Why private equity likes fiber
Interview with Dr. Matt Pearson
The past 12 months have seen a significant upswing in mergers among Tier 2 and 3 communications carriers. Private equity firms have played a large role in this trend, perhaps none more so than M/C Venture Partners. The Boston-based firm invests in companies active in communication services infrastructure, IT infrastructure and services, and new digital media. Portfolio companies such as Zayo Group (whose now former COO we featured last September) and Lightower Communications have been active on the buy side, while Cavalier Telephone was acquired by Paetec.
Lightwave spoke to Gilles Cashman, general partner, M/C Venture Partners, about why fiber-based carriers are good investments and what opportunities may appear in 2011.
Lightwave: Is aggressive M&A a common strategy among the companies in your portfolio?
Cashman: For the large service infrastructure companies, I'd say that's for the most part true. When we do investments, we tend to like to do consolidation–and especially within comms services, the economies of scale really drive that.
But it depends on the industry and the vertical they're in. In the fiber sector, it's compelling to do acquisitions because there are such economies of scale. There are other segments–like, for example, managed hosting–where acquisitions are probably less compelling.
What attributes of the fiber market promote these economies of scale?
Effectively, it's a centralized sales model. There's a given number of companies out there, carriers that you're selling into. The more properties you acquire, the more you can leverage those relationships to sell the same customer over a broader geography. So your sales momentum increases when you've got more footprint to sell.
The other thing is that the financial scale you gain from consolidation allows you to be more aggressive in funding growth. What we've seen in a lot of companies we've bought is the small ones have been capital constrained. It has really hurt their growth, because they've got six months or four months to make the capital payback. When you've got a stronger balance sheet, you have access to cheaper capital. You're able to extend those paybacks to 12 to 18 months.
How has the perception of fiber-based carriers among capital sources changed?
We started Zayo in '07, and raising that first bank facility was not fun. People really did not get fiber. The stigma was still there from '01 and '02. The statements were, 'This is a commodity; pricing is going to continue to decline. This is a wholesale model–why does it make sense?' I think people, especially on the debt side, have dug into this model and have seen that pricing has stabilized and the consolidation that has gone on over the last four or five years has rationalized the competitive environment and improved the overall market structure. So debt capital has become much more available to the fiber space.
In equity capital, we've seen a huge influx of private equity interest in the fiber market. If you look at the overall enterprise value of transactions that happened within the third quarter [of 2010], it represented more than all the deals that had happened from the second half of '06 through the first half of 2010.
The public equity markets still don't yet fully appreciate the opportunities here. As we've gone out and talked to public investors, they're just starting to reengage in this market. A lot of them have the same questions the debt guys had two years ago. I think they're starting to really understand the model and how strong the fundamentals are.
Are you looking to add new fiber companies to your portfolio?
If you look at our latest portfolio, we've got a lot of concentration in the fiber space. We feel really good about the companies we're in. So I don't see us doing, at least in the next year or two, another fiber company.
Where I do see the opportunity set longer term is, if you think about the existing infrastructure, about 80% of buildings still are not connected with fiber. And the demand set is growing daily. There are a lot of people talking about cloud computing, and the only way for cloud computing to really take off is for there to be high-capacity circuits to interconnect locations and data centers and the like. There's going to be a massive upgrade over the next five to ten years of the metro market. Guys that are provisioning customers with T1s–that's just not going to be enough in the next couple of years. Traditional CLECs will have to make the decision whether to build fiber to buildings to replace those or choose another form of access, whether it be wireless broadband or something else.
Will cable companies play a role in meeting enterprise requirements?
Cable [companies] are getting more aggressive on the business side, and they're well positioned. They're building with their own networks and offering 100-Mbps Ethernet services to these enterprises. They'll definitely be a player in the small to medium-sized business space.
The question is always going to be how does their network map to the opportunity set? Most cable networks don't typically have the same architecture that a carrier would have that serves the metro. But that's not to say that I don't see them buying fiber companies. And we've already started to see them buying CLECs. You saw that with Simco being acquired by Comcast.
The question for me will be will the cable companies move up-market and serve the medium to large enterprise. They certainly have the network to do it. The question is will they build the expertise, both on the management side as well as the product side. And I think they will–why wouldn't they? It's a huge opportunity set for them.
As I look at longer term, I see cable being a solid competitor to traditional fiber companies–and I also see them acquiring fiber companies.
Will M/C Venture Partners invest more in cable companies?
Longer term, we definitely will. We've been very specific about the cable companies we look at. That business model is going to undergo a massive transition over the next five to ten years. You're starting to see it today a little bit, but it's going to accelerate rapidly as people view more content over the Internet and scale back their video, whether dropping a digital tier or cutting the video cord altogether.
At the end of the day, it's not bad for cable. I think the margin profile of data is more favorable than the margin profile of video. And the capex profile of serving a broadband customer is more favorable than the capex profile of serving a video customer.
Where we're focused with respect to cable is guys that don't have huge penetrations in video and haven't been able to penetrate with digital product as much as others. They're going to be better positioned to make the transition to more of a broadband provider than those who have $120 video ARPUs and are 70% penetrated in basic video and 50% penetrated in digital.
Gilles Cashman is a general partner at M/C Venture Partners, a private equity firm. The Duke University graduate is chairman of Baja Broadband and sits on the board of directors of Zayo Group, CSDVRS, Corelink Data Centers, and GTS Central Europe.