KKR Bids for Telecom Italia

It is official: private equity firm KKR is making a bid to take Telecom Italia private. Said to be the biggest-ever private equity bid for a public telecom service operator in Europe, the $12 billion deal seems to be opposed by Vivendi, which owns 24 percent of Telecom Italia. 

The KKR playbook would normally involve an effort to streamline, rationalize and reposition the assets. KKR is believed to be interested in separating Telecom Italia’s network assets from the retail operations, turning part of TI into a wholesaler of capacity, likely with a heightened optical fiber position, while retail operations are conducted separately, using the wholesale network. 

At first glance, the proposed deal looks like a standard private equity deal: buy an underperforming asset, make changes and then sell. But the deal might also reflect another private equity focus: buying infrastructure assets to hold longer term, as an alternative asset. 

Perhaps a likely scenario is that KKR hopes to dramatically improve financial performance before selling the asset to an investor that wants the long-term cash flow. 

Telecom Italia, for its part, also fits the “go private” scenario: it has high debt and shrinking recurring revenues and profits, arguably impairing its ability to invest in digital infrastructure including fiber to home facilities. 

Among the key drivers for telecom privatizations is the perception by asset owners that public markets will not positively reward the firms, in terms of equity valuations, commensurate with their revenues, cash flow or potential growth prospects.

Another key driver is private equity firms with lots of private capital to invest, and assets that offer long-term and predictable cash flows to institutional investors such as pension funds and other entities with long time horizons that view infrastructure assets as equivalents to other long-duration fixed-income assets such as bonds.

 

Also, asset diversification is another motivation for investors.

  

There is a good reason why any number of public telecom firms have been taken private, and why others are considering similar moves: high debt, low growth and poor operational performance. And connectivity providers are not the only type of firms facing investment issues.  

That is a fairly-common prescription for any public company to be taken out of the public markets by private equity, and many public telco assets  fit the bill. 

source: Focus Finance

One defining characteristic of infrastructure assets is their monopolistic position. We tend to forget that for most of the history of the industrialized world, much of the funding for large scale public infrastructure such as roads, canals and railroads has come from private sources of capital. And that includes telecommunications in the United States. 

source: Maria Sward 

The function of private equity also has included the rehabilitation of firms that are not performing financially. Private equity buys a public asset, restructures and then sells the asset, often within about a five-year period. 

source: Bain

Will Telecom Italia's Fixed Network be Privatized?

Telecom Italia’s board of directions is said to be meeting Nov. 21, 2021 about a possible fixed network privatization effort by private equity fund KKR, which is already an investor in the Italian phone group's fixed network, Reuters reported. 

At first glance, the proposed deal looks like a standard private equity deal: buy an underperforming asset, make changes and then sell. But the deal might also reflect another private equity focus: buying infrastructure assets to hold longer term, as an alternative asset. 

Telecom Italia, for its part, also fits the scenario: it has high debt and shrinking recurring revenues and profits, arguably impairing its ability to invest in digital infrastructure including fiber to home facilities. 

At the same time, the access network scarcity moat is challenged by the building of a rival Open Fiber wholesale network owned and operated by electrical and gas provider Enel. 

KKR might or might not see value in merging merging TIM's access network merged with that of rival Open Fiber, which would then be able to run as a single national internet and communications access asset supplying retail services to other internet service providers and telcos.

Alternatively, the former Telecom Italia assets might have enough scale to operate independently of Open Fiber. In either case, the value KKR sees is linked to the scarcity value and regulated, stable cash flows the access network would generate.

As the access network is deemed to be a strategic asset by Italy’s government (as is the case in virtually every country), it presumably would benefit from investment to eliminate the digital divide. That changes the business model for FTTH as it introduces subsidies. 

Were the government to sanction a merger of Telecom Italia and Open Fiber assets, to create a single national wholesale provider, KKR’s investment would acquire a business moat. 

Future KKR options would then involve a sale of the assets to a third party or a longer-term holding as an alternative asset. 

Institutional and private equity investor interest in communications infrastructure waxes and wanes. Right now it is waxing, after a precipitous drop in interest in the wake of massive facilities overbuilding around the turn of the century. 

In large part, the interest is driven by returns on other assets, leading investors to desire some exposure to alternative assets, including infrastructure with some market moats, scarcity and dependable demand, plus free cash flow. 

That appetite is matched by connectivity provider capital investment issues, namely low returns on invested capital that have bedeviled connectivity providers in recent years. 

In many cases, service providers have trouble earning back their cost of capital, according to some analysts. 

source: Arthur D. Little

All of that creates a heightened private equity and institutional investor demand for investments in “digital infrastructure” that is similar to demand for the more-traditional interest in real estate and utility investments. 

But the strategies can vary. The easiest and arguably safest choices are core infrastructure operations where most of the return comes in the form of cash dividends. This is most often found in regulated segments of the industry, with low growth but consistent demand. Ownership of electrical utilities provides a good example of this type of asset. 

Most digital infrastructure assets do not offer predictability or moats as high as might be the case for electrical utilities or airports, but arguably is most true for mobile towers. 

In other cases, there are some specific drivers that shift a bit of the story to more growth, if some tweak to the business model is made. That seems to be the case for mass market telecom networks where the upside is the upgrade from copper internet access to fiber to home. 

In other markets, the same thinking underpins buying a regional airport with expectations of creating a higher-value super-regional hub. In the communications assets business, perhaps an example is the “roll up” strategy of amalgamating many diverse and smaller connectivity or data center assets to create scale. 

The point is that a confluence of connectivity provider need and investor want is fueling a resurgence of private equity and institutional investor interest in a growing range of digital infrastructure assets.

Perceptions of Network Asset Value are Evolving

As more private equity and institutional investment funds ponder taking stakes in digital infrastructure assets--including access networks, data centers and fiber backbone assets--we will have to see where the operator comfort level lies. Few have fundamental qualms about divesting tower assets. 

The issue is how much broader involvement in entire core or access assets could occur. Traditionally, private equity investments  have been concentrated elsewhere, especially in real estate, energy assets, business services and software. But telecom infrastructure investments have been growing. 

source: Toptal 

Telecom transactions accounted for 35 percent of total private equity infrastructure deal value in 2020, up from 15 percent a year earlier, Preqin data shows.

Telecom deals involving towers, fiber and data centers are now viewed as possible holdings in the alternative assets portfolio, which generally focuses on  transport, energy and utilities.

source: S&P Global, Prequin 

The trend has been in place and growing for some time, sometimes driven by the traditional “fix and sell” (leveraged buyout, consolidate assets, flip to strategic buyer) model, but with some increasing longer-term holding as well, where private equity might take a minority stake in an operating company without plans to flip the stake in less than six years.  

source: Columbia Business School 

Recently, some big divestitures of whole networks, accounts and infrastructure have occurred, primarily revolving around rural and less-dense fixed networks. Lumen Technologies recently divested about half its fixed network assets, for example. 

And increasing attention seems to be paid to operating assets more efficiently, a traditional driver of private equity investing strategy. 

source: S&P Global, Prequin 

Asset reshuffling tends to be rather common in the connectivity business, with occasional bouts of merger unwinding. Consider the proposed sale of Lumen fixed network assets to Apollo Global Management.   

Basically, the deal unwinds the merger of CenturyLink and Qwest fixed network assets (more an acquisition by CenturyLink of Qwest) in 2011. What remains for Lumen are the original Qwest local exchange operations, plus networks in Florida and Nevada that were not part of Qwest.

Perhaps more important is the Lumen retention of the former Level 3 Communications assets. The proposed deal still leaves Lumen a bit of a hybrid: operator of large tracts of rural fixed networks, plus a handful of tier-two cities, as well as a global enterprise services network. 

source: Lumen

The larger point is that different financing mechanisms for core telecom infrastructure might be entering a phase where there is more “burden sharing” than in the past with private investors. 

That might be far more successful than regulator-forced sharing.

Cincinnati Bell Goes Private

Cincinnati Bell is among the latest to go private, as the firm has been acquired by Macquarie Infrastructure Partners. Iliad in France wants to do so and Altice Europe did so earlier in 2021.

Among the key drivers for those privatizations is the perception by asset owners that public markets will not positively reward the firms, in terms of equity valuations, commensurate with their revenues, cash flow or potential growth prospects.

Another key driver is private equity firms with lots of private capital to invest, and assets that offer long-term and predictable cash flows.

 

That, in turn, is matched by desire to invest by pension funds and other entities with long time horizons that view infrastructure assets as equivalents to other long-duration fixed-income assets such as bonds.

 

Also, asset diversification is another motivation for investors.

  

There is a good reason why any number of public telecom firms have been taken private, and why others are considering similar moves: high debt, low growth and poor operational performance. And connectivity providers are not the only type of firms facing investment issues.  

That is a fairly-common prescription for any public company to be taken out of the public markets by private equity, and many public telco assets  fit the bill. 

source: Focus Finance

One defining characteristic of infrastructure assets is their monopolistic position. We tend to forget that for most of the history of the industrialized world, much of the funding for large scale public infrastructure such as roads, canals and railroads has come from private sources of capital. And that includes telecommunications in the United States. 

source: Maria Sward 

The function of private equity also has included the rehabilitation of firms that are not performing financially. Private equity buys a public asset, restructures and then sells the asset, often within about a five-year period. 

source: Bain

Will Private Equity Move into Connectivity Also Lead to Adjacency Moves?

Brightspeed, the new connectivity provider formed by assets purchased from Lumen, is setting up its headquarters in Charlotte, N.C. Basically representing the assets comprising the old CenturyLink, Brightspeed serves mostly rural areas across the U.S. Southeast, Midwest and South Central regions. 

source: Brightspeed 

The business plan to be executed by new owner Apollo Global Management focuses squarely on an upgrade of the largely-copper physical plant to fiber-to-home for internet access. 

Brightspeed plans to build an XGS-PON network operating initially at 1 Gbps. But one new objective is ensuring that the Wi-Fi experience inside the home better matches the bandwidth of the access pipe. 

What consumers experience as the “speed” of the access network these days is measured by the performance of the Wi-Fi in-home network. Brightspeed is expected to incorporate more measures to enhance the Wi-Fi coverage and speed indoors as an essential part of its “upgrade internet speeds” push. 

The strategy rests on some short-term and some long-term value drivers for the new owners. Near term, Brightspeed believes its cost of FTTH infrastructure will be subsidized by new subsidies for building broadband plant.

That changes the investment calculation and helps improve the payback from new investment. 

Low borrowing costs also are a reason for the push. 

The longer-term goals are different, representing a belief that the fiber access assets will provide an alternative asset to stocks, bonds and other “turnaround” assets in the Apollo portfolio. The hope is that Brightspeed will provide predictable cash flow from a business with competitive moats.

That is similar to the thesis for owning airports, toll roads, seaports or other forms of infrastructure that have been investment targets by private equity and institutional investors. 

In 2020, investment in telecom infrastructure represented as much as 35 percent of private equity deal value in the United States, according to Preqin. 

There are other shifts as well. The financial return from ownership of traditional infrastructure assets is not as high as the returns from operating such businesses. In many cases, the return “as a data center operator,” for example, can be as much as double the return from “simple connectivity” business models. 

The perceived upside now comes from additional expected opportunities in edge computing, private networks, internet of things and digital infrastructure in general. The argument is that many cloud or edge computing ventures are  more valuable when combined with connectivity.  

In addition, scale should increase potential returns, which is one reason for additional investments. 

Also, a significant presence in the connectivity value chain increases the ability to participate in adjacencies, such as::

• Data centers, including colocation services

• Structured cabling 

• Distributed antenna systems (DAS)

• Electrical, aerial and underground fiber deployment 

• Civil construction 

• Small cell or micro cell installations 

• Indoor DAS and outdoor DAS integration

What is not clear so far is whether “wholesale access” will be a significant part of the Brightspeed business model or not, as is the case for some other FTTH business plans preferred by private equity investors.

"Digital Infrastructure" Can Mean "Everything" But Then Means "Nothing"

Digital infrastructure is a term increasingly used by suppliers of connectivity services. But digital infrastructure arguably includes the rest of the information and communications ecosystem as well. To the extent that digital infrastructure includes connectivity, computing, applications and services as well as devices, it is synonymous with “internet ecosystem.”

source: AIIB

When used in the more-narrow sense of “connectivity infrastructure,”however, some connectivity assets are of growing interest to private equity, institutional investors and others, as a form of alternative investment providing diversification. 

As investment organizations sometimes desire to hold assets such as land or real estate, they now sometimes wish to own infrastructure assets that throw off predictable cash flows, have business moats and stable and recurring demand. 

That interest on the part of buyers also  accounts for service provider interest in monetizing some parts of their access infrastructure, steps that might not have been deemed wise decades ago, when ownership of scarce facilities was viewed as a primary source of business advantage. 

  

source: AIIB

But digital infrastructure now sees a confluence of supply and demand interest as much private equity views investments in digital infrastructure the same way other long-lived infrastructure (transportation, utilities, real estate) is seen: reliable providers of long-term cash flows. 

So in addition to investments in infrastructure related to  clean energy, water, and wastewater, some investors see digital infrastructure as part of the mix. 

The capital-intensive nature of these assets also creates barriers for competition, while demand growth is robust. Still, infrastructure investing--digital or not--is an asset class expected to  deliver low returns, but also with low volatility. 

At the same time, interest in alternative asset classes and low dividend yields on bonds contribute to the interest in digital infrastructure asset investment, and the trend to monetize such assets on the part of service providers. 

In substantial part, there also is corresponding interest on the part of infrastructure owners to monetize assets, driven in large part by increasing capital requirements and declining return on investment. 

In Asia, for example, communications infrastructure faces higher capital intensity and yet lower returns on invested capital. In that sense, communications infrastructure faces potential  investment gaps similar to those of other infrastructure categories. 

source: AIIB

That accounts for the prevalence of interest in “capital light” business models, public-private partnerships, wholesale access service models and privatization of assets. 

Is FTTH Some Form of "Greater Fool" Theory?

One has to ask whether some version of the “greater fool” investing approach applies to private equity and institutional investor positions in copper access networks that can be repositioned as optical access assets. 

That theory suggests an investor can make money buying overpriced assets so long as there are investors willing to pay an even-higher price. It works until there are no more “fools” left. 

The issue might be that payback models for today’s investors do not clearly seem to make sense on an operating basis. And fiber-to-the-home always has had marginal payback, even if strategically important. 

The most-shocking changes are the revenue assumptions for consumer locations. These days, the expected revenue contribution from a home broadband account hovers around $50 per month to $70 per month. Some providers might add linear video, voice or text messaging components to a lesser degree. 

But that is a huge change from revenue expectations in the 1990 to 2015 period, when $150 per customer was the possible revenue target. In some cases, revenue up to $200 per home location was considered feasible. 

To be sure, capital costs arguably have fallen to some extent. But most ISPs also operate in competitive markets, which increases the danger of stranded assets. 

And though ISPs might once have built their payback models on three potential revenue sources--voice, video entertainment and internet access--they now tend to base returns on one single service: consumer home broadband. 

To be sure, some ISPs also point to value for supporting small cell networks and upside from business customers. But one never sees detailed financial contributions from these areas in quarterly earnings reports. 

That suggests the contributions are indirect and hard to measure. 

“Our fiber ARPU was $61.65, up 5.3 percent year over year, with gross addition intake ARPU in the $65 to $70 range,” said John Stankey, AT&T CEO, of second quarter 2022 results. “We expect overall fiber ARPU to continue to improve as more customers roll off promotional pricing and on to simplified pricing constructs.”

Lumen reports its fiber-to-home average revenue per user at about $58 per month.

Recent presentations also have shown fiber-to-home home broadband average revenue per user of about $63. 

But assume for the moment that such additional value can be reaped. Why have potential investors other than connectivity service providers seemingly changed, bringing in financial investors from “outside” the ranks of service providers?

The clear argument is that digital instructure now is viewed as within the class of infrastructure investments that long have been favored by institutional investors. Digital infrastructure also is viewed as interesting by private equity firms that long have invested in underperforming or appreciating assets. 

Real estate and infrastructure investors are said to have different motivations for investing in each asset class. Real estate investment trusts, for example, traditionally are valued for their ability to produce income. 

Infrastructure offers predictable cash flow and business moats. But both assets also are supposed to offer diversification from asset risk related to concentration in stocks and bonds. 

On the other hand, both asset classes tend to be viewed similarly these days. Firms that invest in real estate also invest in infrastructure, including digital infrastructure such as cell towers, data centers and optical fiber networks. 

Private equity firms, which tend to invest in assets believed to be underperforming, tend to see similar opportunities in both real estate and infrastructure. Both asset classes are viewed as offering high financial returns. Both offer diversification for investment portfolios. 

Both are hedged against inflation and offer capital appreciation. Both are seen as supply-limited assets. And in recent days, some forms of digital infrastructure also benefit from government subsidy programs that reduce capital investment hurdles. 

And both types of assets are long-lived, capital intensive assets where leverage normally is required. 

We ultimately will see whether digital infrastructure winds up with some form of “greater fool” dynamic, in at least some parts of the sector. 

At the moment, payback from FTTH producing $50 to $70 monthly revenue from perhaps 40 percent to 45 percent of locations does not immediately suggest the FTTH capex produces a clear and interesting financial return. 

That might well be the case in areas where the first firm to deploy FTTH can reap take rates far higher than 45 percent. The payback might also be notable if wholesale access means the facility operator can count on both retail and wholesale market share. 

Such conditions arguably exist most often in rural markets, and less often in urban and suburban areas. Networks in rural areas are more expensive than networks built in urban and suburban areas, so payback seems to remain an issue in virtually all markets, even with government subsidies. 

The point is that some of us have yet to see payback analyses that are completely convincing where it comes to copper access networks intended for FTTH upgrades. Eventually we will find out. Let’s just hope some version of the greater fool theory is not operating. 

“Buy high, sell higher” works until there are no more buyers willing to “buy higher.”

Why more Public Network Assets are Going Private

Institutional and private equity investor interest in communications infrastructure waxes and wanes. Right now it is waxing, after a precipitous drop in interest in the wake of massive facilities overbuilding around the turn of the century. 

In large part, the interest is driven by returns on other assets, leading investors to desire some exposure to alternative assets, including infrastructure with some market moats, scarcity and dependable demand, plus free cash flow. 

That appetite is matched by connectivity provider capital investment issues, namely low returns on invested capital that have bedeviled connectivity providers in recent years. 

source: Arthur D. Little

 

Simply put, it has gotten harder for connectivity providers to generate satisfactory returns on their network investments over time. And telecom is hugely capital intensive. 

source: Bain 

In many cases, service providers have trouble earning back their cost of capital, according to analysts. 

source: Arthur D. Little

All of that creates a heightened private equity and institutional investor demand for investments in “digital infrastructure” that is similar to demand for the more-traditional interest in real estate and utility investments. 

But the strategies can vary. The easiest and arguably safest choices are core infrastructure operations where most of the return comes in the form of cash dividends. This is most often found in regulated segments of the industry, with low growth but consistent demand. Ownership of electrical utilities provides a good example of this type of asset. 

Most digital infrastructure assets do not offer predictability or moats as high as might be the case for electrical utilities or airports, but arguably is most true for mobile towers. 

In other cases, there are some specific drivers that shift a bit of the story to more growth, if some tweak to the business model is made. That seems to be the case for mass market telecom networks where the upside is the upgrade from copper internet access to fiber to home. 

In other markets, the same thinking underpins buying a regional airport with expectations of creating a higher-value super-regional hub. In the communications assets business, perhaps an example is the “roll up” strategy of amalgamating many diverse and smaller connectivity or data center assets to create scale. 

The point is that a confluence of connectivity provider need and investor want is fueling a resurgence of private equity and institutional investor interest in a growing range of digital infrastructure assets.