It wasn’t too long into the covid-19 pandemic before fibre broadband was being hailed as the “fourth utility”. It became as much a buzzword in the infrastructure world as “new normal” and “self-isolation”. Previously a more niche part of the asset class’s spectrum, fibre assets and companies became the new hot commodity for infrastructure investors eager to capitalise on the new work-from-home culture and increased need for high-speed broadband.

And capitalise they did. In the US, fibre broadband rollouts reached 68 million in 2022, up 13 percent over the past 12 months and 27 percent over the past 24 months, according to figures published this year by the Fiber Broadband Association. In Europe, nearly 199 million homes were passed by fibre as of September 2021, up from 176 million a year earlier, according to research published by the FTTH Council for Europe last May.

However, despite the rollout, subscriptions are relatively low for a fourth utility, accounting for 36 percent of fixed broadband subscriptions in the 38 OECD member countries, up from 22 percent five years ago, the organisation says. And, in many markets, fibre broadband critically lacks the monopolistic advantage displayed by many of infrastructure’s other utilities.

Speaking to the Infrastructure Investor Network at our Global Summit in March, Marc Ganzi, chief executive of DigitalBridge and one of the sector’s leading figures, had a catchier term to describe fibre’s challenge.

“Hope capex is what I call it,” he quipped. “You’re putting the capex in and you’re hoping you’re going to get the subscribers. You’re hoping you’re going to get the penetration.”

He compared some of the current trends in the fibre space with the dotcom bubble of the early 2000s, where similarly optimistic business assumptions were made about internet access. Ganzi claimed, we’re in “a movie that’s repeating itself”.

“The capital structure choked those businesses, which went bankrupt, and we spent 2002-05 repairing the credit cycle in digital infrastructure,” he added. “We’re about to go through that same cycle right now, which is businesses that were credited at 30 percent penetration, with four or five fibre carriers running down the same street where they’re overbuilding each other. It’s not happening at the velocity that everybody thought, and guess what? If you have four carriers and everyone’s up to 30 percent penetration, I’ve not found one country in the world that has 120 percent residential penetration. The math just doesn’t work.”

The words of caution from Ganzi are already translating into reality. US-based Lumen Technologies, for example, cut its 2021 aim of reaching 12 million US homes in the coming years, revising it to 8 million-10 million at the start of this year.

“Companies that have
already done that
rollout or are able to
do that rollout under
the protection of a
concession, I think, are
going to be favoured”
JEETU BALCHANDANI
BlackRock

“I was very concerned about putting fibre in the ground for the sake of putting fibre in the ground,” chief financial officer Chris Stansbury said during Lumen Technologies’ Q4 2022 earnings call. “We need to make sure that we remain focused on those large metros that we’ve talked about and that we stop being so focused on a cost per enablement and on a number of enablements, and more around making sure that in those markets that we’re serving, that customers are going to want our product.”

It might not be dotcom bubble mark two, but there’s certainly a growing feeling that the gold rush that started in 2020 is maybe seeing that capital tested a little bit more.

Dialling up on risk

Returns are certainly compressing in this space. While most greenfield fibre-to-the-home investors typically see a 20-30 percent take-up, modelling analysis by McKinsey has found that in some markets, 80 percent of all households would be required to subscribe to the provider’s network to achieve an internal rate of return above 10 percent over 25 years. Not bad, for sure, but hardly value-add in a value-add world.

“This points to challenges we have seen with monetisation and improving take-up rates, which requires excellence in commercial and go-to market strategy including understanding your customer base, having clear segmentation, articulating the products’ value proposition, and having a friction-free customer journey from awareness to conversion across touchpoints,” says Gerardo de Geest, an Amsterdam-based partner in McKinsey’s telecommunications division.

For infrastructure investors, these are required skills that weren’t necessarily always in the toolkit. It’s also a different type of offtake negotiation to that of securing, for example, a power purchase agreement for a power plant.

“I think we do see,
more broadly, banks
taking a bit less
of fibre deals than
perhaps they were
a year ago. That is
probably driven by
macro factors, and
we’re seeing banks
being more
selective”
TOM LEES
Allianz Global Investors

“There’s a lot of complexity to these businesses that you really need to be able to appreciate,” says Jenny Kashdan, managing director at US-based digital infrastructure fund manager Grain Management. “When you’re entering a market, a lot of that comes down to building the network and then executing from an operational standpoint to actually get the customers. It really requires extensive and sophisticated sales and marketing to get those customers quickly.”

Kanan Joshi, a New York-based managing director at Netherlands-headquartered DIF Capital Partners and leader of its digital infrastructure efforts, cautions firms underestimating the marketing element.

“You need to have a solid sales and marketing engine to rapidly achieve a certain percentage of market share. You need to be confident you can achieve the share you’re underwriting based on market data and the [internet service providers’] track record,” she maintains. “For example, if you’re in a multi-player market and need a 30 percent market share to achieve your target returns, in our minds, that’s riskier than if you’re the only fibre provider and are targeting a 40 percent market share. To get that 30 percent needs a lot more sales and marketing muscle than if you’re the only player in town, where you can get much higher penetration rates because fibre is a superior product to incumbent technologies.

“We don’t have the attitude of build and they will come. We will typically get some pre-orders before starting construction,” she continues. “In addition to the commercial analysis, we do demand testing and based on that, we decide where we will go.”

DIF’s first investment in the space encapsulates its changing risk profile. A 2017 deal, it acquired 55 percent of ADTIM, a French fibre player that enjoyed success in France’s rollout of fibre to mainly rural areas through a PPP programme. The structure and the carve-up of the country into different fibre regions meant there was certainty in customers and returns.

InfraVia Capital Partners was the vendor to DIF, having invested in ADTIM in 2012. InfraVia went on to make other fibre investments in France, the UK and Ireland, but it was in Germany where it became unstuck with its helloFiber joint venture with Liberty Global, when plans to rollout fibre across Germany were scrapped earlier this year.

“The technical and IT integration is relatively easier in Germany, which is interesting to attract the big operators onto your network,” explains Bruno Candès, partner at InfraVia. “By far and large, the problem was massive inflation of capex, massive bottlenecks in terms of securing construction capacity in the short- to medium-term and as a result, to reach scale quickly would mean a deterioration of equity returns projection below what we did initially underwrite.”

While Candès stresses that the German joint venture was scuppered before capital could be invested, he draws parallels with InfraVia’s plans with Liberty Global in the UK.

“We liked the opportunity to build because BT was slow to roll-out, so there is a real opportunity to build first,” says Candès. “What’s important in all of these wholesale platforms is the capacity to reach scale to have meaningful discussions with ISPs, so they can come onto our network. Scale is really important. That’s why we didn’t do anything in the UK before this partnership with Liberty Global.”

However, models such as the regional French PPPs or similar structures pursued in parts of the US are favoured by more conservative investors than the more open-market UK or German models.

“Companies that have already done that rollout or are able to do that rollout under the protection of a concession, I think, are going to be favoured,” explains Jeetu Balchandani, managing director and global head of infrastructure debt at BlackRock.

“And that’s what has allowed us to advance long-term, investment-grade debt to some of the opportunities we have invested in. These businesses have a penetration level that is producing revenues and that can be substantiated for future growth. If you have that kind of protection, you might be able to deploy long-term, investment-grade debt. If you don’t have that, you’d probably want to keep your maturity shorter.”

Capex constrained

To battle against a sector’s gold rush is one thing. To do so against a difficult and significantly changed macroeconomic environment, is another. Today’s rising interest rate and inflationary environment is bad news across a number of fronts for a sector that relies on significant capital expenditure and greenfield rollout if modern economies are to get out of the slow lane when it comes to broadband.

“The macroeconomic difficulties mean there might be more of a careful look at fibre investments going forwards,” says Ajit Pai, partner at New York-based Searchlight Capital Partners, whose infrastructure efforts focus on digital. “Some had assumed the curve will always be upwards to the right and we’re now seeing investors have to be careful in this sector as in any other sector.”

The struggle is real. Bare fibre prices have increased in some markets by up to 70 percent since March 2021, according to analysis in October from commodity consultancy group CRU Group.

According to Grain Management’s Kashdan, this will lead to some industry revisions. “Inflation is driving some costs related to network build and operating costs and then the higher rate environment is increasing the cost of funding,” she says. “For some of those builds you then have to be even more selective about some of the projects you’re undertaking.”

That sentiment is also coming across from the debt financing perspective, according to Tom Lees, leading portfolio manager for Allianz Global Investors’ resilient opportunistic credit strategy.

“I think we do see, more broadly, banks taking a bit less of fibre deals than perhaps they were a year ago. That is probably driven by macro factors, and we’re seeing banks being more selective,” he observes.

That’s the pressure on those doing the developing. However, FTTH investments have a reliance on the end user also facing uncertain times.

“What’s important in
all of these wholesale
platforms is the
capacity to reach scale
to have meaningful
discussions with ISPs,
so they can come onto
our network”
BRUNO CANDÈS
InfraVia Capital Partners

“One of the things a savvy investor needs to think about is how do you underwrite consumer uptakes of these deployments given that inflation is eating away more at people’s purchasing power,” says Searchlight Capital’s Pai. “Do consumers take a lower speed of broadband or not take broadband at all, given inflationary pressures? Those are the types of considerations which make it a little more challenging.”

That outcome would certainly put a dent in the idea of the fourth utility. But Pai’s industry peers are somewhat more bullish.

“People are going to switch to fibre. It’s not a question of if, it’s a question of when,” argues Candès. “There are two broader questions: what’s your cost to build? What’s your model, wholesale or retail? Anchor tenants and take-up are risks you need to underwrite.”

Joshi adds: “This is a capex-heavy sector, so the interest rates have an impact on overall returns. Cost of debt financing for these projects has gone up but even in the inflationary environment, we think the demand for fibre continues to be there.”

Financing the future

Putting aside recent developments affecting liquidity in the financing market, some debt providers haven’t been as willing to bet on the long-term future as some of their equity counterparts. Away from the concession-style financing noted by BlackRock’s Balchandani earlier, he has been seeing much more of these shorter-term, ABS-style loans in the digital infrastructure space recently, where the maturities or the anticipated repayment date is much shorter, providing greater protections for the lenders if they aren’t repaid.

Balchandani and other sources Infrastructure Investor has spoken to are also proponents of a phased financing approach for greenfield fibre developments, only providing tranches once certain uptake thresholds have been met. AllianzGI’s Lees, though, is against such an approach.

“In terms of dealing with that first risk, it’s quite difficult to see how a phased approach addresses that risk because you’ve got to just reach a certain scale to be profitable,” he argues. “Phasing it, in a way, puts risk on top of that, which is sourcing future financing.”

“We don’t have the
attitude of build and
they will come. We
will typically get some
pre-orders before
starting construction”
KANAN JOSHI
DIF Capital Partners

Valuations of FTTH businesses also remain a worry for lenders. The McKinsey analysis notes that in the three-year period ending in 2021, transaction multiples averaged 16.8x, compared with 19.7x in 2021 alone, which would require significantly greater subscription rates than seen to date. This could also pose challenges for some businesses’ terminal value.

“Depending on the sellers’ time horizon, they could either choose to sell at lower valuations or wait. We are already seeing a slowdown in deals in some markets because of this,” explains McKinsey’s de Geest. “We also observe a widening in the ‘bid-ask’ spread between what sellers are looking for and what PE players are willing to pay. For investments in greenfield areas, unless the capex and deployment plans are already signed and scheduled, this would also potentially mean a slow down until the situation improves.”

Patrick Fear, managing director and head of digital infrastructure and services at AllianceBernstein Private Credit Investments, worries about a lack of attention being paid to leverage-to-value in the space, which he sees as a large mistake, given that the cost of financing has risen so dramatically in recent months.

“People have been paying 20x or 30x EBITDA for fibre assets. So, in theory, you could lend an amount worth 7x EBITDA to them, which would have been something that we were doing at the top of the market. But the fact of the matter is these businesses can’t service their debt burdens, their interest costs at that level with today’s underlying cost of debt.”

Ultimately, though, just as Ganzi cautioned about not learning the lessons of the past, Fear is concerned about the experience, or lack thereof, of players in the space.

“In this wave of buildout, what is likely to happen is that there are a number of folks who’ve seen the capital flowing into the space. They’ve seen the subsidy discussions and they’re trying to build business plans, but they’ve never done it before. We don’t think that’s a good place to be lending money,” he notes.

It might just be a newer infrastructure sector still on its way to maturity, mirroring some difficulties other subsectors have faced before. But, for some of the more conservative investors, warning signs for FTTH are flashing.