Licking their wounds

Private equity firms will have to be more careful if they don't want to get burned again.

In the long list of casualties of the telecom shakeout are prominent private equity firms, those well-financed, supposedly savvy investors that generally put large amounts of money into companies of all stages, hoping for a profitable exit ramp somewhere down the road.

Many of these firms got into telecom with gusto during the past few years, plunking down hundreds of millions of dollars at a time and showing an ample thirst for emerging service providers (see table). But now they're paying the price, having sustained large losses from carriers that have gone under or have no viable exit strategy except liquidation.

Many private equity firms are unwilling to talk about the losses they've sustained or why they invested in particular companies. In most cases they seem to have been caught up in the euphoria that swept the industry.

But the mistakes made go beyond that, said Rich Nespola, president and CEO of The Management Network Group, a consulting firm that advises companies on telecom investments. Private equity firms made fundamental mistakes in evaluating their competitive local exchange carrier (CLEC) investments, he said. One mistake was thinking that incumbents would pick up CLECs to enter markets — that the best entry for SBC Communications into BellSouth territory, for example, would be to buy a CLEC operating in Atlanta.

Private equity's telecom exposure

Forstmann Little
XO Communications	$250 million
McLeodUSA	$1 billion
Hicks, Muse, Tate & Furst
ICG Communications	$230 million
PSINet	Undisclosed
Rhythms NetConnections	Undisclosed
Teligent	$200 million
Kohlberg Kravis Roberts
Birch Telecom	$60 million
Intermedia	$200 million
CAIS Internet (now Ardent)	$200 million
Welsh Carson Anderson & Stowe
Winstar Communications	Undisclosed
Source: Company reports

“We have always said that that doesn't make sense to us,” Nespola said. “In some instances it was cheaper [for the RBOC] to build it than to buy it.”

Private equity firms also “woefully underestimated” how difficult it was to be in the local service business and, thus, dependent upon the incumbent's facilities, Nespola said. “The capital required to be in the local business is enormous.”

The hardest knock against some of the private equity firms is that they occasionally have poured follow-on money into carriers that didn't have the brightest prospects. Perhaps the most egregious example of private equity firms trying to prop up a dying company was the $750 million in preferred stock and warrants that Liberty Media Group and Hicks, Muse, Tate & Furst bought in ICG Communications about seven months before the company went bankrupt. ICG has been accused of numerous bad business practices, leaving many to wonder why the shenanigans were not discovered by the two firms before they invested.

“It was unconscionable,” Nespola said. “They didn't do any due diligence. They got greedy and they never spoke to anybody at the company. They got what they deserved.”

Forstmann Little recently put itself on the hook with XO Communications, a CLEC that is expected to be one of the survivors but is struggling under a debt load that rang up more than $400 million in interest expenses last year. XO recently closed on a $250 million investment from Forstmann Little, bringing the firm's total investment to $1.5 billion. Forstmann now owns 22.5% of XO's fully diluted outstanding shares.

“The management teams for the big CLEC ‘survivors’ are excellent,” Nespola said. “The conundrum they have is that they have so much debt, and it's taking so long to gain market share — where do they go from here?”

For middle market buyout investors such as Willis Stein & Partners, the lack of any significant M&A activity has stifled the firm's usual exit strategy of selling to a larger strategic partner. “The problem is there is no debt market for telecom,” said Avy Stein, co-founder and managing partner of Willis Stein.

According to VentureOne, in the first quarter of 2001, only five companies completed IPOs, while 40 withdrew their S-1 filings. The number of M&A deals declined 10%, while the value of those deals was about $6 billion — more than a 45% decline from the previous quarter.

Undaunted by the macro environment, however, Willis Stein announced on June 13 it had closed on a $1.8 billion private equity investment fund. Previous investors kicked in about $1.2 billion of the new fund, Stein said. About 20% to 25% of the new money will go to telecom, including numerous opportunities in wireless infrastructure, Stein said.

“A lot of private equity firms have a ton of cash on the sidelines — they can't get CD-type returns,” Nespola said. “They have to invest.”

Stein believes the current environment breaks down into two sections. One section is companies that do not have a viable business plan for becoming profitable. “Those scare the living daylights out of us,” Stein said.

The other section is business models that the market is oversold on — from 2.5G and 3G wireless infrastructure to network management and maintenance plays. “People are not going to use less telecommunications. There may be a lull in spending, but that lull isn't going to last forever,” Stein said.

“Ours is a long-term business,” he said. “It's not a question of ‘what are these assets going to be worth tomorrow?’ [but] ‘what are these assets going to be worth four to seven years from now?’”

The only immediate effect of the downturn on Willis Stein & Partners is the lower price for an equivalent stake in a company, Stein said.

Hicks Muse also is in the midst of fundraising. The firm's losses, however, may have investors worried. Originally targeted to reach almost $3.5 billion, Hicks Muse apparently is closing the fund in the $2 billion to $2.5 billion range.

But private equity firms will have to be more careful if they don't want to get burned again. “I have faith in the telecoms,” Nespola said. “But you have to really examine management teams, business plans and, most importantly, you have to look at the assumptions in that business plan.”

The glut of telecom equipment will mean firms will be shy about investing in some telecom infrastructure sectors, Nespola said, but service provider plays in international markets could be fruitful.

“The smart ones are looking at Latin America and selectively at markets that are nascent, such as China,” Nespola said. “In more mature markets, there's less upside opportunity.”

M&A watch

Acquirer	Acquired	Terms	Closing	Description
ADIR VoIP Technologies	NetSpeak	$46.5 million to $48.2 million	Third quarter	Merger of two VoIP technology providers
RSA Security	3G International	$12 million	Early June	E-security application provider acquires provider of smart card and biometric authentication products
StarNet	Media DVX	Undisclosed	July 1	Provider of promotional management software for cable acquires digital advertising distribution firm
SetNet	Selfswitch	Undisclosed	Early June	Unified communications software provider acquires unified communications ASP
Vitesse Semiconductor	Versatile Optical Networks	$244 million	End of September	Semiconductor manufacturer acquires optical component maker
Wire One Technologies	GeoVideo Networks' assets	$4.5 million in stock plus stock options	June 1	Video ASP acquires assets of Lucent video spinoff
Cypress Semiconductor	Lara Networks	$225 million	June 30	Semiconductor firm acquires packet processing component maker
Compiled by Toby Weber