VCs RENEW INTEREST IN TELECOM WITH RISE IN TECH DEPLOYMENTS

Venture capital investment in the telecom space is starting to rise again after years of decline following the sector's crash. Telecom investments hit a two-year high in the second quarter, according to PriceWaterHouseCoopers, when 53 companies took in $562 million — nearly 10% of the total amount invested across all industries. In the first half of 2005, the number and value of VC investments in communications companies went up 33% and 1%, respectively, reversing a consistent slide in both metrics over the past few years.

“[Telecom] is starting to look more attractive to, and gain some attention back from, the VC community,” said Jessica Canning, DowJones VentureOne research manager.

One factor stirring VC interest is a slight uptick in merger and acquisition activity. Though the number of telecom M&A deals in the first half of 2005 was down from a year earlier, the value of those deals went up. The average deal size for acquisitions in this year's first half was $76.5 million, according to VentureOne; a year ago, it was $69.4 million.

“[Telecom M&A activity] is getting more healthy, but it's not yet at a pace that one could say we're happy,” said Hatch Graham, managing director of ATA Ventures, which in March dedicated a $150 million fund to the telecom sector and plans another next year. “It's still sparse. There's not a big sample population of M&A events. And you just don't see the billion-dollar exits.”

In fact, that increase in telecom M&A may be due partly to the sector's poor showing in the IPO market, Canning said. Of 13 IPOs so far this year, only one came from communications.

Still, the moment venture capitalists search for is not one of high liquidity but of high liquidity a few years down the road. This recent uptick could be an early indicator of that, Graham said. And the swell of “overhang” in recent years — funds VCs have raised but not invested — breeds further optimism. VCs amassed nearly $54 billion in overhang by the end of last year, Canning said, of which nearly $33 billion is earmarked for new additions to their portfolios.

A Carmel Group survey concluded California VCs will invest $5 billion to $7 billion in communications companies over the next three years.

Technology deployments are also making VCs more confident.

“As these new technologies become field-proven, the risk goes down,” Graham said. “When you see Wi-Fi at every Starbucks, that makes it easier to measure the advantages of WiMax and start getting comfortable with it. Same with fiber to the home: You get a chance to taste it; it's in the field, working.”

Although VCs are no longer just doing damage control on their existing portfolios, they are proceeding with caution, spending more time on due diligence and showing a growing preference for maturity. Fifty-two percent of the telecom funding deals in this year's first half were later-stage rounds, up from 41% in 2004 and 22% in 2000, Canning said. Ballast Point Ventures spent a year getting to know the folks at Wave7 Optics before investing $3 million in the company's latest round this month.

New telecom products are also more mature these days, as start-ups hibernating through telecom's long winter had a lot of time to perfect their gear. Last year Infinera unveiled its optical switch product after three years in development.

“You see great products coming out now,” Graham said. “For the past two or three years, [start-ups] haven't been out doing a lot of sales, so they stayed in and made their products more robust. Now these products are entering the market, and they don't get returned.”