cash payment to the sponsors.”

The senior debt facility included a mechanism that would require banks to lend only 55% of the €2.6bn senior debt should regulatory approval be denied. Investors that bought into the first €750m issue of high yield could also put the bonds at par that would be financed by the bridge loan. Under the terms of the financing, the mandated lead arrangers Citigroup, Deutsche Bank, Goldman Sachs and Morgan Stanley would be required to launch a tender to buy back the €750m worth of high yield bonds issued in the first tranche.

Nevertheless, the mandated lead arrangers had their work cut out talking to banks individually to encourage them into the deal. Even then, many committed to the facilities only after including one or two of their own conditions to the facility.

Antitrust issues prevail

As the summer progressed there was a growing sense of unease at KDG, and the various parties advising on the takeover bid, as to whether the Cartel’s office would approve the acquisitions. It became clear that the cartel office opposed the takeover saying that it would eliminate competition in Germany’s cable TV market that was previously dominated by former monopoly, Deutsche Telekom.

At the outset, KDG is said to have indicated that it was not looking to invest in Internet but changed tack to appease the regulator. Many believe that KDG subsequently lost credibility by proposing that it would invest €1.8bn over the next 10 years, the majority of which was to be spent on upgrading its network to make it suitable for high speed Internet services such as broadband, generating more competition to Deutsche Telekom.

“We included plans to provide broadband to 50% of all subscribers in three years and to 80% in the next seven to eight years,” says Hansen.

However, the Cartel office was not appeased by this proposal and remained opposed to the takeover, citing concerns that the move could result in two dominant players in the market, KDG and Deutsche Telekom.

Furthermore, the Cartel office president Ulf Boege stated at the time: “There is a suspicion that a restriction exists (in KDG’s sales contracts) that cable providers must not compete in high-speed Internet access with Deutsche Telekom.” The cartel was in fact in the process of investigating Deutsche Telekom and KDG on suspicion that they had sought to distort competition in the area of high-speed Internet.

The FCO was due to announce its final decision on the takeover on October 7, however, at the end of September KDG withdrew its bid to acquire the three cable companies as it became clear that KDG would fail to get the necessary regulatory approval. Those close to the deal suggested a strong hint had been made that the FCO had made up its mind against the deal despite the fact there had been strong hand waiving in the first two months that the cartel was looking at it optimistically, said Hansen.

The Cartel office’s president Ulf Boge, while welcoming KDG’s withdrawal from the acquisition process, said: “Technical progress in the cable network so far has been powered largely by smaller cable companies. Creating a cable monopoly would likely slow this development.”

However, many believe that the Cartel office’s argument that competition would be hampered by the takeover in relation to Internet/broadband access was a smokescreen.

“The FCO wasn’t clear on the signals it gave the market or what it wanted from KDG,” said Herzog of Rothschild.

There was also concern that the merger of four cable companies would create one network, instead of four, over which the TV companies would have to pay for the distribution of their signal.

“The FCO formed an opinion that the rights of the broadcasters should be protected,” said Hansen, referring to the likes of RTL owned by the Bertelsman Group, and ProSieben which lobbied against the takeover. “The broadcasting landscape was becoming too heterogeneous for the existing broadcasting giants,” he added.

“The FCO is using similar arguments to those used with Liberty two years ago,” he said. At the end of 2001, US-based Liberty Media agreed to acquire six cable companies from Deutsche Telekom for €5.5bn after weeks of protracted negotiations. As with KDG, the Cartel office wanted Liberty to offer telephone and broadband Internet services thus increasing competition in these markets to offset the fact that Liberty would control both transmission and content. However, Liberty refused to make these concessions and the deal fell through.

But after all the discussions and negotiations, it still remains unclear exactly what the Cartel office wants. “The industry requires change,” says Ellen Braun, partner and competition specialist at law firm Allen & Overy. “The financing model for the cable companies won’t survive as it is. The FCO is now thinking about horizontal integration, but they will have to allow for vertical integration as well.”

The shape of things to come

Meanwhile, KDG is moving forward with its business plan. “Their (the FCO) decision not to approve the takeover has held the country back by three years,” says Hansen. KDG is keen to digitalise the system via which consumers will be able to access 500 channels. The company plans to invest €500m in equipment and new services over the next three years to advance digital broadband cable services in Germany to be financed partly through advertising revenue.

“We are now planning more innovative products from KDG,” says Hansen. “We are in the midst of strategic planning.”

The company has two key areas of development. The first comprises the launch of digital and pay TV that is hoped will reach 250,000 subscribers by the year-end, and the second involves the introduction of Internet/broadband via its cable network. With regards to the latter, five or six pilot schemes are currently underway and the detail of the strategy is currently in planning phase.

“KDG will focus on launching its new products and developing its business plan,” says Hansen. “There’s no answer as to where the German cable business is going,” he adds indicating that the cartel office’s opposition to KDG’s acquisition of the three cable companies has significantly held up business development in the country.

Meanwhile, rumours are rife concerning the future of ish, iesy and KBW. With regards to ish, one cable financier commented that the banks that hold a stake in the company are looking for an exit through a trade sale, or a recapitalisation of the business. Interestingly, hedge funds are said to own a sizeable shareholding in ish from buying up the debt in the secondary market and are unlikely to be long term holders of the debt.

The recapitalisation of ish would involve the banks lending additional funds to the company that would then be passed on to the owners (lenders) in a dividend payment. ish’s leverage is around 2.5x which could accommodate an increase in debt. The cable company currently has around €700m worth of debt on its books. Banks have written off loans to ish in the past and the dividend payment would enable them to claw back some money from ish, while retaining their equity.

Citigroup has also been retained to review the various financial options open to ish’s owners following the collapse of KDG’s takeover bid. A shareholders’ meeting has been slated for later in November to discuss the various options.

Citigroup had the original mandate for the sale of ish and is believed to be advising on another sale process. Sources say that private equity firms have been invited to make a bid for the cable firm and new private equity entrants to the German cable sector are rumoured to be showing an interest in ish that is likely to be valued around the €1.5bn mark.

“The market is getting more comfortable with German cable. A new entrant would not have to deal with antitrust issues so a deal would be easier to do,” says Herzog at NM Rothschild. A number of private equity firms are said to be circling all three of the cable companies.

Meanwhile, iesy and KBW are viewed as fairly close to each other. “There may be more co-operation on products between the cable companies,” suggests Hansen. Others suggest iesy and KBW may pursue merger plans in the future. The possibility of co-operation agreements between these two firms and ish have not been ruled out.

Furthermore, sources say Apollo, which controls iesy alongside Blackstone, could move to acquire KBW since Apollo recently made a bid for rival cable company PrimaCom which failed to reach a successful conclusion. However, by making the bid Apollo has confirmed its interest in German cable.