Behind the eye-watering valuations and growth projections, a wider spectrum of risk-return strategies is opening up in the digital infrastructure sector…
KKR and Global Infrastructure Partners’ (GIP) acquisition of one of the world’s largest data centre operators, CyrusOne, in March was notable not just for the size of the transaction at USD15 billion but also for how the two buyers used different risk strategies to close the investment.
Data centres have always featured some overlap between corporates, real estate and infrastructure funds but KKR’s use of both infrastructure and real estate equity along with GIP’s infrastructure funds proved how buyers have expanded their offering in line with the asset class itself.
“The asset class has continued to mature and evolve, with an increase in different profiles of risk capital evaluating the sector,” says Chris Hogg, senior investment director at Amber Infrastructure. “There is a continued richness of opportunities, with investors looking to assess the appropriate risk-return profile for each opportunity for them.”
Risk spectrums
Telecom operators have always been a hotspot for private equity. In the weeks before the CyrusOne move, KKR was simultaneously pushing a buyout (eventually rejected) of Telecom Italia in what would have been one of Europe’s largest in history.
A worldwide boom in data use and storage, and the emergence of data centres and fibre broadband as asset classes in their own right, predate the pandemic by some years but form part of a trend that has accelerated rapidly in in the two years since.
Infrastructure funds in particular can now play these sectors across a range of risk spectrums, from the triple net lease real estate model of data centres through to investment in operating firms taking development risk on new fibre construction, with returns ranging from mid-single digits to high teens and above, say buyside sources.
“We see some of the small private equity groups funding fibre platforms at the small scale, say below GBP100 million, but in general we are finding that non-infrastructure private equity funds are not competitive on cost of capital and therefore struggle to get traction in the digital infrastructure space these days,” notes Matt Evans, head of Europe at DigitalBridge, one of the world’s largest digital infrastructure fund managers.
Some, such as Warburg Pincus with Amber on UK-based Community Fibre, have partnered with infrastructure funds to access the space.
“Different parties bring different perspectives and skill sets to the table,” Hogg comments, “Infrastructure funds can be focused on downside protection and resilience, whereas private equity funds can bring a different operational perspective and a focus on multiple upsides.”
Competitive market
At the core end of the risk spectrum, investors with a lower cost of capital are expecting a pipeline of data centres that have been built and tenanted over the last five years to be transitioned out of value-add capital and into the hands of lower risk buyers, says Evans. But these new core buyers are finding an intensely competitive market with a requirement for deep sector knowledge and long-term relationships with operators to build growth projections and valuations.
“Digital infra is probably one of the biggest infrastructure areas of movement today, even more so following the pandemic which has shown the resilience of the sector, you can see a lot of people piggybacking on this wave which is participating to driving the market up,” says Elie Nammar, senior director at Vauban Infrastructure Partners in Paris. “When we are bidding for fibre, for example, you can see a lot of funds that three, four or five years back, you would not necessarily see there.”
He cites recent examples where in certain auctions, cost of capital was the only differentiating angle which is driving the market up as bidders with lower cost of capital were competing.
Not all of these bidders will have the same level of expertise to partner with sell-side operators seeking investment however.
“I think fibre and towers have moved to a place where people are a little more comfortable but on the data centre front, there still needs some education,” he says. “Large operators get much more comfortable with people that are able to bring in some expertise, bring in some knowledge, both on the operational side because of the experience that we’ve had, but also on the financing and structuring side, which is the place they lack.”
Alongside the core markets of the UK, Germany, the Netherlands and France, European countries such as Switzerland and Poland are seeing extensive new investment in data centres with a jump in new facility build-outs and over 70 projects underway in 12 countries from 2021 onwards, totalling 851,000 m2 – an increase from under 10 per cent in Sweden up to over 100 per cent in Ireland.
“Secular growth in data consumption globally has created tremendous opportunity for skilled data center developers and operators to provide critical infrastructure for their customers, including the world’s leading technology companies,” said GIP partner Will Brilliant following the CyrusOne acquisition.
In Spain, which is being targeted by CyrusOne, alongside other fund-backed operators including EdgeConneX, Equinix, Interxion and NTT Global Data Centers, raised floor space will grow by almost 50 per cent from the beginning of 2022 to the beginning of 2026, according to data provider Research and Markets.
Location, location, location
Geography is becoming more relevant in the race to acquire and build data centres as hub locations become overcrowded. A shift to regional markets and service providers specializing in second-tier cities and edge computing is therefore underway.
At the end of last year private equity firm The Carlyle Group acquired US regional data center provider Involta, based in Iowa, which operates 12 facilities in the Midwest. In Eastern and Southeastern Europe, similar moves have been made by infrastructure funds.
The regional push is even more pronounced in the fibre sector where opportunities to invest in new lines are determined by projected growth in new connections, potential government subsidy or regulation, construction capex and competition from other providers.
“The reason why you’d look at geography, in that sense, is because you’re looking at the level of build versus opportunity but there are other elements to also consider such as cost per premises and wholesale pricing, concession, subsidy, among others,” says Nammar. “Germany and England are places where there is a significant fibre coverage gap relative to other European countries and where everybody’s going or trying to go which is creating a land-grab situation. Ultimately, you’re looking at take-up rate and how fast you can achieve the target take-up rate given the local conditions.”
Although revenues from fibre assets and data centres tend to be index-linked and therefore offer some inflation protection, finding an edge must now be matched against the threat of rising input costs, such as labour and materials, and in the case of data centres: power costs.
“Inflation is definitely a question across the board that will have implications,” Nammar points out, adding that Vauban’s data centres are powered by renewable energy so remain relatively protected from rising gas prices.
In terms of greenfield construction for rural fibre broadband deployment, labour costs can also be eclipsed by availability as large workforces are not always accessible in provincial regions for limited periods of time.
While fibre broadband deployment will generally lean into more captive markets with high barriers to entry, sales and marketing to new clients is also becoming more important for data centre owners and investors. Expertise and knowledge in this area, along with some key anchor clients, can then be used to justify the high valuation multiples paid for a platform, at times going well above 20 times earnings.
“With a limited pool of really deep knowledge, there’s been a lot of people trying to staff up with people who at least have some knowledge,” says Evans.
Despite robust growth projections these teams may have their work cut out in the years ahead.
“Even a strong macro tailwind will never compensate you for bad assets,” he adds.
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