The Birth of Local Telecom Competition and Internet Meltdown: M|C Partners’ Second Decade (1995-2005)
By Gillis Cashman and Jim Wade
During M|C Partners’ second decade, two seismic events impacting our industry occurred: The 1996 Telecom Act and dot-com bubble of 2000. The Telecom Act forced local Bell telephone monopolies to unbundle parts of their networks and lease them to competitors on a cost basis. This opened significant new market opportunities for a wave of competitors, which led to many fiber-based competitive access providers (CAPs) evolving into Competitive Local Exchange Carriers (CLECs).
In parallel, the Federal Communications Commission (FCC) was auctioning new wireless spectrum to emerging competitors, opening the door for new carriers with innovative business models in wireless communications. Together, these developments helped create a new generation of competitive communications companies across wireline, fiber and wireless.
M|C Partners had a front-row seat to these new market opportunities, having previously invested in one of the original CAPs, Brooks Fiber, and one of the first CLECs, Phone Michigan. This experience gave us a deep understanding of the unit economics of various competitive telecom business models and helped shape our view of which strategies could create durable value and which were simply being fueled by cheap capital.
Regulations Opened the Flood Gates, the Dot-Com Bubble and Unprecedented Losses Followed
The 1996 Telecom Act, explosive internet growth and additional wireless spectrum being auctioned to new competitors set off a gold rush of new investment opportunities that were fueled by an indiscriminately accommodating capital market. The inflow of public debt and equity into the telecom industry went from less than $5B per year in the early 1990s to over $30B by the end of the decade. Capital expenditures, which grew at only 5.5% from 1990 to 1996, exploded to a 33% compounded growth rate from 1996 to 2000. Wireless and emerging carriers' capital spending grew from $15B in 1996 to $75B in 2000.
With the continued flow of easy capital from Wall Street, valuations climbed ever higher as the cost of capital went lower. However, telecom revenue grew just 10% between 1996 and 2001, which was nowhere near enough to justify the 33% growth capital spending without creating severe overcapacity.
Explosive internet growth in the late 1990s drastically lowered the costs for a flood of digitally focused startups to broadly sell their products without the geographic constraints of brick-and-mortar businesses. As a result, far too many speculative startups were funded, leading to the 2000 dot-com bubble, and a prolonged period of bankruptcies and value destruction across the emerging dot-com and telecom ecosystems.
When the capital markets turned, they turned abruptly. Many companies that had been aggressively funded only months earlier suddenly had no access to capital, unsustainable debt loads and business plans that depended on a financing environment that no longer existed. For many telecom investors, the result was devastating. For M|C, the dislocation created opportunity.
Discipline and a Long-Term View Allowed M|C to Capitalize
Many telecom investors, particularly in the CLEC sector, lost significant money in this downturn, because they employed a national “land grab” approach: Plant flags in as many cities as possible and let Wall Street reward the footprint with ever increasing valuations. These valuations rested solely on city count and an estimate of future revenue share new competitors might capture from the local monopoly. All this phantom value was being created before any meaningful revenue or operating income, and, in many cases, through a “facilities-light” resale strategy.
M|C took the opposite approach. Rather than simply reselling services from the local phone company to accelerate a national rollout, M|C deployed a facilities-based operating model. Our CLECs built their own local switching centers and “middle-mile” fiber networks, which either connected directly to large customers or interconnected with the local phone companies’ switching centers. This meant our CLECs were dependent on incumbents’ last-mile loops only for their smaller customers.
M|C’s CLECs were also regionally focused, which allowed them to drive deeper market penetration and gain meaningful local share. Among the several CLEC business models being funded at the time, we believed regionally focused, facilities-based CLECs offered the clearest path to success. We also applied a hallmark M|C strategy from the cable and wireless industries: Identify experienced management teams in larger markets and back them in smaller markets, where their expertise could disrupt local competition.
Our deep understanding of CLEC unit economics enabled us to recognize the value of the underlying assets and when they were being mispriced. When Wall Street valuations collapsed and nearly everyone in telecom retreated, M|C was positioned to acquire those assets at cents on the dollar, either folding them into existing platforms or funding new platforms. Our commitment to the more complex but ultimately superior facilities-based model, a long-term view of market share potential and conviction around future value creation from industry consolidation drove M|C’s distinctive investment success in the CLEC sector. Over this period and across the portfolio, we acquired $5.6B of assets for just over $120M.
($ in Millions)
| Company | Prior Invested Capital | Acquisition Price | % Invested Capital |
|---|---|---|---|
| Cavalier/Conectiv | $307 | $10 | 3.3% |
| Cavalier/Net2000 | 439 | 12 | 2.7% |
| Cavalier/Elantic/Dominion Telecom | 1,300 | 11 | 0.8% |
| FDN/Debt Repurchase | 58 | 9 | 16% |
| FDN/MPower (Southeast) | 70 | 13 | 18.6% |
| NewSouth | 435 | 58 | 13.3% |
| ICG | 3,000 | 9 | 0.3% |
| Total | $5,609 | $122 | 2.2% |
Acquiring Distressed Assets at Deep Discounts with Florida Digital Network and Cavalier Telephone
M|C was among the earliest investors in competitive local telecom, backing Brooks Fiber (1993), Phone Michigan (1996) and Ovation Communications (1998). Phone Michigan and Ovation were later merged and sold to McLeodUSA.
In 1998, M|C formed Florida Digital Network (FDN), a facilities-based CLEC serving small and medium-sized businesses across Florida. FDN exemplified M|C's investment conviction and willingness to support portfolio companies through difficult periods. The company scaled rapidly to nearly $50M in revenue but tripped a capex covenant with its senior debt facility at the end of 2001.
In a less hostile environment, the senior credit holders would have approved an amended covenant package; however, with capital fleeing the telecom sector, no amendment on acceptable terms was available. After months of tense negotiations, an agreement was reached and M|C purchased the entire $57.5M outstanding senior credit facility from the lenders for 16 cents on the dollar.
FDN continued to show strong operating results with 40% revenue growth in 2002. In late 2002, FDN acquired the Southeast MPower assets for $13M against $70M of prior invested capital. By 2004, FDN was generating nearly $20M of EBITDA and went on to be a very successful investment.
In 1999, M|C backed Brad Evans, the former CEO of Phone Michigan, to start Cavalier Telephone. Following the dot-com collapse, we opportunistically leveraged Cavalier as a platform to consolidate distressed assets at deep discounts to invested capital: Cavalier acquired Conectiv’s CLEC operations for $1M cash plus $9M of seller paper against roughly $307M of capital previously invested and then acquired Net2000’s assets out of Chapter 11 for $12M versus $439M previously invested. Both transactions were highly accretive to Cavalier’s existing fixed-cost network.
Cavalier subsequently acquired Elantic, an entity we formed to acquire Dominion Telecom, the fiber assets of a large utility, for $1M. In total, Dominion Telecom represented 16,800 route miles of fiber and over $1.3B of invested capital. The steep discount reflected Dominion Telecom's $3M in monthly cash burn, which other investors were unwilling to absorb. Before merging Elantic with Cavalier, M|C took Elantic through bankruptcy to eliminate overhead, shed unfavorable leases and stem the monthly cash burn. Once Elantic was profitable, Cavalier purchased Elantic for $11M, and captured meaningful network and overhead synergies. Paetec ultimately bought Cavalier for its extensive fiber network.
A Parallel Wireless Opportunity with MetroPCS
The CLEC sector was central to M|C’s second decade, but our opportunity set wasn’t limited to local wireline. The same regulatory, competitive and capital market forces that were reshaping local wireline telecom also created opportunities in wireless, as demonstrated by our investment in MetroPCS.
M|C’s investment in MetroPCS was facilitated by the FCC issuing new spectrum with favorable terms to new competitors and reflected the same principles that drove our success in competitive local telecom. MetroPCS was built around a differentiated wireless model: flat rate, unlimited local usage. The company’s strategy of not subsidizing handsets and limiting coverage to its local markets created a structural cost advantage, allowing MetroPCS to profitably serve a previously untapped base of price-conscious subscribers.
Our investment required conviction during a very difficult time. In November of 2000, just six months after the dot-com bubble burst, many investors who had previously committed to MetroPCS were cutting back on their commitments. M|C took the opposite approach and led a $350M investment round in MetroPCS with a $75M commitment, our largest investment ever.
MetroPCS became one of the fastest wireless carriers to reach $1B in revenue and, ultimately, one of M|C’s most successful investments. Much like our CLEC strategy, the MetroPCS investment reflected a unique understanding of the underlying business model, access to experienced operators and conviction at a time when most investors had lost confidence in the sector.
Seizing New Revenue and Restructuring Opportunities with NuVox and ICG
In 2003, M|C led the restructuring of NewSouth Communications, a CLEC backed by KKR and Wachovia. Working alongside the existing investors, we acquired the debt and equity at a steep discount, with the new equity acquiring a 70% ownership stake of a substantially deleveraged company. In 2004, we merged the business with NuVox Communications, a similarly sized CLEC with a 75% market overlap, which created the foundation for significant EBITDA synergies. NewSouth's CEO, Jim Akerhielm, led the combined entity. In 2007, M|C executed a second strategic combination, merging NuVox with FDN to create a super-regional Southeastern platform with approximately $500M in revenue and $100M in EBITDA. The scale and projected synergies of the combined business enabled M|C to drive liquidity through a dividend recapitalization at closing, and in early 2010 NuVox was sold to strategic acquirer Windstream.
In 2004, M|C partnered with Columbia Capital and Dan Caruso, a founding executive of early CAPs MFS and Level 3, to acquire and restructure ICG Communications. ICG was a Colorado-based CAP that had raised roughly $3B in debt and equity, and was facing its second bankruptcy. M|C and Columbia purchased 100% of ICG's common stock for $6.3M in an out-of-court transaction contingent on restructuring $87M of real estate liabilities down to under $10M prior to closing. Post close, the new company aggressively shed sub-scale assets to refocus on the more strategic, higher density Colorado and Ohio metro fiber networks.
The ICG turnaround was striking: EBITDA swung from negative $49M in 2004 to a positive $20M run-rate in 2005, and the company was ultimately acquired by Level 3 just 18 months after the initial acquisition. In ICG's final year, M|C observed accelerating bandwidth demand and recognized the need for significant investment in last-mile fiber infrastructure. The metro fiber market remained highly fragmented, populated by undercapitalized operators who lacked the resources to fund required long-term capital needs, but there were highly accretive investment opportunities. Following our exit from ICG, we partnered with Dan Caruso and his senior team to build what would become M|C's biggest success of the next decade: Zayo Group.
Determined Entrepreneurs and M|C’s Principles Enabled Success in a Turbulent Market
As so many companies and investors succumbed to the aftermath of the 2000 dot-com meltdown, M|C generated strong returns. Much of that success was due to the talented and determined entrepreneurs behind our deals. We have the utmost respect and gratitude for Brad Evans (founder of Phone Michigan and Cavalier), Mike Gallagher (CEO of FDN), Roger Linquist (CEO of MetroPCS), Jim Akerhielm (CEO of NuVox) and Dan Caruso (CEO of ICG).
Since our formative cable TV and radio days, we’ve stayed true to M|C’s founding principles of maintaining price discipline, having a long-term view and backing experienced operators to help forge new businesses in emerging markets. We’re proud of this longstanding commitment and all that we accomplished during our second decade – a turbulent period, to say the least, of competitive opportunity and dislocation.