Making a big deal of small print

Technological change is sometimes the main cause behind the dimming fortune of an industry’s incumbent players. But not always.

In the US, low oil prices are causing stress among both conventional and shale producers. Share prices have been sagging for a while and well count is now beginning to fall. This dynamic, which owes as much to macro developments as it does to technological breakthroughs, is starting to take a toll on the midstream business.

By some accounts, the combined market capitalisation of midstream oil and gas distributors has fallen by a fifth in recent months. Europe’s pipeline sector, while smaller than its American counterpart, has also been through turbulence, thanks to changes in available reserves and regulation.

But it’s another space that’s recently caught our eye: the telecoms industry. In a way that’s not dissimilar to the pressures weighing down on power utilities, European network carriers have of late been squeezed by regulatory clamp-downs and new market entrants.

Just because an industry is under pressure doesn’t mean it isn’t time to invest in it, though. Quite the contrary, in fact. As most private equity players will tell you, this is when the best value can be found and the greatest opportunities to turn around a business often present themselves. Unsurprisingly, quite a few famous buyout names have made forays into both markets of late, snapping up non-core assets that corporate players were looking to get off their balance sheets.

As far as infrastructure investors are concerned, this prompts two questions. Firstly, is the deal flow in both sectors going to be sustained next year? Here the answer is a resounding yes. In the US, Master Limited Partnerships (MLPs), a major force behind the historic roll-out of pipelines across the country, are finding themselves drastically stretched.

Having to distribute most of their earnings as dividends, MLPs, like yieldcos in the clean energy sector, always need to raise fresh money. But with upstream companies scaling back exploration projects, their main source of growth seems to be petering out, causing a growing number of investors and lenders to lose faith in them. Some may therefore look to raise liquidity by less conventional means, or sell assets outright. A good example of that was provided this week by TPG and Goldman Sachs, who took part in a $1.55 billion deal to boost Enlink Midstream’s capital base.

European telecoms should also provide a steady flow of assets to market in 2016. Past months have already offered a good template for this, with the likes of Telecom Italia and Wind divesting thousands of towers to independent operators, some of which are backed by financial investors (existing players in the field include AMP Capital, Antin and Canada’s PSP). Telecom Italia is looking to sell more and last week Spain’s Telefonica said it intended to divest the whole of its towers business, probably in several stages.

These developments lead us to a second question: when should these assets be considered infrastructure? After all, neither type enjoys a full monopoly position. There are sometimes several ways to ship oil and gas and in the US regulation does not guarantee a steady income for the operator. Some European countries have overlapping tower networks.

The answer lies in the contractual arrangements under which the assets, when purchased, are going to operate. Much has been made, for instance, of the long-term, fixed-fee contracts between MLPs and the oil and gas producers they serve. These were meant to protect pipeline owners from turmoil further upstream, where low oil prices are exacting their full effect. But worries are mounting that upstream companies could now seek to renegotiate them. Ensuring that the original small print makes renegotiation difficult will be key for would-be buyers of midstream assets.

Existing contracts are what is often lacking when telcos divest towers, since service provider and clients were previously part of the same entity. This will be the case in the Telefonica sale, which is why an infrastructure fund manager told us earlier this week that it was too early to attach a value to the company’s tower business, let alone decide whether it was an attractive business to buy. Getting greater clarity on the terms governing the relationship between the future owner and its primary client should be a crucial part of any due diligence.

There’s significant upside potential behind both type of assets. Greater gas use for power generation should buoy US pipeline businesses in coming years; lower tenancy rates on towers currently owned by European telcos leave much room for bottom-line growth. But investors first need to make sure downside risks are well covered.