Is the heat dissipating from the US data centre market?

The US data centre market has experienced a steadily increasing pipeline of deals, but ticket sizes really started growing exponentially over the last 12 months. Proximo Playbook data shows a steady upward trend since 2019, with deal volume growing from $700 million in 2019 to $4 billion in 2021. 

Deals in the billion-dollar category are now common. In early August Carlyle’s global infrastructure group agreed to commit $1 billion to Tillman Global Holdings to help it increase its investments through US cell tower platform Tillman Infrastructure, a deal that includes a data centre element. July saw Stonepeak pay $2.5 billion for 29% of American Tower’s US data centre business, which comprises 27 facilities. 

Private equity firms are crowding into the market and M&A deals are getting ever larger, but are lenders still enthusiastic about greenfield project finance transactions for data centres?  

An asset class evolution

There is no longer a single homogenous asset class known as a data centre. At the wholesale end of the market are the hyperscalers, which have massive footprints and huge power and connectivity needs. These assets are very attractive to financial sponsors such as infrastructure funds, looking a lot like core infrastructure but with real estate and power characteristics, and benefiting from long term contracts with attractive counterparties. The other, more retail, part of the market is more service-oriented, and has smaller footprints and shorter contracts (potentially three years with renewal options) with smaller customers. 

Then there are more specific applications. Edge data centres are typically smaller in footprint and located on the outside of a network and subsequently closer to end users and devices, they tend to be useful for proliferation and for latency sensitive applications. Finally, there is the hybrid IT space, which involves outsourcing IT needs from desktops to the cloud as a service.

Historically, data centres have not been defined by one specific type of financing or investor. Kemal Hawa, a shareholder at Greenberg Traurig, explains, "Data centre investments are “tweener” investments, and have not historically fit neatly into any single investment thesis. Private equity investors often approach data centre investments as traditional cash flow deals; real estate investors as real estate deals; and infrastructure investors as infrastructure deals. The sector has components of each. As the industry has evolved, infrastructure investors have gotten most comfortable in the space, especially where a long-term contract with a credit grade tenant is present. But private equity firms and real estate funds have also been active – it all depends on the projected investment horizon, return on investment, and other factors."

Project finance lenders are getting more active in the space. Traditionally the sector has often been financed as real estate credits. But real estate lenders are generally more comfortable with established assets than the typical TMT (Technology, Media, and Telecommunications) lender. 

The US, so far uniquely, also has the benefit of a receptive asset-backed securitisation market for these assets. But other regions may not be far behind. Europe, for instance, has a developed enough market with decent sized portfolios to securitize at this stage. 

Complex demand story 

The debate over how significant COVID has been in creating new demand still rages, but a consensus is emerging that the pandemic probably accelerated existing demand. The pandemic-prompted shift to working from home and schools transitioning to remote learning, as well as an increase in social media use and at home streaming, all relied on fibre networks and data centres. Children may now be back at school and adults back in the office, though to varying degrees, but hybrid remote models are the new normal. 

Greenberg Traurig’s Hawa says, "there is substantial, and rapidly growing, demand for more capacity. We’re hearing, for example, that there is a need for thousands of new data centres globally in the next five years, to accommodate the projected growth in demand, the advent of 5G, and the proliferation of the Internet of things and big data analytics. To be sure, not all of these are massive facilities – many are smaller edge deployments – but regardless, the numbers are staggering."

The next ten years are predicted to witness the emergence of more highly automated vehicles and home appliances as part of the internet of things. Automation requires background data to allow autonomous vehicles and devices to react reliably and safely to external conditions, and all this data needs to be collected, mined, analysed, and stored, which will require more data centre capacity. 

An influx of private capital

Fuelling the data centre deal boom has been an influx of private, most notably infrastructure investors with lower return requirements than public markets. Public shareholders have generally had shorter investment horizons than might be needed for longer duration investments like digital infrastructure. Recent public market volatility has led to even higher return requirements and thus lower valuations from public investors, and this may create an opportunity for longer term-focused infrastructure funds to take companies in this sector private. 

Richard Lukaj, a founder and senior managing director at Bank Street, explains, “The trend away from the public markets has been afoot for some time, with record going private activity in this sector notable in the past couple of years. These larger-scale data centre and digital infrastructure companies are appealing to the infrastructure funds that have grown to record sizes and represent excellent platforms to employ longer duration capital. 

“In essence, recent transactions allow these fund managers to invest large chunks of capital in companies that represent core infrastructure holdings and satisfy their return requirements. With only roughly a third of infrastructure funds having any exposure to digital infrastructure in their portfolios, we fundamentally expect continued appetite from these capital providers to remain strong as they seek increased exposure to data centres, fibre, and wireless infrastructure assets.  Companies in this ecosystem are benefitting from capitalising and recapitalising their businesses for the next generation of growth across these arenas, most notably those companies swapping public shareholders for long-term private capital.”

The recipients of this financing are getting more ambitious. Tract, a new data centre fund set up by ColCap and Grant van Rooyen, founder of the data centre company Cologix, announced that it is seeking $1 billion in funding to build a portfolio of land for hyperscale and wholesale data centres in Nevada and Utah.

Quynh Tran, a managing Director and co-head, infrastructure finance - North America at SMBC, explains, “When we structured our first data centre project financing six years ago, greenfield construction financings were typically in the $100-$200 million range. Over the last few years, transactions have trended larger, particularly over the last two years. Because capex needs have become so much bigger, transaction size has scaled significantly to multiples of what we have seen in the past. Bank groups can now be ten or more for construction of a single project.” SMBC recently led financings as sole bookrunner and green loan coordinator for Stack Infrastructure and QTS.

But the larger players believe there is still a need to get more banks comfortable with construction risk on project financings in the sector. Greenfield financings in the space have been closing but are much smaller than brownfield deals. For example, Vantage recently closed a $300 million green loan for a greenfield data centre in Virginia in a financing structured and arranged by Société Generale. Balance sheet financing is not an option even for the larger developers, and bilateral and club financings are starting to be replaced by deals with more underwriting risk.

Bank Street’s Lukaj notes “Even the mega funds out there don't necessarily want to have a concentrated multibillion dollar singular equity exposure in their fund.  It’s not unusual at all for fund managers to afford a co-investment opportunity for some of their LP’s to participate in the transaction or in some cases even other GPs to fund larger transactions and maintain fund diversity objectives."

Recent transactions with Bank Street involvement include the sale of DataGryd to Cordiant Capital, LightEdge’s acquisition by GI Infrastructure, and the recent sale of Involta to Carlyle.

Signs of a turn in credit markets?

As with the project finance market globally, geo-political uncertainty, inflation and cost of capital challenges could well cool the heat in the US data centre market.  

Greenberg Traurig’s Hawa has concerns about the effect of current market conditions, saying, "there is an enormous amount of capital available to be invested in the data centre sector, making M&A deals and investments extremely competitive. This continues to be the case in 2022. Given the growing pressure on the global economy resulting from war, pandemic, inflation, rising interest rates, among other factors, it is becoming increasingly difficult to get deals over the finish line. In other words, it is still extremely competitive to win a deal on the front end, but more difficult to close deals on the back end.”

However, SMBC’s Tran notes that her bank has underwritten and closed several data centre transactions in 2022, acknowledging that while there is added complexity to get deals across the finish line, there is still significant appetite for the asset class. In fact, instead of things slowing down, some bankers in the market feel the opposite – that debt financings for data centres are competing with multiple similar deals, compared to one or two in the recent past. 

Still, with signs of shakiness in the wider market for leveraged loans, it will be a brave debt underwriter who pushes ahead with the biggest-ticket transactions.