Data centres - here today, here tomorrow Investing and financing part 2

Ruth:
Hello and welcome to this Ashurst podcast on data centres, here today, here tomorrow. This is the second part of our key takeaways episode where we discuss some of the key takeaways from our data centre seminar.

Our seminar was the perfect occasion to bring together the entire data centre ecosystem in one room and bounce around some of the key opportunities and challenges in the data centre industry at the moment. I'm Ruth Harris, a finance partner specialising in data centre financing, and I'm joined by Rebecca Clarke, a digital infrastructure expert, and Chris Grey, a partner in our Tech M&A team based in London. Today we're going to chat through some of our key takeaways from the investing in data centres panel, and later we'll talk about the financing of data centres panel. If you missed part one, please do seek it out. Here, we covered talking points on the securing planning and power for data centres.

So the investment panel was chaired by Stefan Bruder, who is a partner in our M&A team in Munich, and he was joined by Nathan Luckey at Macquarie Asset Management, Head of Digital Infrastructure for EMEA, Tom Roberts, CEO of Torch Partners, and Amanda Ludlow, our partner in Digital Economy at Ashurst. So, Rebecca, do you want to kick off with some of your key takeaways from the investment panel?

Rebecca:
Sure. I found the panel to be really interesting, particularly in respect of its coverage of the who, the what, the where, and the why. So, for example, why data centres are really an attractive investment opportunity.

Ruth:
Well, that's a good place to start then. So let's start with why. What makes data centres an attractive investment opportunity?

Rebecca:
Well, it's the demand for space to house data driven by our insatiable demand for digital services, in turn, driving very low vacancy rates and long-term stable returns. When you layer on top of this, the barriers to entry, it becomes an extremely interesting investment class.

Ruth:
Yeah, there was a lot of talk, wasn't there, about the barriers to entry and some of the unknowns there? It doesn't seem to be putting investors off though.

Rebecca:
Clearly these barriers come in many forms, such as the high cost of construction, driven by scarce materials and labour, the challenges in securing the resources, so sourcing land in the right locations, securing power and chips, and then if you layer on top of this the need to navigate regulations across a variety of jurisdictions, then it makes it a very challenging market, but it's also an attractive market.

Ruth:
I agree, and it'll be interesting of course to see how tariff wars play out here and the effect on the cost and availability of those resources. And for some those barriers to entry would make you run a mile, but for others it is a real attraction, like you say. And I mean the costs here are huge, aren't they? The cost alone of just developing a power shell is roughly about £3.5 million per megawatt and then three times that if you want to do a full fit-out. So whatever the model, that's a lot of capital, a lot of timeframe before any potential return. So I can see those barriers to entry mean it's a specific type of investor attracted here.

And you mentioned access to power, but of course that's the right kind of power, isn't it? Not only because of constraints on the grid, but I suppose the pressures from investors to go green to be ESG compliant. So it's interesting that developers and investors will need to be quite creative I suppose. They talked on the panel session about the creative solutions here, a little bit about private wire, behind-the-meter solutions and also the technology stack needing to keep all those goals in mind using gas or hydrogen solar.

Chris, what do you see? Bringing you in here. The threat of enhanced regulations, to some extent the unknowns there, is this putting off investors?

Chris:
Well, I don't think the regulatory overlay is putting off investors. There's still huge demand and these are sophisticated investors. Now, I think, yes, it does add complexity. I mean to go through some of the list of regulations that we're seeing, I mean we've got foreign direct investment controls, we've got critical national infrastructure rules, particularly in the UK. We've got the new cybersecurity directive. We've got data sovereignty rules, all of this on top of your permits and planning and energy regulations. So yes, it is complex, but I think a lot of investors are seeing this as an opportunity as well, particularly for infrastructure investors for whom this is their bread and butter, they know how to manage this. And frankly speaking, some of this complexity is probably also creating real barriers to entry for other investors and giving them a real opportunity to get ahead of the pack.

Rebecca:
Chris, we've been seeing a broad range of transactions in this sector from acquisitions of data centre platforms to JVs, to carve-outs and minority investments. Is there any that have stuck out in your mind over the last year?

Chris:
Yeah, well, the last year is a good starting point because I think it was one of the record years for data centre M&A, I think particularly in the US and Australia and Europe. We had in Australia Blackstone's acquisition of AirTrunk, I think that was over 16 billion. In Europe there was Brookfield's acquisition of Data4 that was about 4 billion. These were huge numbers, but we're also seeing a lot of joint venture activity. These are complex investments, so investors are bringing together complementary skillsets. Yes, you have the capital from infrastructure and private equity investors, but you also need the operational capabilities coming from data centre groups who understand how to put together the land, the power, the technology, and negotiate with the hyperscalers.

Ruth:
That's great. We've covered the why. We've covered the what, we've even covered the who. Sounds like you need to be smart, have a lot of capital or friends that do. Be patient, because it's going to take a while, and have all the right sort of partners with you. But let's talk a bit about where then. Where are we seeing the investment activity?

Rebecca:
Well, there was a great discussion around the drivers in respect to location from things like data sovereignty, power constraints, and the differing needs of workloads and how that can impact on the location of data centres. There's also a lot of talk around secondary growth markets. So those markets which are outside the FLAAP-D market such as Madrid, Milan, and of course the Nordics and Greece. Alongside geopolitical reasons for location and/or investments such as the power pricing stability, data sovereignty, AI regulations, foreign direct investments, and of course tariffs will also have a role to play going forward.

Chris:
I think it was interesting when Tom from Torch mentioned Greece and the growth potential there because that seems to align with what we've been seeing in terms of the importance of access to subsea cables and there's huge investment going into that as well. That seems to be in a way a leading indicator as to where data centre capacity is going to be needed. The only other region I'd add to that then would just be a lot of the activity we've been seeing coming out of the Middle East, there's really been two branches of that. One is the investment out of the Middle East into Europe. We've seen a fair bit of interest there from various players in the market, but also the real ambitions of certain Middle Eastern countries to develop their own hubs for AI-specific data centres to become real regional champions for data processing.

Rebecca:
And I suppose as well Africa, which is another big untapped market.

Ruth:
That's right. That probably takes us to the end of the key takeaways for the investor panel session. So now moving on to my favourite panel of the day, which was the financing data centres panel. So here I was joined by Michael Suppan from Deutsche Bank, who gave his view from sort of more a project finance, real estate finance point of view. Rob Hughes, who has a lot of experience in ABS and CNBS, and Dharman Sury who gave the chat from the borrower corner if you like. Dharman's a key senior advisor in the data centre industry. So in that financing panel, we covered what data centre owners look for from their financiers and what is on the worry list for lenders and note holders. We also touched on how to structure data centre investments for financing and also for exit.

Ruth:
I'm joined by Rhodri Lewis who's one of Ashurst's infrastructure financing and real estate financing specialists. I'm really pleased you could join us today, Rhodri.

Rhodri:
Hi, Ruth.

Ruth:
It was good to see your friendly face in the audience at the seminar. And I just want to ask you, what were your key takeaways from the finance panel?

Rhodri:
I mean one of the big points which Dharman made was wanting to have that sort of cookie-cutter style financing put in place across the different data centres that they're building around the globe and therefore trying to have that replicable financing in those jurisdictions. Obviously in reality there are some nuances as the different financings will look slightly different in each of those jurisdictions that you're trying to build. But on a sort of more macro level, I think it's an admirable ambition on Dharman's part.

Ruth:
I think that's right and the key to him was that speed to market, wasn't it? But I don't think I have ever seen two facilities the same, but there's probably a common base, like you say, a base ground for developing hyperscaler and one for wholesale perhaps. But it was also very striking on the day the way sponsors and lenders talked about their relationship being more of a partnership, sort of moving away from typical borrower-lender relationships perhaps, and that that relationship and that understanding of the asset class ranked higher in the required criteria for choice of lender than, say, margin financial terms pricing.

Jordan certainly, I've spoken to him, Jordan from Vantage quite a few times and he makes the point of how important building long-term partnerships is in this market. So basically relationships and no burning bridges in the quest for immediate outcomes. That goes across the piece. So financing is one of the factors there, but also your relationship with your construction counterparties and that's all about getting things to market fast, but in a way that when challenges do present themselves, which they will, that you can move with your partners to address those challenges. That's a healthy attitude.

Rhodri:
That makes sense and I suppose like any kind of construction, financing data centre construction will have its ups and downs and its unknowns as you go along in that process and therefore having that good relationship with your lenders. If things do come up and you need more flexibility in your financing terms or push certain dates out because of the sort of unknowns that arise, then that kind of relationship definitely helps to have that good relationship from the start. And I suppose another point is when the financing comes in-

Ruth:
Yeah, talk about that.

Rhodri:
... and how we can think about the different cycle of CapEx that you're looking to spend both from a greenfield perspective right until it's operational. So trying to get financing right at that early stage, pre-planning, pre-let in place is very challenging, but obviously later on as the actual data centre becomes more certain in terms of its planning energy and letting, then obviously the availability of financing becomes that much easier.

Ruth:
Actually that was one of my key takeaways. I was actually quite interested in how that appetite for exposure to data centres is moving up the risk curve from lenders and this is really helpful because obviously sponsors now, the cost of land, then getting the planning and getting the land energised is just increasing all the time. So that's a lot of outlay for sponsors to make before they've got anywhere near operating income. So getting a lender in beside them is really key to securing that leverage and assisting with IRRs.
I think sometimes the lenders will join them on that journey early just so they secure a place at the table for the investment takeout. So it might not be necessarily comfortable for them, but they'll do it because they feel they want to make those relationships, perhaps. Also, I suppose whilst it might be tricky to get the financing if there's no pre-let, certainly for vertical builds, if there's no pre-let, it may be possible if it's part of a portfolio financing. So where there are yield codes or investment codes that have the income to support that, there may be a little bit of spec lending that can take place. That was an interesting discussion around that.

Rhodri:
And then as part of this, when you are structuring your financing, you are thinking both on the sponsor side but also on the lender side about your exit of course, and therefore trying to have that kind of key structure in place whereby you can port particular data centres out of your wider portfolio financing. It's an important aspect that you've got to think about at the start.

Ruth:
And Dharman had his wish list, didn't he? So it was all the obvious ones like double holdco structures, single point sales in the usual way, but also an eye on things like transitional services and how they'll play out if you do divest one of the data centres. Maybe a little bit of focus on key on-site employees, that's more from a sort of lending to the structures point of view and making sure that if you did want to do a single asset exit that you can actually take those employees with you or have the best chance to. Stickiness of tenants, obviously massively key for lenders and just making sure that any key things in the leases or the offtake agreements, customer contracts that they deal with, things like change of control, insolvency triggers, making sure that they're not going to get a tenant that walks as soon as a lender. Maybe looking to take enforcement action.

And then one of the things we're coming across on more mature portfolios now is that extraction of specific data halls from umbrella MSAs and making sure that the MSAs are future proofed for that and that's relevant obviously to investors as well as lenders. And then as you get even more stabilised portfolios and you get intergroup sharing arrangements for site services, for power, for fibre, even for head office costs and all of that usual stuff, it's sort of making sure you've structured for a clean break there. So all these things really worth thinking about at the start and not leaving them till too late because it just causes problems down the line.

Rhodri:
And also thinking about any pass-through electricity charges for data hall space, but also the common space as well.

Ruth:
That old chestnut. That reminds me actually that the other key takeaway is about operating models and operating costs and trying to model the operating costs. I remember when we first started doing build to rent portfolios and financing, a lot of lenders didn't understand the operating model, didn't understand how you could get replacement operators in and what would that cost. It feels a little bit like there's those questions around data halls at the moment, but I think lenders get up the curve quite quickly there. But making sure things like electricity is passed through is going to be key to shaping those financial covenants and sizing the debt I suppose.

Rhodri:
And then also looking at the whole lifecycle of the financing and where that data centre will be in five, 10 years' time because obviously the requirements of these individual hyperscalers are very specific, but also the technology is evolving at a rapid pace. So thinking about what that data centre will look like in five, 10 years' time and what kind of technology you're going to need to potentially reinvest in at that time is critical.

Ruth:
That provisioning for lifecycle CapEx in a world where the tech's moving so fast is quite challenging. I suppose if the tenant is a sticky tenant for whatever reason, maybe long-willed, but might just be that there's no other building that has the access to the power in the location they want, that will help. You could provide for an amortising tail or CapEx reserves, that's all going to help, but there is still that refinancing risk I suppose and you need to keep half an eye on that.

Rhodri:
And that also plays again into what sort of financing package you're trying to access at the start of the project. If you're looking for more long-term project finance style financing with pre-let, long-term, offtake leases having probably a minimum of about 10 years with a hyperscaler tenant and amortisation put in, then you're probably looking at more project finance terms. However, if you're potentially looking at a shorter style financing with a bullet repayment at the end, then probably going to be looking at more of a real estate financing kind of terms.

Ruth:
Or hybrid in between. We've seen plenty of that.

Rhodri:
Or hybrid.

Ruth:
And of course Vantage now has made the way, led the way in Europe on the ABS scene. So who knows what's going to follow there. And it was interesting to actually hear from Rob Hughes and Michael Suppan's interchange on CNBS versus ABS versus whatever else and hearing the challenges from the audience on that. I mean, what's your view? Are all of these financing packages ignoring the refi risk and kicking the can down the road or are there other factors at play here?

Rhodri:
I think the market is particularly buoyant at the moment and the factors that you've mentioned, particularly access to power and also the desire and need for huge amounts of data to be sort of used up in the way that they need to be is leading to the ambition in the market that you don't really need to worry too much about that refi risk down the line because of these very high barriers to entry that we're seeing.

Ruth:
Yeah, certainly the current vacancy rates are indicating that. Well, that's probably all we have time for, Rhodri. So thank you, Rebecca, Chris and Rhodri for joining us. It's been really great to hear your thoughts. I will be interested to follow what our colleagues report following our further events across Europe in the coming weeks. But for now, thank you to the listeners for joining. As always, we're really keen to hear from you to get your own views on the issues that we've discussed. So please do get in touch and hopefully see you soon.