Absence of Persuasive Incentive

As I monitored the intermittent tweetstream from the Telco 2.0 event earlier this month in London, one exchange between attendees caught my eye. One tweeter posited, "Are telcos still mainly driven by fear?" to which another responded, "Gone beyond fear - into risk avoidance because of job insecurity." I initially thought about writing this post upon reading this exchange, but got bogged down with other projects. Then a couple of weeks later Benoit Felten suggested he was generally on the same wavelength, and this prompted further reflection.

I, and a great many others, have pilloried or mocked the industry over the years for what seem to be inherent and persistent cultural or structural inhibitors to innovation. At times I have questioned whether it was even worth the effort for telcos to try to innovate on the services front (as I stated in point nine here), given my view that their true source of cash generation is infrastructure, with their retail units merely another end customer (albeit typically the largest) for their genuinely profitable wholesale services.

Contrary to impressions some may have, based on bland conference presentations, telcos are actually populated and managed by human beings, and what I have lamentably failed to consider over the years is the influence of the basic element of human self-interest in defining their behavior. In other words, what incentives do the people inside telcos and their shareholders actually have to promote change? I'm coming to the conclusion that in this question lies the key to the issue - while pretty much everyone I know in the industry would acknowledge a need to promote change and innovation for its long-term health, there stands in the way a problematic "telco API" (Absence of Persuasive Incentive), which leads to inertia. And viewed through the lens of human self-interest, I think this is an entirely reasonable reaction.

Consider, for example, the lack of alignment between radical thinking and investor conservatism. Investors on the whole view incumbent telcos in mature markets as reliable sources of cash, like utility businesses. As an extreme example, France Telecom's dividend yield is currently 8.7%, and having just pledged to maintain the dividend at the current level of EUR1.40 for three years (from which the French government stands to collect EUR1bn per year), it is hard to see the company backing away from this. So as, say, a pension fund portfolio manager, you have a company with a reliable dividend yield higher than some of the yields on offer in the "high yield" bond space at the moment, theoretically with lower risk, so why wouldn't you want to own it? And why would you encourage the management to do something which might put that at risk, particularly if you have limited confidence in them to actually execute it? So you urge them to just keep doing what they do, better, with fewer people, and to hand over any excess cash to you, because you can invest it more efficiently than they can. I think this is a fair representation of the general attitude of institutional investors, like it or not, and I can't find many flaws with this argument on the whole, taking their position into account. They have a fiduciary duty to allocate capital among different sectors, and if they see what they regard as reckless or irrational behavior in one sector, they will put money elsewhere. So from their perspective, "If it ain't broke, don't try to fix it." That doesn't mean they don't acknowledge the longer term risks to the industry, but they are charged with protecting people's pension money in the near term and adapting to change longer term, so when they see an industry capable of pumping out this much cash for now through maintaining the status quo, they will hardly demand change which increases risk.

Even if there were a consensus from shareholders of a need for urgent action, some of the projects involved would no doubt require continuity of management over the long term (e.g., a truly committed FTTH strategy is at least a 10-year project in countries of any significant size). Contrast this with the reality among telcos - data from the US in 2009 shows that C-level IT execs in telecom have the shortest life-span of any industry, at 4.7 years, and my experience with Europe suggests the same is true here. Think about the incumbents you know, and count how many people in senior positions in 2002/3 are still there now (indeed, in 2004 the telco CEO lifespan was four years). Just thinking of the companies I have covered in my career, I would put the average tenure at under five years, and in many cases more like three. So if you're one of these people, under pressure to stabilize cash flows and satisfy your shareholders, just from the standpoint of human self-interest, what incentive do you have to promote radical change, the effects of which you know you will never be around to see or be rewarded for? If you have four years to make an impact, and a choice between investing in an emerging segment with perhaps undefined revenue opportunities (M2M, cloud, smart grid) and an OSS/BSS overhaul which you are fairly confident will lower costs against a flat/declining revenue line, I think I can guess which choice you will make. Play the game, pull down that bonus, and work on your post-exit strategy.

So the executive suite has a revolving door, the organizational chart is written in pencil, corporate governance guidelines ensure short tenures for board members, and investors on the whole don't want to derail the gravy train in the short term as they regularly reassess the long-term prospects. Arguably none of the key stakeholders is truly incentivized to look beyond the five-year time frame, perhaps with the exception of the rank-and-file employees who hope to retire with a pension, and the pension trustees themselves.

I had lunch recently with a very bright friend who has done a lot of work on the publishing industry and its attempts to get to grips with reinvention in a crater-scarred landscape of paywalls, e-readers, iPads, and smartphone apps. His platinum comment was along the lines of, "The discussion about transformation only got serious once managements were confronted with having to sack 70% of the newsroom." By which time, presumably, it is very late in the day. However, for a "beleaguered" telecom industry wherein a company like France Telecom can generate enough cash to commit to a EUR3.7bn dividend for the next three years while still having flexibility to invest in infrastructure and engage in M&A, that day still looks very far off indeed.

I, for one, feel as though my error has been in wanting too much from the telco, expecting it to react to a long-term threat with a quantum leap, when in fact, I now see, it has limited incentive to acknowledge or address anything more than a need for cautious incremental change and adaptation. I will cut it some slack in future. After all, it's only human.

The reports of my death have been greatly exaggerated

Turn off your mind, relax, and float downstream to the good old, bad old days. October 4, 2006 - day one of the first-ever Telco 2.0 event. I was honored with the opening presentation, as "analyst in residence" for day one. In the presentations which followed, Abdul Guefor from Intel Capital further piled on the agony, highlighting some of the cultural and structural issues which hamstrung telco transformation, and warning, "If you don't address these issues, Private Equity will." An icy sense of dread enveloped the room, and the already-battered audience shook its collective head in pained recognition of the inevitable. And we were still at least an hour from the first coffee break.

"Private Equity" - two words which could inspire fear in the most self-assured telco management teams in 2006. The elephant in the room, wielding in its well-fed trunk a Sword of Damocles over the head of an industry still in therapy from the near-death experiences of the tech implosion. Anything was possible, nothing was unthinkable, even the unthinkable.

And the unthinkable continued a few months longer, until the credit market began to seize up, and the inevitable populist backlash began. Previously feared and respected, PE was now vilified, pilloried, and dragged before Parliament to explain itself. Schadenfreude gushed forth as access to LBO financing ran dry. The dreaded PE juggernaut found itself neutered, and the angry masses danced in the streets.

Well, not exactly, and not for long. As the quaintly named "credit crunch" (God, I cannot hate this phrase enough) intensified into a bona fide financial crisis, evil, greedy PE was replaced in the stocks by investment banks, financial regulators, hedge funds and politicians, to be taunted by village idiots and the swelling ranks of those who had miraculously become experts on financial markets overnight (and who, of course, had never fudged a self-cert mortgage or exploited equity release to buy a nicer car).

The perceived atrocities of PE were downgraded to misdemeanors, and the world moved on. With no access to finance, they could do no more harm, and anyway, their over-leveraged investments, apparently justified on champagne-and-Ferrari-fume-fuelled delusional assumptions of recurring access to refinancing, were doomed in this new era.

Well, that was the consensus view, but it's interesting to take note of a few recent developments in the telco space which suggest that the consensus was, once again, wrong. To be sure, there have been a few situations where things have gone spectacularly wrong. But there are a number of situations where things appear to have gone much better than anyone would have ever expected, particularly given the macro headwinds.

For example, German cable, an industry strewn with the corpses of investors who previously tried to improve competitiveness, has come of age and produced returns for PE sponsors. BC Partners and Apollo built a great business in Unitymedia, and were well down the road to an IPO when they opted instead to sell to Mr. Malone for 7.7x LQA EBITDA. The other German cable behemoth, Kabel Deutschland (KDG, an early 2006 secondary LBO by Providence Equity, which bought out partners Apax and Goldman Sachs) this year has successfully pushed out maturities on debt, defied market jitters by getting an IPO away, followed with a secondary private placement, and just this week, asked senior lenders to give the company greater flexibility in refinancing debt and paying dividends to shareholders. The last point is crucial - as the company approaches its target leverage levels, the sponsors want the flexibility to refinance more expensive junior tranches of debt and take cash out of the business in dividends, on the basis that the capital structure of the business will be self-sustaining. In summary, the PE sponsors have generated nearly EUR1.2bn in gross proceeds this year from sales of shares, and are now opening the door to a future dividend stream. I don't know what it's like to be a KDG customer or employee, but as an outside observer, this looks to me like pretty much the way LBOs are meant to work out. The sponsors have seen a partial exit, and minority shareholders are pretty well aligned with the sponsors' interests. The stock is up 50% since the March IPO (most of that since August), while Deutsche Telekom has managed only a 3.9% gain. I can think of far worse outcomes.

Or take Dutch cable company Ziggo, an early 2006 LBO by Warburg Pincus and Cinven, which many (yours included) dismissed at the time, given the 7.5x leverage the business was carrying. This year the company has joined the refinancing frenzy, placing EUR1.2bn in senior notes in April, at an 8.125% yield, and then returning in October for a EUR500m offering of senior secured notes, which was upsized to EUR750m due to demand, and priced at a cheeky 6.125% yield. Net leverage was down to 4.7x in the September quarter, so not entirely out of the woods yet, but very close to the level of debt UPC carries today as a matter of policy, with no adverse effects. The business itself continues to perform well, so presumably the next major milestone is an IPO, as the sponsors have now been in the asset for nearly five years.

Or how about TDC, still the largest incumbent telco to ever have been the subject of an LBO, and a flashpoint for criticism as well as various predictions of failure? I will hold up my hand and say that Denmark, one of the toughest markets in Europe, would not have been my first choice of target markets in 2005, and I was one of many who expected the company to have its lunch eaten by the rise of FTTH deployments by local utilities. Well, it's the job of the incumbent to play the long game, and TDC did this by allowing the challenger to fail, picking up assets in the process. The sponsors also commenced the dismantling of TDC's international mini-empire, which developed during the era when Ameritech controlled the company. Proceeds from this process are to be applied to further de-leveraging the company, which is apparently on the runway for IPO, and eventually a return to the ranks of investment-grade companies. I wish there were some Danish proverb I could quote about a vulture giving birth to a phoenix, but I don't expect it exists, and my Danish is very poor in any event.

Or what about beleaguered Spanish cable company ONO? Here is a company which every member of the distressed investing and restructuring community in Europe fully expected to end up in a debt restructuring in late 2009 or sometime in 2010. Of course, however, debt restructurings mean lending banks take write-offs/haircuts and end up owning assets they don't want to have to actively manage, like Spanish cable companies. So ultimately, ONO managed to pull off a forward start agreement with lenders, returning to the market to refinance in October with a EUR500m senior secured offering, which was up-sized to EUR700m (do you see a pattern here?), and priced inside 9%. That's one helluva comeback for a company which in mid-2009 saw its CDS trading in line with that of WIND Hellas - revealing similar expectations at the time for two companies which have subsequently seen very different outcomes. Apparently ONO's chairman was quoted by Expansion last week as saying the company would look to IPO when market conditions permit.

Hell, we've even seen the return of the dividend deal, which gives everyone in the credit market an uneasy sense of deja vu, but apparently not enough to keep them from joining in. Asian undersea cable operator and data center hopeful Pacnet last week closed a $300m senior secured bond offering priced at par with a 9.125% coupon. $100m of the proceeds are earmarked for a dividend to shareholders Ashmore, Spinnaker and Clearwater, typically something which bond investors frown on, but I understand that the deal was 2x covered at mid-week, with demand from Asia alone covering 80% of the announced deal size. Eventually it ended up 5x oversubscribed. And this is for a single-B-rated company (albeit a good one, I think) in a sector where investors have a large store of really terrible memories.

These are but a few examples of how things have gone right so far for PE investments in our beloved telco space, and I am not making any value judgements here about the PE industry, its tactics, or its ethics. It is full of smart people, and intelligence is a large part of survival, but in this case, I think it has also gotten lucky. "Lucky" in the sense that the popularity of the high yield market seems to have attracted a significant participation from non-traditional participants, many of whom will need to put money to work and are more interested in income than they are worried about short-term market risk or the yield compression in new deals which many of the rest of us have found so disturbing this year. In other words, there is a wall of money which seems to chase any deal which comes to market, and if you're a PE sponsor looking to refinance, it's a nice problem to have people queueing up to hand you money, sometimes even more than you asked for in the first place.

While I don't expect a return to the Golden Age of the telco mega-LBO any time soon, if ever, it does seem that finance is available for the right types of assets, and I expect PE to continue to be more visibly active. For one thing, as the examples highlighted above suggest, the 2006/7 era deals are moving into their fourth or fifth year, and the sponsors must surely be feeling pressure to generate liquidity events of some sort, or at least to put the building blocks in place. It's also important to recall that some of the funds raised in 2006 and 2007 are still nowhere near being fully invested, so there must also be mounting pressure to put money to work in new deals. Nor is it the case that inflows to the space have totally stopped since, though the climate is obviously more challenging.

So where should we expect new activity to come from? I think there may be three broad categories:

1) I think it may be of fairly limited impact in the telco space, but the trend towards secondary buy-outs (welcome to the FT paywall) may turn up some deals, as companies increasingly look to deploy older vintage capital;

2) Deals driven by a desire to augment the value of existing portfolio companies, one example being Silverlake's presence in the Skype acquisition, which has given rise to a partnership with legacy investment Avaya. Trying to predict where and why these occur will take careful analysis of existing PE/venture portfolios and a detailed matrix of good matches;

3) New deals, with a focus on strategic enablers, not the "big game" network LBOs of the past. I was intrigued by the two deals Carlyle announced last week, the acquisitions of CommScope and Syniverse. The former is a key infrastructure solutions provider to some interesting subsegments including wireless, fiber, cable, and data centers, while the latter is a key enabler of mobile roaming services and datamining for telcos. Maybe I'm reading too much into these deals, but it looks to me as if, rather than following the playbook of buying up network assets and sweating them, Carlyle seems to be working from an industry matrix which points it towards companies active in defensible strategic choke points. Which is an approach I like.

So welcome back Private Equity, you make life more interesting and keep us common folk on our toes!