What a difference a year makes. Communications service providers that were once Wall Street darlings have struggled to stay in business as the capital markets deteriorated around them. Public and private companies of all sizes have failed at an alarming rate as their access to capital dried up almost immediately. How did this happen to an industry where the demand for services continues to explode? Which companies will survive and how will residential and business consumers, landlords, and property managers be affected? To better understand the conditions of today's service provider market, we thought it might be useful to examine how we got to today.

The Go-Grow Era: 1996-2000

Spurred on by the promise of the Internet and deregulation of the Telecommunications Act of 1996, telecom and Internet related firms had capital thrown at their feet during the late 1990's. According the National Venture Capital Association, the amount of venture capital invested in Internet and communications companies grew from $6.6 billion in 1998 to $65.5 billion in 2000. Entrepreneurs were incentivized by venture capitalists and Wall Street to aggressively attack the newly deregulated, $100 billion local voice market and the explosive growth Internet market. The large sums of money available created a "land-grab" mentality as venture capitalists pushed their portfolio companies to grow as quickly as possible. A "growth at any cost" mentality was pervasive, and, as a result, too many companies were funded, many of which were premised on unreasonable business plan assumptions.

More than 300 competitive local exchange carriers ("CLECs") were formed during the late 1990's and many of them spent heavily to plant flags in new markets to build a larger platform for growth. The public markets reinforced this behavior by valuing the early CLECs at huge multiples of property, plant and equipment (PP&E), incenting them to grow and spend as fast as possible. Data-CLECs ("DLECs"), such as Covad and Northpoint, raced to build collocations in Regional Bell Operating Company ("RBOC") central offices. Building-centric providers ("BLECs") rushed to lock up large property owners for building access agreements. Although these actions were costly, the financing markets for start-up telecoms had never been better and there was ample capital to finance them.

The Bubble Bursts

Like all good parties, the music had to end eventually and so it did with communications providers starting in early 2000. As the Nasdaq began to fall from its peak in March 2000, many private and public investors became much more discerning with their investment capital. The promise of performance that had allowed companies to raise billions of dollars was no longer enough. The market began to focus on actual performance, such as revenue and cash flow, instead of hype. Telecom and other technology companies shed millions of dollars in market value and IPOs were reduced to a trickle. In the hangover period that followed the wild party, communications providers saw both the debt markets and public equity markets close completely.

Firms that not long ago had been urged by their investors to grow quickly and aggressively found themselves whipsawed into a period of retrenchment, restructuring, or worse, bankruptcy. All sectors of competitive communications market were hurt: BLECs that had paid high prices for building access rights and opened too many markets, thereby creating unsustainable expense structures; DLECs that had built too many collocations and acquired too few customers lost millions of dollars; and, CLECs that had been proficient at spending capital but poor at acquiring customers wound up with underutilized networks and negative cash flow.

Firms that previously could do no wrong on Wall Street now found themselves needing additional capital to survive but with little hope of raising additional equity. Companies pulled back on operating expenses to extend their life with the cash on hand. "Burn rate" replaced "growth rate" as the new buzz words in the start-up industry. Venture capitalists began a triage period, separating the dying from potentially viable companies among their portfolio in the wake of the markets' about-face. Many companies simply went out of business, unable to stem the bleeding.

The New Old Economy: 2001

So where's the good news? Ironically, the wreckage affecting the communications service market may prove to be a long term plus for the industry. Capitalism is a game of survival of the fittest and this recent process will continue to clear the market of the weakest competitors and allow a stronger competitive communications industry to emerge. The demand for broadband services continues to grow and no one is expecting the growth rate to abate any time soon. There is still a lot of private equity capital patiently waiting on the sidelines for the appropriate opportunities. For now, the world has gone back to basics. Investors and management are now focused on fully funded, more rational business plans. Service providers that have fundamentally sound businesses will always find investors willing to back them. The service providers that survive this shakeout should be stronger and face a less competitive environment.

Conclusion

Until this market shakeout has ended, which we believe may not occur for another two to three quarters, it may be difficult for prospective customers or business partners to know how viable a communications service provider really is. Not too long ago, one could take comfort that a public company was stronger than a private company and, therefore, was more likely to survive long term. That's not necessarily the case now as we have witnessed a number of public companies fail recently.

While there is reason to question the strength of a service provider under consideration to be a vendor or a business partner, there is no need to panic. As in any business decision, a little research and caution will go a long way. Ask a potential service vendor or partner about their financial strength, financial sponsors, customer references, etc. There are many well-financed, professionally managed communications companies that deliver on their promises with excellent service. You may even be happy that there are likely to be fewer of them knocking on your door these days.

About the authors
Mark Evans and Mark Taber are Partners in Boston based Great Hill Partners, a private equity investment firm. Great Hill was formed as a successor to Media/Communications Partners in January 1999. The partners at Great Hill Partners have invested in more than 35 companies in the communications, media/information and IT infrastructure services sectors and has over $1 billion under management. Their recent investments in broadband services include CityNet, Edge Connections, and ManagedStorage International. Great Hill Partners is currently pursuing investment opportunities in several segments of the broadband services market including wired and wireless voice and data services and next-generation carriers. For more information visit www.greathillpartners.com. The authors may be reached with questions or comments via email at taber@greathillpartners.com or mevans@greathillpartners.com