This article is sponsored by Ardian
Carve-out opportunities are expected to proliferate in Europe as major telcos come under mounting pressure. As Ardian’s Gonzague Boutry and Michael Obhof explain, what began in the tower space is likely to spread to other sectors and could increasingly involve active as well as passive equipment.
The carve-out story has already played out in the US, but fibre roll-out continues to require significant investment and valuations are starting to moderate in reflection of climbing costs.
How are existing digital infrastructure assets being impacted by the macroeconomic environment?
Gonzague Boutry: Inflation has been high in both Europe and the US. Forecasts indicate that is likely to continue, with predictions of 5.3 percent for the eurozone and slightly under 5 percent for the US. Telco P&Ls are inevitably being impacted, particularly by pressure on wages. Energy costs have also had a material impact, especially in Europe.
The main question is the extent to which it will be possible to pass through these cost increases to end customers and what will happen to revenues. Assuming revenues remain flat, market research expects 3.5 percent decrease on EBITDA in 2023 implying a 13 percent decrease on free cashflows.
Michael Obhof: On the contrary, our digital infra investments are strongly inflation-linked which provides a material amount of protection in the current macro environment. The other factor at play, of course, is the cost of debt. We are experiencing an interesting phenomenon in the US currently in that SOFR rates are as high as they have been in a decade, but forward rates are materially below that level. If you are executing on finance right now, you really must think very carefully about any additional debt funding you might require over time and what the cost implications may be.
How is the macro environment impacting your ability to deploy capital in new deals?
GB: Telcos’ balance sheets are going to come under increasing pressure but there is still a massive need for investment in things like 5G, fibre roll-out and in-building wireless. In fact, mobile operators are expected to invest approximately $115 billion in their 5G network by 2025 in Europe and approximately $200 billion in North America, according to data from a market adviser.
Additionally, operators still need to spend heavily to establish fibre connectivity in some larger regions: 32.4 million houses need to be passed in Germany, 21.1 million in the UK and 13.7 million in Italy, according to ING data.
We have already seen a first wave in the tower space, and we have also seen some fibre carveouts in Europe. Further carveout from mobile network operators (MNO) will represent a strong source of dealflow for our next generation of funds.
It is in our DNA to be the long-term partner of incumbent operators. We have partnered with Telecom Italia and Vodafone on INWIT and we have partnered with the largest MNO in Iceland, Síminn and Míla, to name just two. So, we feel we are ideally placed to take advantage of these opportunities.
Which subsectors do you deem to be particularly attractive in Europe right now?
GB: We continue to see fibre opportunities as well as towers transactions. We also see a new trend involving active equipment. Our investment in Iceland is a good example. We executed the carveout of all Síminn’s passive and active equipment across copper, fibre and mobile connectivity. These are complex transactions and not for everyone, but we expect to see more of these deals in the future.
Do you view the opportunity set differently in the US?
MO: Carve-outs from MNOs are no longer prevalent in the US. That all played out 15 to 20 years ago. There is still significant capex required to fund fibre roll-out, however, and that is one area where we are starting to see real movement. We spent some time on the sidelines in that space; the valuations felt too rich.
But investment opportunities are now starting to become more attractive. I would add that I cover all the OECD Americas and so also look to other geographies including Mexico, Columbia and Chile. The benefit in these regions is inflation-linked revenues, especially on the tower side, which you don’t see in the US.
“We do not just rely on equity research or macro forecasts, we do our own modelling”
Michael Obhof
What is your approach to origination?
MO: We have local networks in both Europe and the US, while our office in Santiago provides additional Latin American expertise. We also have a highly experienced operating partner team. That team enables us to properly diligence assets and to really understand what the business drivers are. Candidly, it was because of our operating partner network that we held back in the fibre space.
We were making changes in capex costs sooner than most. That may have made us uncompetitive 18 months ago, but now we are right in the middle of the pack. That knowledge and expertise ensures we are underwriting investments appropriately for the current macro environment.
Would you say that the emphasis of your diligence has changed to reflect this new economic reality?
MO: We have had underwriting standards for inflation for a long time. We do not just rely on equity research or macro forecasts, we do our own modelling. What I would say, however, is that we have fine-tuned the microscope. We run more downside sensitivities, covering a greater breadth of possible scenarios. I would add that there is no substitute for good-quality management teams, so that is a big part of how we underwrite investments.
We look carefully at track record and analyse a team’s ability to react to different macro environments, to adjust business plans and to think outside the box. We want management teams that are well prepared for any storms and can proactively respond.
Which new subsectors do you expect to emerge over the next few years and which are likely to become less prominent?
Michael Obhof: One sector that went on pause in the US, but is now expected to make a material comeback, involves outdoor small cells. These are nodes that either provide coverage or capacity to macro tower sites. It is half fibre and half mini-macro. That market was growing at double digit figures for most of 2010 through to 2019, but then fell back significantly as carriers focused more on 5G.
As that begins to be resolved, in the US at least, outdoor small cells will become increasingly important. We believe mid- to high-single digit growth is very achievable. The same is true of in-building wireless.
Meanwhile, we expect to see a slowdown in the fibre-to-the-home market, which has become all the rage over the past 18 months. Unlike in Europe, there is no real wholesale market. It is all B2C businesses, and we are starting to see some pullback there.
Gonzague Boutry: I would point again to the active equipment trend that we are starting to see emerge in Europe and which is increasingly generating further carve-out opportunities. So long as we do not take technology risk and the transactions are appropriately structured, we believe there will be lots of opportunity there over the years ahead and we believe we are ideally placed to execute on that.
How do you approach portfolio construction?
MO: We have two funds – one in Europe and one in the Americas. Both are essential infrastructure funds that cut across digital infrastructure, transportation and the energy transition. That means that while we underwrite the investments that make the most sense at any given time, we also keep in mind the broader composition of the portfolio.
We are careful to ensure a balance of drivers. Most of our assets are not directly correlated to GDP fluctuation, providing great protection. In practice, each asset is following specific trends. The digital space, of course, is primarily being driven by exponentially increasing demand for data. By balancing these different drivers, we aim to create a portfolio that is resilient.
Meanwhile, we also look for diversification within digital infrastructure itself. We look for investments that will provide downside protection but that also represent a mix of different drivers. Fibre companies have a slightly different base driver to a tower portfolio, for example.
What is your approach to value creation and how do you incorporate ESG into your management of digital infrastructure assets?
GB: We have a very strong focus on value creation, which is why we like to take co-control or controlling positions. Strong alignment with management is very important in terms of where we want to push the growth plan and, of course, our operating partners have a critical role to play as well. We work closely with those partners to ensure we are ready to push ahead with our investment case as soon as the transaction is signed.
ESG, meanwhile, is integral to our value creation approach and a significant part – usually between 15 and 20 percent – of our management teams’ remuneration is linked to meeting agreed upon ESG goals.
“Strong alignment with management is very important in terms of where we want to push the growth plan”
Gonzague Boutry
MO: We do not invest in turnarounds. But we do like to invest in good businesses, which for one reason or another have meaningful operational levers that we can pull. We identify these levers alongside our operating partners during due diligence and implement them during the 100-day plan. It could be that the asset has been non-core to its previous owners, for example. It may not have been given much love in terms of capital allocation. An asset that does not offer that opportunity to add value is unlikely to be exciting for us.
In terms of ESG, obviously our fiduciary duty is to provide strong risk-adjusted returns for our investors and we believe that ESG is a critical component of that. ESG can provide cost savings and improve reliability. But making a business more sustainable also adds value simply by making it more attractive going forward. We are future-proofing investments, which improves the sales price we are able to command at exit and therefore improves returns.
Gonzague Boutry is managing director and Michael Obhof is senior managing director, leading digital infrastructure investment at Ardian.