Private Equity and Telecom:
Managing the Portfolio’s Enterprise Contracts
Walt Sapronov
The much discussed convergence of telecommunications and Internet protocol (IP) technologies is changing the way corporate enterprises buy voice, data, and other services. When multiple enterprises are part of a private equity portfolio, this convergence presents significant cost savings opportunities–albeit not without its complications. To realize these opportunities, the private equity (PE) firm must address certain unique contract issues and complications.
With increasing frequency, PE firms are reshaping the corporate landscape by taking ever-increasing stakes in once public companies. Although chiefly financial buyers, PE firms may also exercise varying degrees of management control over their portfolio investments, typically for purposes of cost control, sale preparation, or both.
Telecommunications (telecom) purchases are an area ripe for PE firm involvement, typically representing a sizable out-of-pocket expense for each enterprise within the portfolio. Cutting this expense increases the value of the PE firm’s investment and can make one or more portfolio companies that much more attractive for future sale.
There are a number of ways to achieve this savings during the telecom contract renegotiation process, a bi-annual ritual for most enterprises.
A Refresher on Enterprise Procurement
As many readers know, enterprise customers purchase voice, data and other telecom services in bulk. Such purchases involve negotiations with carriers, who typically offer lower rates in exchange for large, multi-year purchase (or “revenue”) commitments. Historically, such purchases were made under tariffs, but in today’s detariffed environment, these have largely been replaced by negotiated commercial contracts.
As a rule, the higher the minimum annual revenue commitment (MARC), the lower the voice, data or other rate that the carrier will typically offer to the customer. Thus, enterprise customers can generate significant savings by making sizable telecom purchase commitments to their carrier suppliers over a multi-year period.
Such commitments carry some risk, as the contracts are often of the “take or pay” variety: Customers who fail to meet their purchase commitments are often faced with the prospect of paying the difference between their commitment and what they actually spent (“shortfall”). These commitment failures can also result in other penalties, such as a loss of discounts or payback of credits (for example, credits given for service installation).
Traditional voice and data services are priced on per-minute or other usage based schemes. With the convergence of telecom and IP technology, carriers and other vendors are replacing the traditional circuit switched services with a “platform” carrying integrated voice, data, Internet, and video as packets delivered over a single, large access connection (e.g., a DS3 circuit of 45 Mbps). Many enterprises are also using this platform to deliver voice over IP (VOIP) calls, replacing traditional TDM (time division multiplexed) circuits. These converged IP services are largely priced at much cheaper flat, bulk rates. Stated otherwise, telecom expenditures are moving from pricing “by the drink” to an “all you can eat” menu.
As converged IP technologies–at cheaper flat, bulk rates–replace the more expensive, usage-based TDM circuits, these MARCs become lower (see “Enterprise Contracts in the IP Era,” BCR, June 2006, pp. 54-56). In response, some of the major carriers have begun lowering even their per-minute circuit prices in response to IP pricing pressure. The overall economic impact of IP convergence for enterprises has been positive, making it a propitious time to renegotiate overpriced telecom contracts.
Negotiating a Portfolio-Wide Agreement.
Sooner or later, this paradigm shift will affect the telecom services purchased by the enterprise companies making up the PE portfolio, each of which likely has its own contract, customarily entailing separate, traditional (usage priced) purchases of voice, data, and other services.
As a first step in the renegotiation process, the PE firm may consider consolidating the various portfolio companies’ telecom contracts into a single, portfolio-wide contract with one or two major suppliers. Our firm has negotiated several such deals for PE firms, and believe such consolidation can work to a PE firm’s advantage.
There are, of course, major potential stumbling blocks that a PE firm must be aware of if it is considering such a consolidated deal. Here are some complications to consider:
* First, each portfolio company likely has an unexpired telecom agreement with an “unsatisfied” MARC. Collectively, the portfolio will thus probably have multiple, unsatisfied MARCs, under unexpired agreements that will almost certainly not be coterminous.
Failing to satisfy a MARC may trigger a shortfall penalty. Early termination of unexpired contracts may also create such a shortfall and, in some circumstances, trigger additional termination penalties. Making up these “shortfalls” has to be considered in the cost/benefit analysis of combining the portfolio companies’ multiple MARCs.
* Second, each of the portfolio companies will have their own preferred carrier supplier(s). For some, the supplier(s) may overlap, with AT&T and Verizon Business having the lion’s share of today’s enterprise customers. There are however, others to choose from, e.g., Sprint, Qwest, Global Crossing, and Level 3.
Each portfolio company’s IT manager will have his or her own, presumably valid reasons for having selected its current carrier rather than others. Changing that selection will likely require a portfolio-wide bid process, with cooperation of each of the companies’ technical staff.
* Third, a related issue is that an incumbent supplier that “wins” a renegotiating bid for a consolidated contract may be expected to waive shortfall and termination penalties; the losing one probably will not.
Timing is obviously a key point. The transition process from one carrier to another easily requires six months to a year or more. This window gives an enterprise customer time to mitigate the effects of shortfall and termination penalties, even as it plans the transition process. Failure to recognize these potential liabilities early in the process could undermine the economic rationale for the renegotiation effort.
* Finally, renegotiating a single enterprise contract can be complicated enough; renegotiating multiple contracts concurrently is much more so. MARC estimation typically requires detailed review of call detail and other records, perhaps with a consultancy experienced with telecom bid (RFP) preparation. Each company within the portfolio will then have to weigh the benefits (and disadvantages) of renegotiation vis-à-vis its share of the portfolio-wide savings.
In summary, the key to realizing telecom cost savings is to replace many contracts with one (or two for back-up). This combines the companies’ aggregate spend, thus permitting a higher MARC. At the same time, the current service mix can be replaced with more efficient IP technologies. A properly negotiated new agreement can thus result in portfolio-wide lower rates that can be shared by all.
Risk/Reward Sharing Within The Portfolio
That “sharing” process, however, raises another set of complications. These begin with the negotiation of a multi-party agreement for (otherwise unaffiliated) companies that comprise the PE firm portfolio. One must also arrive at a pro rata sharing of the benefits and risks among each. Here are a few of the complexities that will arise in structuring the new deal.
* First, there is the question of “who” is the customer of (i.e., the party or parties to) the new agreement? The PE firm? Some or all of the portfolio companies?
A related issue is liability: joint or several? If so, is each of the portfolio companies responsible for one another’s performance or default? Should there be an indemnity? Or does the PE firm assume some or even all of the risk?
There is no quick answer for the “who is the customer?” issue. Factors to consider include the degree of perceived risk by the companies in relying on one another’s performance; the proportionate usage of service by each, and--not least--the carrier/supplier’s perception of the credit-worthiness of the enterprises making up the portfolio.
Another factor is whether the PE firm (or perhaps one of the larger portfolio constituents) is willing to serve as a surety for the others--something that might be demanded by the carrier in exchange for pricing and other concessions. Inter-company agreement(s) among the portfolio companies (and perhaps the PE firm as well) may be required to allocate the default risk.
* Second, the “MARC sharing” concept, simple enough on first blush, is not easy to craft. The MARC is the linchpin of the new deal: to repeat, the higher the MARC, the better the chance for a lower rate, and failure to meet the MARC carries serious liability. What pro-rata proportion of the MARC will each portfolio company agree to meet? What happens if it does not? Must the other portfolio companies make up the shortfall? If so, what is the consideration for doing so?
* Third, there are issues associated with multiple “users” of the services who, but for their common PE firm ownership, have nothing to do with one another. That brings up complex questions of confidentiality, billing, sharing of credits, notices, and similar administrative complexities. It also raises an issue of whether the individual portfolio companies have third-party beneficiary rights and thus could perhaps seek enforcement of the agreement notwithstanding the others’ interests.
Anticipating the Sale
Finally, there is the question of what happens when a portfolio company is sold (or “flipped”) to a third-party buyer. Is there an assignment of its contract rights under the telecom agreement? If so, then this should be coupled with a delegation of its MARC obligations. This raises complex contract assignment issues for the PE firm when contemplating a possible future sale of a portfolio company, as well as remedies against a future default by a buyer (e.g., failure of a sold entity to meet an agreed-upon share of the MARC by the once-affiliated company).
Once the portfolio company is sold, the PE firm will no longer control its performance. Unless addressed in the sale transaction, such a default could leave the PE firm with a shortfall penalty, with only a damages remedy (if that) against the erstwhile affiliate.
Conclusion
In sum, the telecom convergence era is an opportune time for private equity firms to review and renegotiate the telecom contracts within their portfolio. Doing so is not without its challenges, but these are not insurmountable and the savings opportunity may well be worth the effort.
For example, Advocate Networks, a consultancy focused on private equity telecom cost management, estimates that savings, depending upon the portfolio, may range between 15-40 percent over what the individual portfolio companies could negotiate on their own--representing significant real dollar savings when aggregating the entire portfolio.
For the private equity firm, this can also creates significant EBITDA improvement and thereby increased portfolio valuation. In addition, the portfolio companies, through leverage of a unified effort, may well have the benefit of much better contract terms and account team support than any could have achieved individually.
Walt Sapronov, partner with the Atlanta law firm of Sapronov & Associates, P.C., has been negotiating telecommunications contracts for over two decades. While the Firm represents various private equity firms, the views expressed herein are the author’s own, not that of any client, and are not intended to be legal advice. For more information on this topic, please contact the author at wsapronov@wstelecomlaw.com or visit www.wstelecomlaw.com.
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