by Michael R.Flynn

In our last article, we discussed the positive implications of the recent entry by private equity firms into the satellite operator sector. The financial discipline, strategic focus and managerial acumen that leveraged buyout (LBO) investors bring to the table are all welcome–and in some cases overdue–developments. Of course, there is another side of the story. This month, we analyze the bad news.

First, the new owners will be unusually stingy about cash outlays that do not yield immediate revenues. The term "private equity" is a misnomer: these deals are all about debt: specifically, the ability to service substantial debt obligations from the operators’ cash flow stream. The operator buyouts have been much more highly leveraged (paid for with debt) than recent norms in the LBO market. To an equity investor, more leverage in a deal means a greater possible return and less of the investors’ own cash at risk. Future expenditures, whether for new satellites, terrestrial infrastructure or new applications, could require additional injections of equity capital. This is an anathema in an LBO.

A couple of consequences immediately suggest themselves. The operators will be much less likely to pursue any innovation for its own sake, or to fund highly speculative business cases. Historically, operators have played a limited role in bringing to market the "next big thing" in the satellite sector; that role is likely to diminish as operators concentrate exclusively on revenue generation.

Also, satellite and component manufacturers should prepare for operators to exploit the continued overcapacity in their space. More price compression is on the way. Operators may also be more creative about redeploying underused in-orbit transponders, thus avoiding new manufacture entirely. In other words, at a time when the health of the manufacturer and launcher sectors depends on the willingness of operators to embrace a spirit of cooperation, risk sharing and innovation, the operators’ financial models will push them in exactly the opposite direction.

The second area of concern relates to the operators’ newfound obsession with watching the clock. The satellite industry views developments throughout the long term. Projects can take a decade or more to implement; trends and forecasts cover similar periods. Likewise, emerging technologies have even longer life cycles. By contrast, private equity funds typically expect to be liquidated within a decade, and fund managers will look to exit (sell or take public) an investment within three to five years. Since fund managers are judged only by the returns they achieve for their investors, they tend not to invest in projects that will not yield near-term benefits. It is impossible to overstate the degree to which this time frame pervades the mind-set of private equity investors.

The operators will be forced to adapt to the new timetable irrespective of the normal ebb and flow of the satellite industry. This timetable will only aggravate the operators’ disinclination to spend money generally: to a fund manager, the only thing less impressive than a speculative project is a speculative project that does not show a payoff until 2015.

More importantly, the exit horizon for private equity investors coincides with a predicted spike in capital expenditures for the operators. Current analysis of the operators’ fleets point to a new round of replacement satellite procurement in about three to six years. As that period approaches, fund managers will focus on selling the operators–to the public in an IPO, to a strategic competitor or to another financial buyer–in advance of having to write checks for new satellites. Ideally, the operators would rack up several profitable years (waiting for IPO demand to strengthen while paying off debt) and then go public for a huge profit to the funds. Unfortunately, the public may wind up with a bad bargain: the operators’ next cycle of capital expenditures will just be starting, aggravated by several years of shoestring capital expenditure budgets. Unless the public markets show unusual sophistication in weighing the looming capital demands, their investments could well result in operator share price declines, diminished liquidity, a credit crunch and other ills.

Alternatively, if the public markets are still quiet, the managers may start pursuing consolidation, liquidation or other comparatively drastic measures in the hope that a reshaped market will create other exit opportunities. In other words, profound change in the operator sector could result solely from the funds’ desire to secure short-term returns, rather than the long-term need to fix endemic overcapacity.

All this suggests a potentially troubling immediate picture for manufacturers, launchers and other businesses that rely on operator spending. The concern for the long term is that private equity is not concerned about the long term. Five years from now, the funds could leave behind an industry in much worse shape, having pocketed a nice profit by exploiting the odd confluence in 2004 of low interest rates, insatiable debt markets and favorable capital expenditure cycles. The best way to avoid this outcome is for the industry to pay attention to the operators’ new mind set and to seek creative, complementary business models, ventures and financial strategies.

Owen d. Kurtin co-wrote this article. Kurtin and Flynn are partners in the New York office of law firm Sonnenschein Nath and Rosenthal LLP. They may be reached at 212/768-6700 or by e-mail at [email protected] and [email protected], respectively.