Investing in telecoms

There is still a great deal of uncertainty and disagreement in the venture industry at present. While general partners of technology venture firms argue that the next few years are promising to provide very attractive investment opportunities, many investors and industry analysts remain sceptical.

To understand why many GPs feel so strongly about their case at present, it is necessary to think through the market dynamics of the industries that they target, as well as the drivers behind entrepreneurial innovation in these industries.

The first thing to remember though is that venture capitalists investing in technology tend to think of entrepreneurial innovation as a disruptive process, as opposed to an incremental one. The history of technology-focused early stage investing shows that, while fewer venture capital investments actually succeed than other types of private equity transaction, the returns generated by investments in businesses that bring disruptive innovation to market can adequately compensate for the overall risk in a venture portfolio. Some industry sectors are obviously more conducive to this process than others, and I believe that, at this point in the cycle, the communication sector is one of them.

In trying to assess the opportunity for telecom-related venturing over the next decade, one should ask the following questions:

1) Is the communication sector a good target for disruptive innovation? Is it ripe for it? And is it large enough to sustain valuable companies?

2) Are entrepreneurial ventures, i.e. start-ups and small companies, the right vehicles to bring communication-related innovation to market?

A look at the sector's fundamentals provides a good starting point. Despite the doom and gloom of recent years, the sector remains very large and highly diverse in terms of market segments, industry dynamics and underlying technologies. In 2002, telecom operators worldwide produced revenues of about one trillion dollars. And in spite of the strong downward correction of capital expenditure in recent years, carriers still acquired communication technology and infrastructure in the order of $200bn. European telecoms generated about a third of this demand for equipment and infrastructure. The industry is now committing about 20 per cent of revenues to capex, down from an historical peak of 34 per cent in 2000. Most analysts predict that stabilisation will occur at historical averages of 17 to 19 per cent of earnings.

Moreover, communication technology comprises a broad range of activity. The sector has both a residential and corporate customer base around the globe; a vast community of service providers specialising in voice, data, content and applications; and a proliferation of dramatically different underlying technologies ranging from software to hardware, from semiconductors to materials.

For investors, this constitutes an opportunity as well as a challenge. Different sub-segments follow their own dynamics and may or may not produce good investment opportunities for venture capitalists. Only a deep understanding of the sector will allow firms to identify the best areas for growth, which can be far from obvious.

For example, the area of broadband connectivity has seen significant growth in recent years, which amid the overall pessimism of late has gone somewhat unnoticed. The importance of this trend cannot be overstated though. DSL alone, a particularly popular flavour of broadband connectivity, grew over 80 per cent in the second quarter of this year, relative to the same quarter a year earlier. Many carriers across the world are accelerating their plans for deployment of even higher bandwidth solutions based on fibre-based connectivity.

Essential innovation
However, while carriers are poised to gain from the growth of broadband services, they are also facing mounting technological and operational challenges arising from the shift in usage patterns that the new medium brings about. One of the key drivers behind the growth of broadband is the popularity of file-sharing technology. This allows users to easily and effectively swap software, movies and music, legitimate or illegitimately. As broadband connectivity is generally always ?live? and un-metered, users download very large files very often. This results in an unprecedented volume of data (in the order of hundreds of megabites if not gigabites per day, per workstation) to be distributed across telecom networks and onto people's desktops.

There are, in other words, powerful market forces at play that continue to require large-scale innovation and additional infrastructure. Moreover, there are other segments within the communication sector with similar potential, including mobile data services, e-commerce infrastructure, wireless broadband and next generation semiconductor technology. These are not minor niches. Each one of these innovations look set to produce multi-billion dollar capital expenditure in the near future, and in many cases already do.

For the communication sector as a whole, therefore, innovation is not optional. It is absolutely critical for telecom operators to innovate over the next three to five years, otherwise their very survival will be at risk. Just ask mobile operators such as Vodafone, Orange or TIM. Their market is approaching saturation with flat or declining revenues per user. Yet most of them are valued today much beyond the metrics of a flat let alone declining business. If they want to maintain their valuations, they have no choice but to pursue growth outside of their traditional voice business and most likely in data connectivity.

Obviously the investment freeze of the last few years has not helped make this evolution happen. After years of cost-cutting and the need to improve efficiency, the question of growth is returning to the centre of attention everywhere. Where will improved earnings per share growth actually come from? This question is critical to most industry participants, from wireline and wireless carriers to large network vendors, and it gives rise to favourable conditions for venture investors, both with regard to commercial conditions facing portfolio companies and in terms of potential M&A exits for the most innovative businesses.

The role of start-ups
There is no question that both academic institutions and established corporations play important roles in generating technology innovation. However, it is also difficult to overstate the impact that entrepreneurs have had over the last 40 years in bringing innovation to market. As a matter of fact, some of the largest and most exciting technology companies today were venture-backed start-ups not so long ago. They are too many to mention, but the list includes among others Cisco Systems, Sun Microsystems, ARM, Juniper Networks and even Microsoft.

There are some powerful reasons why new businesses backed by venture investors have proven so influential. Innovation tends to happen better and faster in unstructured environments, where the intuition and technical know-how of a brilliant entrepreneur can translate into a product without the constraints that large organisations often impose. Also, entrepreneurs are more motivated than employees as they stand to personally gain from success and suffer from failure. Finally early-stage companies tend to focus on a discrete set of technical and market challenges, and often manage to attract the strongest and most specialised talent to face these hurdles.

European entrepreneurs in particular have come a long way during the 1990s. Countries like Ireland, England, Sweden and Israel are already producing second and third time entrepreneurs with a successful track record, especially in the communication area, where European technology developer have arguably been more successful than in any other segment. Companies such as Iona in Ireland, Checkpoint and Comverse in Israel, Across Wireless in Sweden and many others have nurtured an entrepreneurial spirit that has manifested itself in many new and innovative companies financed by local and international VCs.

The European venture capital industry, despite recent setbacks and consolidation of active fund managers, has developed as well, and today successful communication entrepreneurs can count on capital available from general partners that understand their industry to great depth. And a solid infrastructure of high quality professional services to the sector is now in place, encompassing recruiters, lawyers and technology advisory supporting start-ups in their entrepreneurial endeavours.

These are some of the considerations that make general partners managing technology-focused venture capital funds feel good about their prospects ? notwithstanding the challenges that are undoubtedly ahead.

Financing disruptive innovation implies taking very significant risk. A high proportion of start-ups fail for reasons often impossible to predict at the time of the investment or even years thereafter. Virtually all of the successful venture firms in the world owe their returns to less than a third of their investments, and in many cases to just one of the companies in a portfolio. This implies that venture investors must target opportunities that truly have outsize return potential, pay low valuations when they acquire their ownership, and use capital very efficiently to break even. It is an approach that requires discipline. It also requires a very deep understanding of the relevant end markets, strong industry connections to support the opportunity evaluation process and the development of the portfolio, as well as command of the technologies in question. And it takes perseverance and long-term commitment.

This is not a business for the ?get rich quick? or equally the exceedingly risk-adverse. These are values that in a poor exit environment, general economic downturn and increasing LP pressure are strongly put to the test in the mind of an investment manager. It is our view that the best strategy in this context is to simply continue to focus on the fundamentals of our business, the financing of disruptive entrepreneurial innovation in large markets with the calculated assumption of inherent risks.

Investing in innovative communication technology companies over the next few years is as good a bet as it has ever been. The most specialised, disciplined and technically savvy managers (and their investors) will do well. Regardless of the next doom and gloom article you are going to read on the troubles of telecoms.

Giuseppe Curatolo is General Partner at TLCom Capital Partners in London.