Investing in Data Centers? Throw Out Your RE Playbook. And Your PE Playbook, Too
In the fiercely competitive data center (DC) investment landscape and the new playbook of DC investing, mastering three critical pillars—platform, real estate, and energy—is essential. Financial investors looking to deploy meaningful capital in DCs need to stand out from lesser-equipped, lesser-informed and narrower-minded investors who are also looking at DCs, but who will lose out on opportunities to those who are more comfortable with DC market practices. To put it bluntly, investors who execute transactions through a typical real estate (RE) lens or private equity (PE) playbook are already a generation behind.
Platform
At the core of any successful DC investment lies a robust platform. To the extent an investor does not want or cannot afford to go it alone given the capital intensive nature of the sector, platforms involve structuring ventures with cutting-edge JV and governance standards, and incentivizing management teams with performance-based and profit-sharing arrangements. High-performing DC management teams are making increasing demands on sponsors beyond those we customarily design, including requesting flexibility to pursue adjacent investment strategies outside core platforms. We frankly see no sector with greater balance of power towards management teams than we now see in DCs – so investors well prepared (and willing to think outside the box) to navigate these waters will be well-served.
A well-structured and durable platform that stands the test of strategic transactions, and that has flexibility to adapt to new demands and increased capital requirements (including for example, DC joint ventures and platforms that become fund-like over time), will ensure stability and align stakeholders toward a common objective. What is the lesson here? Don’t be bogged down by traditional structures, think creatively with your partners and management to create arrangements that permit new opportunities and growth, adapt to changes in the industry and incentivize management to take on risk and pursue development and partnerships as new opportunities emerge.
Real Estate
DCs have historically been viewed as brick-and-mortar RE investments (with a power supply and data connectively arrangement). With the influx of global capital and sophisticated sponsors, the RE component is now more critical than ever. Strong underwriting requires excellence in site selection, development, and leasing. Optimal site selection involves choosing locations with superior connectivity, security, and scalability (in addition to stable power, discussed below). Developing state-of-the-art facilities that meet industry standards for cooling, power, and security is essential to attract premium tenants willing to pay for reliability and performance. Devising flexible leasing structures that accommodate tenant growth, while securing long-term commitments, is paramount to stabilize revenue streams and enhance investment profiles.
Recent trends include integrating call and put rights on projects, allowing premium tenants to treat DC platforms as long-term off-balance-sheet financiers of this component of their business -- which fills a strategic and immediate need for capacity growth.
Energy
Energy management is as critical as, if not more critical than, the other two pillars. DCs are energy-intensive (the annual electricity report from the International Energy Agency (IEA) says global data centers consumed 460TWh in 2022, a figure that some predict could rise to more than 1,000TWh by 2026), making reliable and sustainable energy supply paramount. This involves sourcing appropriate energy solutions, often tied to the geographic location of the RE and sometimes including on-site or nearby green energy generation and storage.
Further, green energy initiatives are increasingly being prioritized by tenants, with investments in renewable power sources like solar and wind potentially reducing costs and, at a minimum, aligning with broader sustainability goals (even if DCs themselves are inherently energy intensive and by some measures not green). Energy efficiency measures, such as advanced cooling systems and energy management software and increased density, enhance the sustainability profile. Strategic energy procurement, including negotiating favorable contracts, leveraging power storage solutions, implementing demand response programs and sourcing back-up supply (through generators or otherwise), is essential to mitigate risks associated with exposure to system downtime, energy costs and regulatory pressures.
Binding Everything Together in a New DC Playbook
Executing a successful DC investment strategy requires a comprehensive and modernized perspective that integrates platform structuring, RE excellence, and cutting edge energy arrangements. By focusing on these three pillars, embracing flexibility in addressing the various concerns within them and adopting industry-leading practices, investors can navigate the complexities of the DC sector and achieve sustainable, competitive returns. This holistic approach is crucial for leading in the evolving landscape of DC investments, ensuring that investors remain at the forefront of innovation and performance. Even more importantly, the pace and complexity of DC investments will only increase – putting pressure on historically structured platforms to continue delivering, and perhaps adapting, through strategic transactions and eventual exits. Addressing and bolstering an understanding of these three pillars is the surest way to decrease execution risk, maximize management team alignment, and deliver returns to direct and indirect investors ahead of others who are still running through yesterday’s plays.
Financial investors who are cognizant of today’s market dynamics and invest alongside strong teams (while giving sufficient runway and wiggle-room for them to perform) will have the widest opportunity set and will be poised to capture most of the upside as DC investing continues to dominate private capital and infrastructure investing and fundraising globally. Don’t be left behind applying legacy RE or PE perspectives to today’s high-octane DC investing climate.
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Brian Gingold is a Partner in the Private Equity practice at Weil, Gotshal & Manges LLP
Arnie Fridhandler is a Partner in the Private Equity practice at Weil, Gotshal & Manges LLP
Jacqui Bogucki is a Partner in the Private Equity practice at Weil, Gotshal & Manges LLP
Pej Razavilar is a Partner in the Real Estate practice at Weil, Gotshal & Manges LLP
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