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.

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

Building Something from "Nothing"

“You can only build something from nothing with a private equity mindset,” says Matthias Fackler, EQT Partners head of infrastructure Continental Europe. It’s an interesting phrase. In the case of connectivity assets, it might imply a view that infrastructure--in some cases--is worth "nothing" or very little.

The statement also illustrates two key issues in the connectivity business: low revenue growth and low profitability.

source: STL Partners

So almost by definition, if private equity firms are active in an industry, it means there are financial stresses. 

Private equity is about the buying of public assets, taking them private and then selling, typically when a public company asset is deemed to be underperforming. Quite often, the goal is to sell the assets within five years. That virtually always means that long-lived investments such as capital investment in networks are avoided, with the emphasis on operational restructuring. 

Public companies tend to “buy to keep.” Private equity always “buys to sell.” In other words, private equity acts as a turn-around specialist. They arguably excel when able to identify the one or two critical strategic levers that drive improved performance. 

They have a relentless focus on enhancing revenue, operating margins, and cash flow, plus the ability--as private entities--to make big decisions fast. That might be a greater challenge than is typical as a result of the Covid-19 pandemic, which is depressing connectivity provider revenues and profit margins.  

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.

Higher Interest Rates Should Slow Digital Infra Investing

If interest rates remain high, or climb, for an extended period, transactions in the digital infrastructure space are going to slow down, since many deals are financed using borrowed money. The only issue is “how much will the deal flow slow?” 

The other issue is “how long will higher interest rates prevail?” Lower interest rates enable more transactions. 

Since the beginning of 2022, the private equity industry has finalized 92 data center transactions representing  $41.5 billion in deal value,, according to PitchBook data through August 25. 

Global Switch, which manages 13 data centers across Europe and Asia-Pacific, appears ready to join that list. According to Bloomberg, EQT, KKR and PAG are the final bidders for that asset. 

The $15 billion take-private of CyrusOne by KKR and Global Infrastructure Partners is by far the largest PE-backed data center deal this year.

Separately, Time dotCom has said it will sell part of its data center business to DigitalBridge. The sale of AIMS Data Centre appears to be part of a bigger expansion effort in Southeast Asia in conjunction with DigtalBridge. 

Between 2015 and 2018, private equity provided 42 percent of deal value in the data center sector, according to Synergy. Between 2019 and 2021 private equity share of the total deal value rose to 65 percent. 

In the first half of 2022, private equity deal reached more than 90 percent, according to Synergy analysts. 

But higher interest rates  should slow the pace of dealmaking, since debt is used to finance the deals, and debt is becoming more expensive. 

The longer term issue is exit strategy. Virtually all private equity assets are sold over a period ranging up to six years or so. So who are the eventual buyers? Public companies who prefer to operate businesses longer term, institutional investors with a longer time horizon or some strategic buyers, in some cases. 

Two decades, the quip often made was  that a software startups exit strategy was “we sell to Google.” In principle, hyperscalers could be buyers, though it seems more likely they also could be anchor tenants in markets where leasing makes more sense than building or buying. 

Private Equity FTTH Interest is About Asset Growth, As Always

One lesson observers might have learned from past investment bubbles in the computing and connectivity businesses is the importance of maintaining sanity when evaluating the prospects for sustainable financial returns. 

Granted, many investments are either designed to be short term. The investors assume they can build an asset that is expected to be acquired by some larger entity before the issue of sustainability must be addressed. 

In the software business, the example is a small start-up whose financial backers believe is destined to be acquired before it must actually scale up as a sustainable business. 

Some observers might find it odd that private equity capital is being invested in fiber-to-home networks. Under present conditions, these investments have very-long payback cycles (10 years or more), which would seem unsuited to the private equity need to sell off assets within about a five-year horizon. 

Still, as always, private equity investments are about growing asset values, not operating businesses long term. And that explains the investment thesis. 

But the assumption seems to be that willing buyers can be found. Consider take rates and monthly revenue for Google Fiber, which targeted areas where it would be the first FTTH supplier in each city. Results suggest that Google Fiber is getting market share from customers who want faster speeds and are willing to pay for it, as its average monthly revenue is higher than incumbent ISPs (telcos and cable TV) generate. 

Google Fiber prices range from $70 for gigabit service up to about $125 per month for 5 Gbps service. And speeds of up to 8 Gbps are being offered in several of the markets, for about $150 a month. 

City	Years of marketing	Take rate	Average monthly revenue per home per account (ARPU)
Austin, TX	6	25%	$120
Kansas City, MO	8	30%	$110
Provo, UT	7	35%	$100
Salt Lake City, UT	6	40%	$90
West Des Moines, IA	5	45%	$80

That suggests a calculation has been made that the assets can be created and then sold to other owners over a relatively short period, before full payback on the investment has occurred. 

Consider the generic example of a PE firm buying an existing telco with little to no FTTH footprint, and then rebuilding using FTTH. 

Assume the asset can be purchased for about $1,000 per home location, and then the owner can build a new FTTH network for about $1,000.

I am skeptical of the payback model for private equity funding of fiber to home (FTTH) networks, especially in cases where the PE firm has to buy an existing telco and then invest another $1000 per household to build the FTTH network.

Assume the firm can get 40 percent take rates, as it might already have about that level of customer penetration to begin with. Assume its home broadband revenue is about $90 a month. 

So the key high-level assumptions include:

• Upfront investment: $2000 per household ($1000 to buy the existing telco + $1000 to build the FTTH network)

• Annual revenue per household: $90 x 12 = $1080

• Operating expenses: Assume 50% of revenue, or $540 per household

• Annual operating cash flow: $1080 - $540 = $540 per household

• Assuming the PE-backed firm can achieve 40% market share, this means it will generate $540 x 40% = $216 in annual operating cash flow per household on average.

To reach operating cash flow breakeven, the PE-backed firm needs to generate enough operating cash flow to cover its upfront investment. This means it needs to generate $216 x 9.26 = $2000 in operating cash flow per household over 9.26 years.

Assuming a 10-percent required rate of return, the PE-backed firm needs to generate $2000 x 10% = $200 in annual profit per household, as well. 

To earn a full recovery of invested capital, the PE-backed firm needs to generate $200 x 10 = $2000 in profit per household over 10 years, assuming the take rates are at 40 percent and customer revenue is $90 a month. 

Of all the assumptions, the take rates at $90 per month, per account, are likely the most challenging. 

Most incumbent ISPs selling FTTH have managed to get only about 40 percent take rates after several years, and at average selling prices closer to $50 a month. 

So builders of new FTTH networks might do best when targeting more-affluent neighborhoods, rather than whole cities. 

In this simplified model we do not include any inflation-related price increases, some amount of business customer revenue (for enterprise or cell tower backhaul, for example) or wholesale revenues from allowing competing ISPs to use the network. 

The observation is simply that private equity firms historically want to sell assets after about five years (the range being three to seven years). 

So such investments--always designed to be sold--will likely have been sold to other investors before full payback is reached. 

On the other hand, at least at the moment, terminal values would seem to warrant the investment. In principle, investments of up to $2000 per home could reach $3000 per home in a sale, assuming present trends hold. 

Year	Transaction value (per home)	Buyer	Seller
2023	$3,250	GIP	Zayo Group
2022	$3,000	Apollo Global Management	Lumos Networks
2021	$2,750	KKR	Hargray Communications
2020	$2,500	EQT	Suddenlink Communications
2019	$2,250	Warburg Pincus	Charter Communications
2018	$2,000	TPG Capital	MetroNet
2017	$1,750	Berkshire Hathaway	OnFiber
2016	$1,500	Goldman Sachs	WaveDivision Holdings
2015	$1,250	Carlyle Group	FiberNet Holdings
2014	$1,000	Providence Equity Partners	Clearwire Communications
2013	$750	Blackstone Group	FiOS Networks