Chris Hughes is a Bloomberg Gadfly columnist covering deals. He previously worked for Reuters Breakingviews, as well as the Financial Times and the Independent newspaper.

Leila Abboud is a Bloomberg Gadfly columnist covering technology. She previously worked for Reuters and the Wall Street Journal.

For years, bankers have salivated at the prospect of private equity firms mounting a mega-deal in the UK. mobile industry. O2 now provides that seeming opportunity.

The U.K.'s second-largest mobile operator by customers is set to become available after regulators last week blocked its purchase by Hong Kong-based CK Hutchison Holdings, operator of the U.K.'s upstart Three network. O2's owner, Madrid-based Telefonica, needs to sell all or part of O2 to bring down its borrowings. So it has to find a plan B.

Telefonica Dragged Down
Spanish telco's shares drifted amid concern its disposal of U.K. phone unit O2 would founder
Source: Bloomberg

Private equity firms are mulling an 8.5 billion-pound ($12.2 billion) offer for O2 alongside its managers, the Daily Telegraph reported on May 15. It's easy to see the attraction. With a weaker negotiating hand, Telefonica may be amenable to a pitch at well below the 10.3 billion pounds Hutchison agreed to pay.

Telefonica's Valuation
Spanish phone company's enterprise value to Ebitda ratio is higher than its European peers
Source: Bloomberg

At the mooted lower price, a transaction would value O2 at about 6 times its operating income before depreciation and amortization (Or, Oibda), the standard industry metric as forecast for 2016 by analysts at Barclays. That looks relatively cheap when peers trade or more than 7 times on a comparable basis. If just over 2.5 billion pounds, or 30 percent, of the deal was funded by equity, that would leave O2 bearing nearly 6 billion pounds of debt. These borrowings would be about 4 times Oibda -- high, but just manageable.

The challenge would be selling the business at price that generated private equity's desired mid-teens returns over a five-year holding period. An exit at 11 billion pounds would see the investors take out 5.1 billion pounds, a 15 percent internal rate of return, assuming no cash was used for dividends or paying off debt. (Bear in mind, the industry has a voracious appetite for capital expenditure as networks have to be continually upgraded.)

If a future buyer paid the same valuation multiple, achieving that price would require O2's operating income to gain another 450 million pounds, a compound annual growth rate of 5 percent. That would be a tough slog: Barclays analysts estimate it will remain flat until 2018. There may be some scope for cutting costs, but that's unlikely to be enough to turbo-charge the numbers. The other possibility is selling at a higher valuation multiple -- essentially pinning hopes on drumming up an auction for O2 between, say, Sky and Virgin Media owner Liberty Global. That's a big gamble. This industry could look very different in the next five years.

Telefonica, for its part, has other options. An initial public offering of O2 would allow the Spanish parent to raise some money for paying down debt, while still being able to record O2's financial performance in its accounts, thereby appeasing rating companies. Keeping private equity firms interested would, at least help, Telefonica to increase the valuation it would achieve for O2. But lacking the scope to make savings by merging O2 with another business, a leveraged buyout would be a huge challenge.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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Chris Hughes in London at
Leila Abboud in Paris at

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Edward Evans at