Investor interest in the data center sector remains high, according to investment bankers and securities analysts, who predict that the wave of mergers and acquisitions (M&A) will continue in 2020.
The high level of investor interest is creating competition for opportunities, nudging deal valuations higher. That trend is prompting some investors to tread carefully and adjust their strategies accordingly. But there is broad agreement that there is upside in the growth of the digital economy.
“It remains an incredibly dynamic sector, with lots of highly concentrated demand,” said Peter Hopper, the CEO of DH Capital, an investment banking firm focused on the data center sector. “Investors, both financial and strategic, are in search of growth. Capacity has to be deployed in these markets. There is a very good combination of a lot of private capital, as well as strategic buyers (data center operators) who still want to add capacity.”
“A lot of these technologies are waves that haven’t hit the beach yet,” said Hopper.
“There’s a lot of investor excitement around data centers,” said William Lawson, Director at Phillips Realty Capital. “There’s almost a herd mentality. It’s become more traditional CRE (commercial real estate) investors.”
Investor Interest in Digital Infrastructure Remains High
As we noted last year, some of the world’s largest investors are raising billions of dollars to invest in digital infrastructure, citing extraordinary demand for capital to fuel the data economy. Investment interest in data centers has been boosted by the growth of hyperscale computing, where the tenant is a giant corporation with excellent credit, lowering the risk profile for investors.
“The broader acceptance of this as an asset class has moved a lot of money,” said Rashad Kawmy, founder of Boundary Street Capital, which provides debt solutions for the technology sector. “Infrastructure funds have always been around. It’s only been recently that these massive capital allocators have included wholesale data centers as part of their telecommunications portfolios.”
The influx of money has created an active M&A scene, with multiple suitors competing for acquisitions and boosting deal valuations. As a result, some industry watchers see a more complex landscape for assessing valuation and investment risk.
“We’re not seeing a bursting of the bubble, but a more realistic view of the market,” said Kawmy. “We’ve been in this golden age of data center investing over the past 10 years. We’re going to start to see shifts, and they’ll have consequences. Folks who were tourists in this market will find that it might be a harder market than it seemed at first.”
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Deals Are Competitive, Valuations are High
Some large players say the current environment has led them to be more selective, and to carefully weigh deal valuations.
“Data centers are one of our key development interests,” said Kristin O’Connor Leung, Senior Vice President at GIC Real Estate USA, which is backed by the sovereign wealth fund for Singapore. “We’ve had a hard time making acquisitions, so we haven’t done many of them. The issue is that there’s a lot of people with capital to invest and the competition is significant. In the US, we’ve seen more capital and more supply. So we’re investing less there.”
GIC has focused on the wholesale data center sector, providing backing for Edgecore Internet Real Estate and the Equinix xScale hyperscale initiative in Europe. But GIC is wary of retail colocation. “We think that features a lot of small installations that will eventually move to the cloud,” said Leung, who spoke on an investment panel at the recent PTC conference in Honolulu.
“Over the past 12 months, we’ve been devoting more time to data centers,” said Waldemar Szlezak, Managing Director, Infrastructure for KKR USA. “We’re cautious about the pricing of assets. It’s very opportunity specific.
“There’s a lot of capital looking at this sector,” said Szlezak. “The path is not always clear and there will be misses along the way. I think there will be a different distribution of value, and finding where it will shift is important.”
At the recent CAPRE Digital Infrastructure Forecast, Credit Suisse senior analyst Sami Badri noted that deal valuations have remained high, even as hyperscale operators appear to be moderating their investment in hardware and new data center capacity.
“Towards the end of 2019, and into 2020, you’ve actually seen (acquisition) multiples expand to their highest levels,” said Badri. “Normally when spending decelerates, valuations compress. This isn’t the case. Multiples are actually expanding.”
Badri said that the valuations reflected the maturity of the sector and execution of the companies being acquired.
“Investors are starting to really grasp this asset class and are willing to pay up to get access to the data center industry,” he said. “The other factor is that profitability is getting enhanced across the industry due to operational excellence.”
Need for Scale May Drive M&A
Badri said he expected the deals would continue, driven in part by a growing “winner take all” dynamic in the colocation market, as enterprise decision makers are increasingly looking to large global providers to meet their data center and cloud computing needs.
“I think a lot of these mid-cap sized providers may need global scale and bigger sales solutions to win over enterprise CIOs,” said Badri. “This will mean more industry consolidation, and more efforts to deliver interconnection density to the major Tier One data center providers.”
“This seems to be an industry that’s ripe for consolidation,” agreed Jennifer Fritzsche, Managing Director at Wells Fargo Securities, who tracks the public data center companies.
The exit strategies for private equity firms could be a factor in ongoing deal activity, panelists said.
“A lot of the retail colo players are owned by private equity firms have made investments in the last three to five years,” said Kawmy. “It wouldn’t surprise me if you saw M&A there, simply because you have a fixed return timeline for their investors.”
Edge Computing Highlights Second-Tier Markets
Edge computing is a hot topic at every industry conference, and that was true of the discussions at both PTC and CAPRE.
“The edge has been talked about for years,” said Hopper. “I think we’re finally seeing the impact of the edge now in tier two and tier three markets.”
One investor who is bullish on the edge opportunity is Steve Smith, Managing Director of GI Partners (and previously CEO at Equinix). GI Partners is a veteran player in the sector, operating 27 data centers as well as colocation provider Flexential, which targets second-tier markets.
“I think the thesis a lot of us are looking at is the concept of the edge,” said Smith. “We’re headed toward more distributed computing. I think we’re at the start of seeing more compute and storage being deployed into secondary and regional markets. They need broadband and data center capacity, and I think there will be a lot more capacity pushed out to these communities. I think this is going to bring a lot of opportunities for people in this room.”
“I think cities number 15 to 50 will get a lot more attention,” said Wells Fargo’s Fritzsche, adding that “the profitability of the edge is questionable.”
Kawmy said we should expect to see more edge-related M&A like the recent acquisition of Packet by Equinix.
“We’ve seen some of the large strategics make ‘toe in the water’ moves in edge computing,” said Kawmy. “We will see little acquisitions like that.”
Data, Data Everywhere
In our DCF 2020 forecast, we noted that “the explosive growth of data will be felt like never before. We believe this is a sign of things to come, as next-generation technologies transform how we store, manage and move data.”
This is a positive trend for the data center sector, as noted by Simon Cooper, the CEO of Australian provider NEXTDC.
“Everyone is figuring out how to instrument everything,” said Cooper. “And no one is throwing data away.”
As data stockpiles grow, many companies will need help managing it.
“The business driver is that more enterprises are deciding they don’t want to be in a data center business,” said Hopper. “Think about our lives and how much we do online. All of that requires more Internet infrastructure.”