What’s behind the biggest LBO ever attempted in Europe?

The American fund KKR is going after Telecom Italia, ready to bet more than €33 bn on the largest leveraged buyout ever attempted in Europe.

But KKR isn’t the only fund interested in European telecom as there might be more to this than meets the eye.

On the 22nd of November 2021, the American fund KKR proposed to the shareholders of the Italian incumbent operator, Telecom Italia, to buy it for € 10.8 bn while taking over the debts of the said operator and withdrawing it from the list.

Considering the more than €20 bn debt of the target company, the overall deal value would reach €33 bn, representing the biggest LBO ever attempted in Europe.

If this offer convinces Vivendi, the main shareholder of the Italian operator, it will also be the second-largest LBO ever signed in the world, after TXU in 2007.

This transaction is intended to be concluded in a friendly manner but must still be studied in depth by the board of directors of the Company and by the Italian government.

Despite potentially being the largest LBO in Europe, our focus isn’t limited to this transaction, as this operation is part of broader market logic and part of a sustained and increasing interest in European telecom companies from private equity firms.

It should be noted that due to low valuation levels, several companies in the sector are going out of business and are pulling out of the stock market. 

This is the case for the large operator Altice, of which SFR France is a subsidiary, and for the Iliad group.

Even Stéphane Richard, the CEO of Orange, dreams about a potential delisting: “If I could, yes, I would take Orange off the stock market,” he said recently. It must be said that the group’s shares are trading at a historically low level (9.8 euros). An “under-listing” that affects almost all other European operators.

As a consequence of this turbulent environment, private equity firms are closing in on these high reward investment opportunities.

Why is the “broom wagon” of the market attracted by the European telecom sector ?

This mistrust of the stock market towards the telecom sector has increased the appetite of investment funds towards companies operating in this sector, by multiplying purchases.

The stock market has not appreciated telecom operators lately, as they are considered too competitive, too mature, too capital-intensive and not sufficiently profitable in the short term. Indeed, the operators of this sector suffer from a phenomenon of desynchronization, between their economic model and the financial logic. 

It is known that in terms of the financial cycle, the listed markets follow a logic of a relatively short financial cycle (between one and two years). However, the heavy investments of the telecom sector involve huge projects (fibre optics or the introduction of 5G) whose first financial returns will take no less than five years to materialize. 

On the other hand, investment funds have, by nature, a longer horizon and are therefore more suitable in the current period. Coupled with the still low cost of debt and their almost infinite capital resources, private equity funds have an almost unbeatable advantage that allows them to offer valuation premiums that are impossible to refuse for the shareholder of an operator that deals at best at 5 times its EBITDA.

This misalignment between companies of this sector and the public market makes them particularly attractive to private equity investors who love to play the role of “broom wagon” in the sector. Hence the multiple investments that are being made in this sector: between the proposed acquisition of T-Mobile Netherlands – an unlisted operator and subsidiary of Deutsche Telekom – by the funds KKR-Providence-Cinven – and the British TalkTalk, which was taken over by the fund Tosca, while the German TeleColumbus joined the portfolio of Morgan Stanley Infrastructure Partners, the appetite of private equity for this sector is growing.

Where does the upside for PE Firms come from ?

The covid-19 pandemic proved to be severely damaging, having a negative impact on global economic growth.

However, every cloud has a silver lining. In response to this situation, Central Banks all around the world have upheld historically low-interest rates, in the hope of boosting the economy.

This decision has allowed PE firms to borrow funds at an exceptionally low cost, increasing their expected return and giving them access to the necessary funding needed to conduct large acquisitions.

Secondly, despite the troubled financial health of telecom companies, there has been an explosion in demand for data and wireless connectivity.

Part of it can be a direct and obvious consequence of the pandemic’s social distancing measures, which shifted the way we operate as humans, on a professional and personal level, increasing our need to stay connected in order to remain competitive.

However, this trend is also due to the much-anticipated growth in digitalization, as the rise of the  “Interest of Things” (IoT) technologies is driving demand upwards, since these technologies require constant and stable connectivity to mobile networks.

Moreover, while the telecom sector is expected to grow tremendously going forward, small telecom companies are facing cash flow and liquidity problems, mainly due to the pandemic.

Due to the appearance of new disruptive technologies, such as 5G and network virtualization, new and innovative companies have emerged, making them attractive acquisition opportunities for bigger players who are looking to adjust their operations and product offerings to the latest technological trends.

Therefore, PE firms can take advantage of a market ripe for consolidation by buying both mature struggling companies at a discount and technological innovators, and consequently restructuring and consolidating them into larger reorganized companies they can ultimately sell to strategic players at a premium.

All that glitters isn’t gold

High levels of debts, mainly due to the extensive usage of leverage in past acquisitions and in previous investments, remain a key concern in the telecom industry. According to the Financial Times, market capitalization is dwarfed by borrowing and, as revenue growth continues to shrink, telecom companies in Europe, such as Altice Telefonica and TIM, are being closely monitored by rating agencies. 

Also, high levels of Capex required might become problematic for PE funds, especially since recent Capex investments did not produce growth in the industry. According to the financial times, political pressure is being exerted on companies to stop relying on the Huawei networks and invest in building their own full-fibre network and 5G technologies. Moreover, companies are also feeling pressured to invest in 5G because they need to handle the increased demand for data. Investing in this technology would cost companies billions with no viable commercial justification, knowing that consumers are not willing to pay higher fees for faster service and will most likely shift to cheaper rivals. 

What’s the outlook for the telecom firms ?

The benefits of these acquisitions may not be limited to the investors, as there may be an upside from private ownership for the target telecom firms as well.

Indeed, Private Equity investors can bring a range of technical and industry expertise to the running of these services, increasing efficiency through harmonized management processes and modernized platforms and systems.

Furthermore, there may be great benefits to be gained from consolidation under private ownership that can on the one hand lead to cost synergies and on the other hand to better integration within the value chain resulting in higher effectiveness.

Also, private ownership would give telecom firms access to funding that they would unlikely raise due to their already levered capital structure and that they deeply need for the capital intensive projects in key technologies that may give a competitive advantage in a crowded and competitive market.

The only way out ?

Historically low borrowing costs, rising demand for data services and an alignment in economic and financial time horizons.

Take all these ingredients together and add in the mix a group of PE funds that are desperate to deploy their funds in highly rewarding investments, the outcome seems clear.

In an extremely crowded market in need of consolidation, PE funds may just have found one of the best investments available and telecom firms may have found the perfect partner to kickstart and support their long term high tech projects.

Authors : Eugenio Molinatti, Elie Farah, Aya Abied, Niccolo Esposito

Glossary

LBO : Leveraged Buy-out – acquisition financed by debt

Capex : Capital Expenditure

Sources

https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/pe-interest-in-europe-s-telcos-is-rising-due-to-covid-19-8211-experts-60187837

https://blog.outvise.com/private-equity-has-its-sights-set-on-telecom-infrastructure-investment/

https://www.adlittle.com/sites/default/files/viewpoints/ADL_CreatingValueInTelecomsConsolidation.pdf

https://www.datacenterdynamics.com/en/news/kkr-offers-to-buy-timtelecom-italia-for-12-billion/

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