As pressure on cashflow mounts, data infrastructure is one of many sectors and technologies that could represent an opportunity to investors although largely ignored so far. Here, we explore the concept of distressed assets and why this could apply to data centres in the current economic climate…
Avoiding the White Elephant
In the last decade, investments in data centres have been growing in correlation with the insatiable expansion of the data economy.
As data infrastructure players continued to expand rapidly, there were 87 deals in the global data centre market with an aggregate value of $24 billion in Q1 of 2022.
As we enter the first quarter of 2023, the landscape looks decidedly different for all infrastructure. While the data centre market is very diverse globally, there are many friction points ahead.
Industrial real estate’s significant rise during the pandemic was already beginning to suffer due to soaring inflation and interest rates linked to scaling capital in the industry.
During the first half of 2022, the spike in energy prices had a noticeable impact on the balance sheets of operational data centres. While there has been some price levelling because of supply chain improvements, government action in many countries has been obstructive.
Those investors committed to the sector are looking to move away from legacy infrastructure and instead are developing an expanded thesis to cover green energy, cooling solutions, and management technology to create more value chain exposure.
Decentralised Energy and Smart Grids
A ‘distressed asset’ refers to an investment in a physical asset priced below market value.
Given the strain on cash flow, a common occurrence, companies often leverage or borrow through various debt instruments to finance their business expansion, new projects, or existing business operations. These instruments come with certain conditions or covenants that form a framework of rules for the borrowers to follow until debt repayment. They would primarily include financial obligations put in place to safeguard the debt.
When companies are near bankruptcy or already in default, they fail to maintain these covenants, and the value of these securities falls significantly, making them distressed. Some investors may find these securities attractive as they offer a high return but with increased risk.
In most cases, a distressed situation could be temporary, and the company may be able to come out of distress through either operational, financial turnaround or both.
Distress situations arise due to internal and external factors. Examples of internal factors include a mismatch in assets and liability duration, incorrect strategy, and mismanaged financials. External factors include a macroeconomic downturn, industry downturn, and structural market changes.
During 2021 and 2022, many sectors of the economy have been under pressure due to rising energy prices and inflation.
Some of the worse affected sectors include transportation, shipping, chemicals, metals, cement etc. But one of the most critical sectors that many investors have not focused on is data centres.
Why Can Data Centres Be Distressed?
Data centres’ cost of operations depends heavily on energy costs which form more than 50% of operational costs. Most data centres have so far not been affected by the rising energy costs as they have long-term contracts for energy supply, usually two-three years. But as they come up to renewal, there may be instances where their energy costs may be much higher, sometimes even depending on the geographical location and the supplier.
Data centres are also similar to infrastructure businesses and have financial structures with a large amount of debt. Long-term customer contracts allow owners to service the debt with matching long-term cash flows. But with rising interest rates, there will be increasing pressure on these projects as interest payments have increased.
With increased consolidation among smaller players and the rise of the big three, Amazon, Google and Microsoft, that command significant market share, it is difficult for medium-sized players to compete as they continue to lose customers.
There are also regulatory and socialissues with an increasing focus on sustainability which affects both existing and new projects.
The above factors will significantly impact incumbent data centres and lead to many distressed assets in the next 12-18 months. Both existing and new players and investors will also have to re-assess their pipeline, keeping in mind the possibility of stranded assets due to distress situations.
How Has the Market Treated Distressed Data Infrastructure?
While data infrastructure is a relatively new sector for distressed investors, there have been very few instances of publicly visible distressed assets. Most assets are sold to a competitor or converted into alternate facilities.
Unlike traditional sectors, data centres have underlying assets like land, building and other supporting infrastructure, which they can repurpose for other activities. Investors also consider data centres similar to real estate infrastructure, and some of the largest companies are trading as Real Estate Investment Trusts.
But a few assets have been in the news recently, as we can see in Table 1.
Investors in these assets usually depend heavily on restructuring or asset sale, as seen in Compute North (restructuring) and Sungard (asset sale).
Table 1 – Distressed Data Centre businesses
Compute North Holdings Inc. is a developer and operator of data centres used primarily by crypto mining and blockchain companies.
They filed for Chapter 11 in the United States in 2022. The primary causes of distress were lack of debt from its current lenders, energy issues, supply chain issues, dislocation in the capital markets, energy price volatility, and the decline in the price of Bitcoin. The company is now in the middle of a financial restructuring process.
Sungard Availability Services is a provider of Cloud-based Data centre solutions.
It went through bankruptcy in 2019 and again in April 2022. The primary causes of distress were the economic downturn, structural market changes, and an increase in energy prices. After financial restructuring, equity and debt holders sold it to another competitor, 11:11 Systems, in September 2022.
De-risking Data Infrastructure in Uncertain Times?
Investors in data infrastructure must change their existing strategy to succeed during this period of uncertainty, high inflation and high energy costs. Some methods they could use are diversifying revenue streams, reducing operational expenses, and focusing on sustainability.
Data centres must move from an existing enterprise model to hyper scalers and colocation models. There is also an increasing demand for edge computing due to low latency and data privacy requirements. Smaller data centres are crucial elements in edge computing as they need to be closer to the data origin. Existing data centres can take advantage of this model if they are close to city centres.
New technology brings the advantage of both higher output as well as reduced energy consumption. These include immersion cooling, artificial intelligence, and machine learning. These features provide immense savings and much higher revenue potential, thus increasing investors’ ROI.
As large energy customers, data centres can also benefit from purchasing renewable energy directly from sources like wind and solar projects through long-term contracts, thus lowering their energy costs and impact on the environment.
Data centres can also use the waste heat generated during their operations for applications like water heating that they can supply to utilities. This supply will generate additional revenue for the data centres. We are already observing these in data infrastructure in some Scandinavian companies.
The purchase of renewable energy and reusing waste heat for hot water will reduce the carbon footprint of the data centre operations, offsetting a significant amount of carbon that the data centres would have emitted. Investors can look to monetise these offsets through carbon credits which they can eventually sell on the voluntary carbon credit market. While these require advanced analytics as well as expertise, the carbon credits will provide a boost to the revenues of data centres.
While considering the above, investors must evaluate them based on operational and financial metrics to justify investments in an asset. Power usage effectiveness (PUE), Data centre infrastructure efficiency (DCiE) are some of the key operational metrics. The financial metrics include Net Present Value, Gross margin per square foot, and Return on Investment. Investors must use a combination of both metrics to evaluate and make an informed decision.
Early assessment of legacy components, the flexibility of the assets, and potential investment capital to scale and de-risk are all essential elements to maximise the true potential of a distressed data infrastructure asset. White elephants are not a preordained destiny for legacy data infrastructure. But these assets are multi-dimensional in operating model and risk. Learning and acting on which components are worthy of staying and which are needed to extend value and de-risk can make or break the potential for success or failure.
We at Redsand Ventures work with data infrastructure industry players and capital allocators to identify market opportunities, optimise them for operational excellence, and generate financial returns while ensuring maximum value for all stakeholders.
Nicole Anderson, Managing Partner Redsand Ventures
Sandeep Dama, Partner Redsand Ventures
Redsand Ventures is committed to breaking barriers between funders and industry to fuel further innovation at scale. We do this through our unique experience in asset funding and industry specialism in energy, data infrastructure and fintech sectors.