Juliet’s lexicological lament, “What’s in a name? That which we call a rose by any other name would smell as sweet” may be true in love, but rings hollow in the world of data center investing (“DC Investing”), where categorizing a data center investment (“DC Investment”) as a real estate investment, an infrastructure investment, or operating platform (“DC Platform”) has historically impacted the investor base and how a DC Investment is structured, financed, underwritten, and ultimately exited.
While there is a movement afoot in the real assets investment industry to reconsider whether the historical siloing of infrastructure investments, as distinct from other real asset investments, (e.g., real estate investments) still makes sense—see for example KKR’s recent reorganization of its real estate and infrastructure businesses under a unified real assets platform—we are wary that some participants in the DC Investment marketplace may not have a fulsome appreciation of the historical differences in market practice across the distinct real asset investment verticals. While there are many valid reasons for the market trend towards a less siloed approach to real asset investing, there is also a risk that in the midst of the current DC Investment frenzy, some participants could apply the wrong set of experiences to individual DC Investments.
In recognition of this period of upheaval when the historically fragmented private real asset investment industry (and the historically segregated infrastructure investing space) is on the precipice of an epoch of reorganization and consolidation, we’ve prepared this this brief exploration of the taxonomy of DC Investments with the hope that it will be useful to the reader in navigating the evolving DC Investment marketplace.
To start, we believe there are two basic ways to think about how to structure a DC Investment. There are DC Investments that look more like traditional private real estate investments (“RE Style Investments”) and those that look like more traditional private equity investments (“PE Style Investments”).
Let’s first consider the key structural differences we see between RE Style Investments and PE Style Investments. Starting with RE Style Investments, most are held by joint ventures (“JVs”) or private funds, and the actual “business” of acquiring, developing, managing, leasing, and selling the real estate is handled by one or more affiliated (or independent) managers.
In contrast, most PE Style Investments are typically vertically integrated and asset light, meaning the assets of the business are held by a common parent and the value of the business is not tied to the physical assets of the business, but rather the revenue generated by the business in delivering products or services to its customers. While private companies may own real assets, typically these holdings are driven by a need to ensure maximum control over a key input to the business (e.g., owning physical factories, or in the case of DC Platforms, data centers), not because it’s inherently value maximizing to the business to tie up capital in real assets.
This basic difference between RE Style Investments and PE Style Investments ripples through their respective investment structures. It starts with how the economics flow. For RE Style Investments, the profit from owning and operating the real estate will flow up through the JV (or fund) to the operating and capital partner (or LPs), with management fees to the operating partner (i.e., GP) being paid as an operating expense of the JV (or fund) and with incentive compensation taking the form of promote or carried interest at the JV/fund level. Considerations associated with things like employee recruiting and retention, executive compensation, company culture, and property management are all outsourced to affiliate or third-party managers. Other considerations, such as branding and marketing, are not relevant or materially less relevant than for PE Style Investments.
In contrast, most PE Style Investments are structured so that all assets, operations, and liabilities flow up to a common parent entity. Private companies will have direct employees, with all the associated benefits and burdens, e.g., employee recruitment, management, compensation, and retention. Unlike RE Style Investments, given the nature PE Style Investments, compensation takes the form of salaries, bonuses, and incentive compensation plans, not management fees and promote paid out via a cash-based waterfall.
The differences continue on the debt side of the investment structures. For example, PE Style Investments (including DC Platforms) are able to access corporate credit markets, potentially in addition to real estate lending facilities. In contrast, RE Style Investments are typically limited to mortgage debt, mezzanine debt, and perhaps preferred equity.
So which structures suit which types of DC Investments?
A lot turns on the ultimate goal, and skill set, of the sponsor (and its investor base) because how a DC Investment is structured will impact the amount of asset management required and the investment’s ultimate disposition.
For PE Style Investments, the value of the investment is in the business as a going concern, and many infrastructure investors are drawn to the stable cash flows that DC Platforms produce. Meaning PE and Infra investors alike may be drawn to DC Platforms which operate as a going concern, despite such DC Platforms potentially having more complex operations and management. Successful DC Platforms can take the form of businesses offering customers anything from co-location space, interconnections, and remote hands to hosting private cloud or delivering managed services. The common thread amongst these DC Platforms is that all of these use cases require that DC Platforms retain their ability to use their physical real estate at exit (or recapitalization) and thus attractive exit (or recapitalization) options for DC Platforms include the sale of the entire DC Platform, a public offering, entering into an asset backed securitization facility (with physical data centers being the primary collateral), or longer dated commercial mortgage-backed securitization. The key attribute that makes DC Platforms well suited for PE Style Investment structures is that the DC Platform’s ultimate product is not “just” the physical real estate—the DC Platform is marrying physical assets with operational talent in a way that provides more than a big, chilled box to its end user.
In contrast, private real estate investors typically have little incentive to hold a stabilized RE Style Investment long term because once built and leased (or entitled) the high IRR generating value creation for the RE Style Investment has already occurred. For Data Center investments structured as RE Style Investments, typical exits will take the form of a sale, whether to a data center REIT, DC Platform, a hyperscaler, or other investor (including traditional infrastructure investors) looking for a stabilized stream of cash flow. Thus, DC Investments that work well with traditional real estate structures are focused on satisfying the data center market’s enormous demand for physical plants to support DC Platforms (including hyperscalers). In this segment of the overall data center market, the “product” is the physical infrastructure that DC Platforms or hyperscalers will buy or lease and then fit out and run to deliver their own products and services to end users.
In sum, while there is much discussion of data centers as “the hot asset class,” with any combination of traditional infrastructure investors, private equity, and real estate investors all chasing exposure to the DC Investment space, in our view, it’s better said that DC Investments comprise multiple asset classes. And that it’s important for investors to think through how the unique features of each DC Investment impact the optimal structure for that investment. Whether a given DC Investment is best suited for a RE Style Investment or more of a PE Style Investment does, and in our opinion, should, impact how the DC Investment is structured, managed, and exited. Investors who don’t take the time to consider the right label (or labels) to apply deprive themselves of the wisdom of the investors who came before them and run the risk of ending up like a famous star-crossed lover. Remembered, but not living happily ever after.
