Global M&A trends and risks
Powerful new forces shaping in the M&A landscape
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Global | Publication | February 2023
Over recent years, we have seen a significant increase in the provision of debt and equity funding in the data centre space. There has been a growing focus by infrastructure funds and other investors on data centres as a distinct asset class, which has in turn led financiers to follow suit. The impact of Covid-19 combined with a growing governmental focus worldwide on improving connectivity has resulted in digital assets becoming increasingly important to support remote working, increased connectivity and the digitisation of company operations such as supply chains.
Demand for data centre capacity is currently at record levels. Cloud revenues of global hyperscalers (e.g. Microsoft, Google, Amazon) worldwide have grown by approx. EUR45bn year-on-year over the past couple of years according to Synergy Research Group. Experts predict that data centre capacity will need to double in the next 4 years to meet the ever-growing demand.
The current macroeconomic headwinds, including inflation, supply chain issues, political risk and rising interest rates, are expected to have short-term effects. With record-high demand, appetite for investing in and funding of hyperscale data centres will continue to be strong, and the past 12 months have continued to see significant private equity activity and corresponding debt financings, notwithstanding the wider macroeconomic circumstances.
Global supply chain issues in terms of both lead times and inflationary costs require developers to manage pipeline and offtake arrangements more effectively. Market players see that this will benefit larger developers who are able to use their market strength and portfolios of projects to negotiate certainty of supply and manage inventory and cashflow sensitivities. It is felt that hyperscalers will prioritise commitments to “go live” dates over slightly higher lease costs and will reward players accordingly.
It remains to be seen whether the current macroeconomic realities will dampen the recent high valuations that the sector has experienced, previously driven by significant competition between investors, particularly as the cost of debt increases.
Securing power supply, water and land has proven to be challenging recently. Although data centre capacity in Amsterdam and London is still expected to grow further, as evidenced by Vantage Data Centers’ recent announcement that it will be developing a 48MW campus for London, these supply issues have put pressure on a number of Tier-1 locations, which has translated into increased activity in other locations such as Warsaw, Berlin, Zurich, Milan and Madrid. Tier-1 locations are located near so-called internet exchanges where the connectivity is optimal. However, not all applications require low "latency", enabling offtakers to assess whether they can relocate certain workloads to other (Tier-2) locations.
ESG is a key theme for developers themselves but also for their investors, lenders and offtakers. Most hyperscalers have pledged to achieve carbon free or carbon neutral targets. Constraints relating to power and water supply have further increased focus on this topic. In addition, environmental regulation is also a critical factor. Some of the particular focus areas on this front are described below.
a) Power cosumption
Given the vast power consumption of data centres, power usage efficiency (PUE) is obviously very important. PUE measures the overall power used by a data centre against the power used by the computing equipment. New hyperscale data centres can reach a PUE of approximately 1.1, which is much better than some smaller or older data centres.
Smart software can help increase energy efficiency further, for example by regulating the speed of processing at night.
b) Power supply
With a focus on sustainability, data centre developers attempt to secure renewable energy supply or, alternatively, renewable energy certificates or guarantees of origin. Some hyperscalers are themselves securing partnerships with renewable energy suppliers in order to directly purchase clean energy (such as Amazon’s wind project with Scottish Power).
c) Water usage for cooling
Water usage efficiency continues to improve, with excess heat generated by data centres being increasingly used to heat nearby buildings.
d) Back-up generators
Back-up generators which used to run on diesel are being replaced by more sustainable alternatives.
Efforts are being made to reduce carbon emissions during construction. Developers carefully assess their supply chain, use more sustainable equipment and re-use technology, limiting the waste to landfill as much as possible.
f) Focus on “S” and “G”
Developers also focus on making improvements as to “S” (social) and “G” (governance) aspects, for example by promoting diversity and inclusion in the workplace, supporting charity and demonstrating good corporate behaviour.
a) Borrowers/investees and lenders/investors have become more educated
Lenders and investors have come to better understand this asset class and the risks involved. In parallel, borrowers and investees have also become more experienced and have a good appreciation of their bargaining position.
In the equity markets, high valuations seem to have cooled as competition from investors has decreased, but there now seems to be a slight mismatch between this reality and the expectations of investees and sponsors going to market.
b) Developers taking more risk buying speculative land
Given the constraints with regard to land, water and energy, and the backdrop of continued strong demand, developers need to take some risk to secure new locations (e.g. purchasing land without having certainty upfront as to whether the required permits can be obtained).
c) Scale is important
We have recently seen a number of structures and features in transactions which confirm the importance of scale.
(i) Accordion features
Developers often anticipate growth and therefore request (uncommitted) accordion features (also known as incremental facilities). This avoids the need to amend the legal documentation if debt capacity is increased for additional projects or expansion of existing projects.
(ii) Portfolio financing
We have been involved in a number of financings of portfolios of data centre projects (as opposed to the financing of a stand-alone project). Portfolio financing has the following advantages:
Although data centres can be financed on a wide variety of bases, we have predominantly seen project finance as the preferred structure for stand-alone projects. This means that the financing is provided to a special purpose vehicle (which will own the data centre) on a limited recourse basis. Lenders are willing to provide financing based on the expected revenues generated by one or more long-term offtake contracts.
However, portfolio financings can differ substantially from stand-alone project financings in a number of ways. For example, financial covenants are usually tested at a portfolio level rather than per individual project. Drawstop and event of default mechanics may not be triggered merely by an individual project being in default, depending on the importance of the project within the portfolio.
(iii) Borrowing base facilities
We have also advised on a borrowing base facility in the European market, an instrument not uncommon in the US. The structure was set up such that it functions as an umbrella facility for a pool of data centres whereby projects may be added or removed from such pool from time to time. The overall debt capacity fluctuates during the lifetime of the facility as the pool of data centres changes and/or matures over time.
(iv) Refinancing at holdco level
We have seen overall refinancings at holdco level of a large number of stand-alone project financings. This is attractive for developers which have built up a more mature portfolio of data centres, generating steady cashflows. An overall refinancing at holdco level will leave the developer with one syndicate of lenders, such that it no longer needs to manage various lender groups for individual projects. Lenders at holdco level will be financing on the basis of the aggregate cash flow generated by the holdco’s subsidiaries, with only limited controls at asset level. This is more akin to a corporate financing than a traditional project financing.
d. Flexible financing is important
In a rapidly changing and growing market, developers require flexibility. This may explain why we have not seen institutional investors becoming active as lenders in the European market. For this reason, we have also not seen securitisation in Europe, whereas this is more common in the US market.
e. Green and ESG-linked loans
Green data centres are a core area of green financing and we are seeing these implemented increasingly frequently, with a PUE metric as a methodology to define data centres as green (there appears to be an accepted market position of a PUE less than 1.5 being the threshold for a data centre to be defined as green). However, although there is an increased focus on ESG and green loans are common as a use of proceeds based instrument, the number of ESG-linked loans in this space seems to be limited. This may be explained by the fact that the new generation of hyperscale data centres are being built in accordance with the highest environmental standards, which is driven by all stakeholders involved (investors, offtakers, lenders and developers). Further incentives included in the financing documentation may not help to drive further improvement for this category of data centres. Where it is not evident that the incentives built into the documentation lead to actual improvement, lenders may fear being accused of greenwashing in view of recent legal action undertaken against banks. Also, negotiating effective key performance indicators (KPIs) has proven to take quite some time, which is not ideal in such a fast-moving market.
f. Green bonds
The market has seen a number of developers issuing green bonds, giving them access to long-term financing aimed at further reducing emissions and building more energy efficient data centres.
Nina Varumo is a freelance portrait and documentary photographer based in Stockholm. A recent project of hers Kvinnor till sjöss (‘Women at sea’) is on ongoing photo series highlighting the working life of female seafarers in order to change the stereotypical image of what and who is a seafarer.
Companies have been publicly reporting on their financial performance for over a hundred years. However, they are increasingly having to make public non-financial disclosures relating to sustainability and environmental, social and governance (ESG) matters as a result of rules, laws and regulations issued by stock exchanges, governments and regulators worldwide.
© Norton Rose Fulbright LLP 2023