The data center sector appears set for a sustained boom, fueled by the acceleration of digital transformation across the business world as a result of the pandemic.
That’s according to a panel of investment bankers who advise data center operators and large investors on deals in the sector. The panel took place last week during the HCTS 2020 conference by 451 Research, held digitally.
The combination of spiking demand for digital services, driven by trends like remote work and home entertainment, and widespread access to low-cost capital makes for a particularly rosy picture for the sector’s foreseeable future, the experts agreed.
“Digital transformation by all accounts will be dramatically accelerated by the pandemic and the aftermath,” James Henry, senior managing director at Bank Street, said. “By and large, that is really positive for anyone owning and operating a data center.”
Much of the growth at the physical infrastructure level is driven by hyperscale cloud service providers, who offer the go-to digital services consumers and enterprises rely on. These providers will have deployed 2.1 million new IT racks between now and 2025, which translates to roughly $62 billion in capital spend on data center infrastructure, according to 451’s projections.
“These incremental deployments … won’t be made solely by the cloud players themselves,” Jonathan Schroth, research analyst for data center services and infrastructure at 451, said. “They will need to work with these data center providers and operators to expand their footprints, especially in the markets where they are not located today.”
Uncertainty about the future in the initial months of the global lockdowns has now been replaced by bullishness in the sector, reflected in the resumption of steady M&A activity – which had paused earlier in the year.
“There’s secular growth in demand, irrespective of economic growth, as we’ve observed now,” Fred Rosenberg, managing director and head of US credit solutions and direct lending at Deutsche Bank, said.
“And so, the trends are very favorable,” he continued. “COVID has … taken digital infrastructure and made it obvious how central and how core it is to everything we do.”
The pandemic has further bifurcated the digital infrastructure sector between businesses focused on hyperscalers and those focused on traditional enterprise customers, Adam Lewis, managing partner at DH Capital, said.
While the former segment has continued to see fast inventory absorption, much of the growth in the latter has come from existing customers, he said. These providers’ ability to add new logos to their client rosters has been limited as a result of travel restrictions and uncertainty about the future.
But for the same reasons, customer churn has tapered, Lewis added. Data center tenants aren’t doing migrations as quickly as planned, and IT changes in general have slowed.
Data Center M&A Deals Are Up Despite COVID
Besides data centers, digital infrastructure includes fiber networks and wireless towers. Together, the three have emerged as a highly sought-after category of investment assets, not only because of their essential nature today but also because of their potential for future growth, driven by the arrival of 5G connectivity and the proliferation of IoT devices and AI-powered applications.
There had been no shortage of acquisitions in the space before the pandemic, but deals had all but stopped coming from March through May, Rosenberg said. Investors feared that although the fundamentals were intact, the unprecedented nature of the crisis could bear some “unknown unknowns.”
By June “that effectively faded, and markets were in my view largely reopened,” he said.
So far this year the number of data center M&A deals is up compared to last. There were 123 deals in the first three quarters of 2020, compared to 108 deals during the first three quarters of 2019, according to 451.
The total value of businesses in the sector changing hands is up as well. Data center and managed services businesses sold during the 12 months ending last September were worth $10.2 billion, compared to $3.5 billion for the same period a year earlier, 451 estimated.
While deal volume is up, the increase doesn’t correlate with the total deal value estimate, which can be heavily skewed by a single deal, such as Digital Realty’s $8.4 billion Interxion acquisition, closed in March.
The volume of deals this year was boosted by lots of small managed services firms being acquired as service providers look to expand their portfolios, Kelly Morgan, research director for data center infrastructure and managed services at 451, said.
Infrastructure Funds Alter Sector Dynamics
Funds that invest in airports, tunnels, toll roads, shipping ports, and other “traditional” infrastructure saw this year that these things aren’t the “absolute bedrock investments” they were thought to be before the pandemic shut down most activity, Bank Street’s Henry said.
“Some of those businesses have seen their revenue go to zero for six months,” he said. Meanwhile digital infrastructure investments not only have been resilient but benefitted from the crisis.
The industry-changing influx of traditional infrastructure investors into the digital infrastructure space that started a few years ago should now accelerate. We may see a “sector rotation,” where infrastructure funds whose investments have been overweight in traditional infrastructure pivot to being overweight in digital infrastructure, Henry said.
Infrastructure funds have been a “change agent” for the sector, he said. They’ve made capital available on much more attractive terms than data center providers have been used to.
“The first generation, or even second generation of private capital that funded the data center world” came from private equity firms that “were trying to make two to three times their money in three to five years, shooting for 20, 25, 30 percent IRRs,” Henry said. (IRR is Internal Rate of Return.)
Infrastructure funds are willing to buy the same assets, with the same cash flows, while looking for mid-single-digit IRRs from providers of core data center infrastructure and low-to-mid-teen IRRs from providers of hybrid cloud and managed services businesses, which are considered higher-risk, he said.
The “abundance of liquidity entering the market” has manifested in lower interest rates, Deutsche Bank’s Rosenberg said. Capital rates are now down to 5 percent in the sector, “which seems awfully low, until you consider that treasury rates are near zero.”
The likely buyers in the space today are data center operators with deep-pocketed sponsors behind them, Henry said, examples being Expedient, which was recently acquired by AMP Capital, or TierPoint, which recently received a $320 million equity investment from Argo Infrastructure Partners, Wafra, and Macquarie Capital.
Such providers are looking for deals that would expand their geographic reach and/or augment their product portfolios, he said. Security, for example, is an “attractive overlay” for a colocation and hosting business. The ability to offer network onramps to large cloud providers, such as AWS, Azure, or Salesforce, is another sought-after capability.
The largest data center providers have also continued expanding via acquisition, lately focusing on reaching beyond the markets they’ve been in, largely as a response to cloud providers’ desire to do the same. Equinix and Digital Realty have invested in data center capacity in places like Canada, Mexico, Kenya, India, and smaller European markets, such as Milan, Zurich, Madrid, and Warsaw, 451’s Morgan said.
For data center business owners looking to sell, Henry’s advice is to focus on cash flow, or adjusted EBITDA.
“That is the answer at the end of the day,” he said. “As much growth as the sector enjoys, and as much asset value [that] underpins these companies intrinsically, we’re still in a very rational market, where investors, lenders, buyers are focused on cash flow.”
If you’re in the process of selling a company, there’s nothing better than your sales team hitting targets quarter after quarter while you’re negotiating a deal, Henry said.
The second important variable is capacity for future growth in your existing portfolio. If half or two-thirds of your capacity in a given market is utilized, there’s capacity for growth for the next owner, he explained.
It’s important that that capacity is offered in high-quality, state-of-the-art facilities, he added.
Few Worries About the Future
Asked whether they worried about anything that could spoil the rosy picture for the digital infrastructure sector they had painted during the panel, the investment bankers couldn’t think of much besides two things.
First, pricing has been inching down in some markets as a result of oversupply and willingness by some providers to lease at lower than market rates. Second, the impact of accelerated digital transformation on the smallest regional data center providers may be painful.
“The real risk comes into play when there’s a ton of excess capacity available, and competitors are sort of pushed to offer pricing that’s just not sustainable,” DH Capital’s Lewis said. In such cases, some operators “sit on the sidelines” and wait for pricing to firm up, while others “squint and go for the lower return.”
In Henry’s opinion, major data center operators can’t afford to “look away” in these situations. He pointed to Amazon Web Services, which alone generated $35 billion in revenue in 2019, growing at 37 percent year over year.
“There’s no scenario in which any of the major data center operators can afford to just bypass that and let others go after that extraordinary growth opportunity,” Henry said.
That growth means that over time, the companies that have been building enormous data center campuses will see “remarkable absorption and remarkable revenues,” he said.
As more businesses turn to cloud services hosted in those campuses, however, the future of smaller local or regional service providers looks uncertain. When a small business’s server or storage array sitting in a local colo reaches its end of life, chances are it will be replaced by a cloud service, in which case “a dollar of colo revenue probably turns into somebody else’s dollar of revenue, in a hyperscale facility,” Henry said.