Non-Linear Growth

A glimpse around the next corner; mind the curves.

March 30, 2012 • 8:52 am 0

Introducing Digital Fortress

Today, my Partners and I at Meritage Funds announced that we’ve established a new platform in the data center colocation market. Headquartered in Seattle, WA, Digital Fortress operates nearly 50,000 square feet of data center colocation space, focused on delivering high-power density installations to enterprise customers. A  Meritage Funds blog post announcing the investment has much more on our thesis and goals for the investment.

Getting this transaction done was a long an arduous process. In earnest, we began evaluating the Pacific Northwest data center market in October 2010. What we found was a fragmented market that had great supply-demand characteristics. In addition, the market has great power-dynamics, meaning that power is cheap, stable and largely from renewable sources. It blows my mind every time I cite this statistic, but over 95% of the power in metro Seattle is from renewable sources, principally because of the huge hydroelectric energy production in eastern Washington state.

It was easy to see there was a great opportunity for data center operators in the PNW. But, finding an entry point into the market was a bear. Because the market is fragmented, there was no natural starting point. Rather than buying a platform, we would have to create one. In the end, we made that happen by completing the simultaneous acquisitions of two data center operators that happened to be located in the same building. In concept that sounds easy. From first hand experience, I can tell you it was really hard. There were an incredible number of moving parts here, including simultaneous negotiation, documentation and diligence processes on both acquisitions, a debt syndication, an equity syndication, and most importantly, the establishment of a new management team which has the chops to achieve our goals for the investment. In all, executing the transaction took the better part of ten months.

In the end, it was worth it. Overnight, Digital Fortress has become the leading independent colocation provider in its market. We’ve established a strong leadership team with the addition of Mark Hughes (former EVP of Operations at SunGard) as Executive Chairman and Tim Doherty (former CEO of Fortress Colocation) as Chief Corporate Development Officer. Already, the Company is executing its expansion plan with the announcement of a new facility in downtown Seattle. With our equity partners, Halyard Capital and Sweetwater Capital, we have dry powder to fund further organic and acquisition-based expansion plans.

If you believe that the hard things are the most rewarding, then our investment in Digital Fortress is sure to be a success.

For my friends in Seattle, please let me know how Digital Fortress can be a resource to you in your market.

Filed under: Growth Equity, Investment Selection, New Investments, , , , ,

September 17, 2009 • 4:18 pm 1

When Expectations Converge

Yesterday, I posted on a VentureBeat piece covering the correlation between exit market conditions and venture capital company-building behaviour and philosophy; or lack thereof. The piece called for a back-to basics approach to venture capital, where investors are focused true partnering with entrepreneurs to build fundamental value over a traditional investment horizon (5-7 years).

In today’s post, I wanted to tackle the flip side of this issue; the notion that exit markets and general public equity market conditions also have an impact on venture investor investing behaviour. In my opinion, there are three things required for a healthful level of new venture investment activity; liquidity, valuation stability and convergence of expectations

Liquidity

Venture investors fundamentally sell two things; money and expertise in helping the real heros – entrepreneurs – create value. But in order to “sell” money, we have to “buy” money. By by money, I mean we have to fundraise and create a committed pool of capital to invest; a fund. If VCs can’t buy money, we can’t sell money. And right now, many VCs can’t buy money at any price. There are many reasons for this, although I won’t digress into those issues here. Suffice to say, the number of venture funds and venture capitalists is shrinking. And as funds move past their initial investment period, there is less and less liquidity in the market. In the end, this is healthy as many have made the case that the venture asset class has been over-capitalized. But regardless, if there is less capital available to venture funds, there will be less capital available to emerging growth companies.

Valuation Stability

The best proxy for valuation stability is public equity markets. Anyone who has been paying attention in the least knows we’ve had an extremely volatile twelve months. Venture investors don’t like investing in falling markets. Some refer to this as the phenomenon of “catching a falling knife”; not something you want to try, you might get cut. Point being, an investor can look “stupid” for making an investment at a valuation that is cut in half in six months by a falling public equity market. This affects the early stage less than growth and later stage deals, because there is a floor on valuation; you can’t go lower than zero. Early stage deals; particularly Series A rounds simply have less far to fall than their growth and later stage brethren. But when a business can be valued on metrics; multiples of EBITDA, revenue, subscribers, etc., as growth and later stage deals can, new investment activity comes to a screeching halt in falling markets.

The flip side often occurs in rising markets, entrepreneurs think valuations are going to continue to go up and they try to price their deals to implied future valuations as if the market were guaranteed to go up. Point being, both falling and rapidly rising public equity markets can impede new investment activity.

Convergence of Expectations

The final requirement is a convergence of valuation expectations. When markets have recently fallen, investors adjust their valuation requirements down faster than entrepreneurs. And when markets have recently risen, entrepreneurs adjust their expectations down faster than investors. After a down market, entrepreneurs may “wait it out”, refusing to come to grips with the new valuation reality. And in an overvalued or over-bought market, investors may “wait it out” waiting for the bubble to burst or a correction. Again, this applies more to growth and later stage deals than to the early stage, although all stages are affected to some degree.

So where are we now?

I don’t know, but I do have an opinion; no surprise right. I think we’re entering a period of significant deal activity. There is a low, but appropriate level of liquidity in the venture asset class. We’ve come through one of the biggest stock market corrections in history and are now up greater than 50% from the bottom on all the major market indices. Valuations are stabilizing. Entrepreneurs have had the time to adjust to the new valuation realities and investors don’t have an argument that they are either catching a falling knife or that we’re in a bubble. It all sets the tone for a reasonable and balanced valuation discussion between investors and entrepreneurs.

I for one am glad to have a new fund to invest in this environment. I think it is going to be a great time to invest and to build strong, growing and profitable operating companies that can stand-alone for years to come.

Filed under: New Investments, Risk, Venture Capital, , , ,

May 7, 2009 • 1:35 pm 3

The next generation of towers

A few weeks back, we at Meritage announced our investment in NewPath Networks. I didn’t have a chance to blog it then, although my Partner Stephanie McCoy did. I wanted to share some thoughts here; albeit delayed. NewPath is an operator of distributed antenae system (DAS) networks. NewPath operates these “active” networks on behalf of major wireless carriers, like AT&T Wireless, Verizon Wireless and T-Mobile.  

The wireless sector is one of the real bright spots in the network-enabled economy. Despite macroeconomic conditions, consumer demand for data services is really taking off. The recent launches of Internet friendly smartphones like the iPhone, the Blackberry Storm and phones based on Google’s Android operating system have only served to accelerate the pace of growth in demand for wireless data services. The big carriers have a great problem on their hands; how to serve this growth in consumer data demand.

To be specific, the problem for carriers is that their existing networks were optimized for carrying voice traffic. Those of you in the industry know that voice is a remarkably lightweight application in terms of data consumption. Yes, it is highly sensitive to latency and jitter, but it is not a data hog. Data applications are, by definition, highly data intensive, but for the most part, are not sensitive to latency or jitter. If you are wondering if that has implications for carrier network design, you are asking the right question.

The carriers are in fact serving data services out of an infrastructure that is optimized for voice, but not necessarily for data. This creates bottlenecks all over the carriers’ networks, including at the backhaul level and the equipment level. The carriers are making adjustments on both fronts by pulling fiber to their towers and re-architecting their networks for 3G and 4G radios. But there is a more fundamental issue. It turns out that towers, where carriers co-locate their wireless equipment, were also designed to serve voice traffic, not data traffic. So what is the problem with towers? First, they are high (40+ feet off the ground) and height is a disadvantage in data services. Second, towers are unsightly and more and more communities are fighting tower zoning (particularly wealthy communities where there are lots of iPhones and Blackberries). And third, some topologies are not conducive to more towers because of RF interference issues.

So what is a wireless carrier to do; ignore the demand? Not a chance; there are alternatives. It turns out that DAS is the solution that the wireless carriers are increasingly turning to. DAS is a fiber-fed, low to the ground, non-intrusive wireless network that connects to the wireless carrier’s infrastructure. DAS puts radios on light-poles and utility poles. It is ideally suited for driving data bandwidth to ground in areas where tower zoning is not feasible or where the topology is not conducive to additional towers. DAS is not a new concept; it is a proven network toplogy that has been around for decades. Consumer demand for data service is the driving force; and it is causing wireless carriers to implement DAS at a pace never seen before.

NewPath builds these networks for carriers and then operates the networks. Thematically, this is perfectly aligned with the trend toward carriers outsourcing their active networks. Getting into the DAS business is not for everyone. Running an active network on the part of AT&T takes a very high level of sophistication and frankly, a high-level of trust on the part of AT&T. This is not a landlord/tenant relationship like exists in the tower space. It is a long-term operating relationship, where by contract, NewPath will operate a network for AT&T or Verizon on an initial contract term of ten years. That is a long time.

Thankfully, the NewPath team, including Mike Kavanagh and Sean Coopriderare pros. Having been in the wireless sector for a long-time, they have the relationships with the carriers - and frankly the trust of the carriers - that is required to make the business work. I’m excited to have them and the entire NewPath team join the Meritage portfolio. Kudos to my Partners Stephanie McCoy and Jim Dovey for pulling this one over the line.

Filed under: New Investments, Portfolio, Wireless, , ,

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