How Much "Overinvestment" Danger in Digital Infra?

It has been a couple of decades since we faced systemic risk, major fraud or major overinvestment in what we now call digital infrastructure facilities. Around the turn of the century the issue was overinvestment in data transmission capacity, optical cable networks and  local access networks. 

In the five years after the Telecommunications Act of 1996 went into effect, telecommunications companies invested more than $500 billion in capacity, mostly financed with debt. About $2 billion in market value was lost when the investment bubble popped. 

Some argue technology startups are once again in a bubble that is bursting. And though venture capital investment is quite different from private equity, some might worry that PE investment in digital infrastructure is overheated as well. 

There are micro and macro level risks. At the micro level, some firms might wind up overpaying for assets, overinvesting in assets and then finding themselves insolvent. At the macro level, as often happens, we might see the whole infrastructure market flooded with capacity far beyond demand. 

Since nobody is in charge of the whole market, investment booms will tend to overshoot. Eventually, we will have an oversupply of capacity, compared to demand. 

It might be easy to argue that investors are rational, and will not again fall prey to excessive enthusiasm. But greed is a powerful motivator. The fear of missing out appears at times to overrule other considerations. 

On the other hand, some might note, the current valuation reset for venture-funded technology firms is different from 2000-level valuation in part because most of the present venture-funded firms actually have visible revenue models. The issue is valuation, not a viable revenue model. 

There are public market implications as well. After the 2001 internet bubble burst, firm valuations spent roughly a decade resetting to “rational” levels. 

source: Datastream, McKinsey 

Excessive investment between 1995 and 2001 led to a sharp destruction of wealth, although levels of investment had been on an upturn before the exuberance phase. 

source: Wallstreetmojo

Again, VC investors operate in a different part of the market from private equity or other institutional investors. The point is simply that enthusiasm sometimes can overtake a segment of the market, leading to overinvestment. 

When--and if--that happens in the digital infrastructure market is hard to predict. But some might see increasing levels of threat as valuations climb and low-cost capital availability shrinks. Some later-stage deals might take longer to produce expected profit levels, or produce less profit than originally expected. 

source: Data Center Knowledge

Will Edge Computing Investments by Private Equity Slow?

Edge computing infrastructure has been among the beneficiaries of investment by both operators (data centers) and investors (private equity and others). But a climate of rising interest rates will not be so helpful for investors, whose payback models have been built on cheap investment capital. 

Operators are not driven so much by the level of interest rates, but more by the strategic need to support their customers with edge solutions. The level of interest rates matters, but not so much as for investors. 

What we will have to see is the impact on digital infrastructure privatizations in the near term. If interest rates climb to five percent or more, it is going to affect the payback model for taking digital infra (towers, data centers, distribution networks) private.

Low interest rates have meant cheap borrowing costs. All that is going in reverse now, as monetary policy is shifting to higher rates to halt inflation. Higher borrowing costs should slow dealmaking, as payback models get worse. 

source: Bain 

On the other hand, if inflation remains high there are other risks, including severe recession, which likewise would affect deal flow. On the other hand, severe recessions also create buying opportunities for firms with available capital, able to snap up distressed properties. 

So the digital infrastructure investing boom will face new challenges over the next several years, some negative, some perhaps positive. Continued high inflation will mean continued rate increases, a negative. On the other hand, high inflation also can boost asset values, a possible positive. 

Stagflation and recession should slow dealmaking while putting pressure on price multiples. Again, some negative and some positive effects will occur. 

Still, a clear impact might be that the wave of private equity purchases of formerly public infrastructure from service providers would slow, as interest rates rise. 

How much slower is the issue, and for how long. Observers do not expect five-percent (or higher) interest rates for the long term, but activity will hinge on the level of rates and their duration. 

In fact, the whole digital infra privatization business has been fueled by near-zero “real” interest rates. Inflation rates also matter, as they affect “real” interest rates. For the whole class of “alternative” infrastructure (power utilities, roads, airports, oil and gas, renewable energy and data centers, towers and fiber infrastructure), expected returns have been dropping, and specific returns for digital infra might arguably be closer to five percent than 10 percent. 

source: McKinsey 

But that is why five-percent interest rates slow activity. If the expected return is five percent, borrowing costs are five percent and inflation rates are high, investments no longer make sense. 

The point is that it would not be unexpected to see a slowdown in digital infra privatizations for a while. The business case--with higher interest rates--does get worse. 

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Recession Fears Haven't Dampened 2023 IT Spending Forecasts

Industry participants rightly worry about the state of enterprise information technology spending whenever there is recession fear. But analysts at Gartner predict worldwide IT spending will grow five percent to $4.6 trillion in 2023, despite the expected economic difficulties. 

All other things being equal, that also should translate into growth of cloud infrastructure services as well. Gartner's “software” category (which includes cloud spending) is expected to rise 11.3 percent in 2023 to reach $880 million. 

source: Gartner. 

Third quarter 2022  enterprise spending on cloud infrastructure services exceeded $57 billion, says Synergy Research Group.  This was up by well over $11 billion from the third quarter of last year despite a strong U.S. dollar that knocked about six points off the growth rate, and a severely restricted Chinese market, Synergy Research says. 

Still, cloud infrastructure services grew at a 24-percent clip, year over year. 

Google increased its market share in the third quarter, while Amazon and Microsoft market shares remained relatively unchanged. Amazon, Microsoft and Google combined had a 66 percent share of the worldwide market in the quarter, up from 61 percent a year ago, the firm says. 

source: Synergy Research 

“Beyond these three, all other cloud providers in aggregate have been losing around three percentage points of market share per year but are still seeing strong double-digit revenue growth,” said John Dinsdale, Synergy Research Group chief analyst. 

Aside from other considerations, Google’s lower overall market share should sustain its growth rate, as AWS and Microsoft face the law of large numbers, which tends to depress growth rates from a high installed base.