This article is sponsored by Digital Alpha, DigitalBridge and Vauban Infrastructure Partners
Digital infrastructure has been an overwhelming beneficiary of the pandemic and consequent international lockdowns. “We have seen a marked increase in demand in terms of computing and connectivity across all major digital infrastructure segments – towers, data centres, edge infrastructure, small cells and fibre,” Kevin Smithen, chief commercial and strategy officer at DigitalBridge, reveals at our roundtable discussion. “Many of the largest and most profitable companies in the world are increasing their capital spending on digital infrastructure and are looking for turnkey partners that can provide holistic solutions across multiple segments and geographies. That all means we are deploying capital at an accelerated pace to meet the needs of those key corporate customers.”
Rick Shrotri, founder and managing partner at Digital Alpha, says his firm is also deploying capital faster than ever before, adding that the demand shift is global: “That is being driven by a sharp increase in remote interaction. The world is not going to return to a traditional office environment. Some sort of hybrid model will emerge for everything from work and education to entertainment. Industries such as healthcare and transportation are all embracing the internet in new ways due to covid, as well. And those trends are here to stay.”
Yet although digital infrastructure has demonstrated relative robustness in the face of this step change in demand, there have been challenges, including slippages in timelines around the availability of silicon. “We have also seen some logistics constraints in terms of access to sites,” says Shroti.
Smithen adds that labour shortages represent an additional challenge: “There have been difficulties getting people back to work and that has resulted in a shortage of construction and provisioning labour that is causing delays as well.”
Elie Nammar, senior director at Vauban Infrastructure Partners, says that while there were some difficulties with labour shortages, the tide appears to be turning. “More recently we have seen labour move between industries. Industries such as digital infrastructure have been beneficiaries of that, although demand is high and there is still significant tension in the market.”
Another challenge that digital natives must face, of course, is growing levels of competition, as the pandemic has provided definitive proof that digital infrastructure is indeed critical. But while the volume of capital pursuing opportunities is swelling, so too is the opportunity set itself.
“It is important to put increased competition into context,” says Shrotri. “The compound annual growth rate of internet traffic between 2017 and 2022 is between 25 and 30 percent. That is a dramatic increase. Contrast that to global GDP growth of between 2 and 3 percent, and you can see that demand for digital infrastructure is growing at around 10 times the rate of real economic growth.”
Smithen, however, believes that we will start to see a stratification in digital infrastructure returns. “Clearly, there has been a lot of low-cost capital entering the space as it is increasingly being viewed as resilient and core,” he says. “Over the past 20 months, it has become clear that every infrastructure portfolio needs to have renewables and needs to have digital. That wasn’t the case two years ago. When you have $20 billion funds and $200 billion LPs that need an allocation to digital, you are going to see the auctions of large towers, or stabilised hyperscale data centres priced for high single-digit or low double-digit returns.”
Smithen adds that for those players with operational capabilities and an additional value-add component, there will still be opportunities to deploy at scale over at least the next decade, and that returns will be consistent with those that have historically been achieved: “What we are seeing is more greenfield opportunity, albeit backed by investment-grade anchor customers with long-term leases. We are also targeting opportunities in more operationally intensive segments, such as enterprise fibre, small cells and indoor DAS [distributed antenna systems]. Those segments are too complex for core infrastructure funds and most direct investors. There may be an element of expanding beyond North America and Europe, to developed Asia and emerging markets, as well.”
Vauban, meanwhile, is a core infrastructure player, but Nammar believes that, here too, significant opportunity remains for those that have demonstrated a history of successful investment and partnership with industrials. “I think that is true, even in the more traditional areas of digital infrastructure, such as fibre deployment,” he says.
“Countries including the UK and Germany still have a significant gap to fill with regards to fibre roll-out. And with 5G coming, demand will increase further. We also see increased willingness from incumbents to open up their assets. But they want to work with experienced investors. Having that expertise and track record is still a differentiator and means that it is still possible to generate attractive returns.”
A supportive policy framework can also prove critical to maintaining financial performance. Nammar has had direct experience with a French scheme to support fibre rollout in rural markets. “One of the main challenges with fibre rollout is ensuring rapid take-up while mitigating the risk of overbuild, which in turn can negatively impact take-up,” he says. “Having a government scheme that limits overbuild in rural areas, as exists in France, is definitely an enabler for a more conducive business case. The French broadband PPP market is a successful endeavour, leading to take-up of around 40 percent in rural areas, compared to around 20 percent in other markets.”
The speed of innovation means that investors in digital infrastructure must also keep a watchful eye on the level of technology risk to which they are exposed.
But, according to DigitalBridge’s Kevin Smithen, technology evolution tends to be positive: “Additional equipment will need to be placed on our towers for the rollout of 5G and ultimately 6G. Meanwhile, 3G is still in existence around the world. More and more wind load or capacity is being added to those mobile masts and that typically means more rent for us. At the same time, data centre server technology has benefited from improved processing power over the past decade. Current servers are smaller but consume more power. So, revenue per square foot has gone up fairly consistently over time.”
Smithen adds that the bulk of technology risk is borne by customers: “For the most part, we are not managing the active infrastructure. We are just providing a space and power model. That is the case for towers, digital billboards and dark fibre, as well as hyperscale, and in some cases edge, data centres. So, the vast bulk of our business is tech-agnostic.”
Elie Nammar of Vauban Infrastructure Partners also believes technology risk is limited: “I think the chances of something new and disruptive coming in and changing the whole industry is relatively low across data centres, fibre and towers.The bigger risk is that existing technologies will begin competing against each other – for example, fixed wireless access competing with fibre. But, for now, the two appear to be complementary.”
Rick Shrotri of Digital Alpha says the ability to identify key technology inflection points before they happen is a core competency: “We were able to predict what would happen to internet traffic. We know that we are in the early days of 4K video, with 8K video on the way. We know that VR and AR are going to drive additional use cases and we know that security remains a key threat. The only question for investors such as ourselves is how we build agile infrastructure that can adapt to those changes as they happen.”
Shrotri adds that the US government also has a role to play in supporting rural initiatives, but says he would like to see governments opening up certain existing assets to outside investment as well. “That would enable us to deploy connectivity in urban environments and help bridge that digital divide that exists,” he says. “We are working with a handful of cities in the US that are embracing this idea but there is still a lot of education
Top of Smithen’s wish list for government, meanwhile, is easier permitting, particularly for the siting of small cells. “With the rollout of 5G over the next decade, we believe there is going to be a tremendous need for both outdoor and indoor DAS infrastructure,” he says. “That RF equipment needs to sit on streetlights and utility poles or inside public venues, so governments should be more accommodating. I think a simpler permitting process will ultimately prove critical to the success of 5G and low latency broadband connectivity in dense urban markets.”
Nammar adds that a simplification of the permitting system would also enable an easier and faster fibre rollout. “This is an area that would benefit from greater flexibility and
co-ordination,” he says.
As well as additional support from government, a more open attitude towards digital infrastructure from lenders would also be a boon. “It takes time to educate lenders about newer asset classes,” says Shrotri. “But the fact is that the underlying drivers of demand in this sector are both strong and predictable. Lenders should take comfort in that predictability, along with the fact that there can be no doubt now that digital infrastructure is absolutely mission-critical.”
Many lenders remain wary of digital infrastructure, however. In response to this, Digital Alpha has pioneered an outcome-as-a-service approach, leveraging customer outcomes such as revenue generation and expense savings to finance capital investment.
“It takes time to educate lenders about newer asset classes. But the fact is that the underlying drivers of demand in this sector are both strong and predictable”
Nammar believes there has already been a shift in thinking among lenders when it comes to the more established segments, such as towers and brownfield fibre. “Those are easier discussions to have than discussions around active infrastructure – the move to 5G, or small cells,” he says. “It depends on the level of commercial risk you take, including targeted use cases, having competing infrastructure alternatives and how secure future cashflows are over a certain period.”
DigitalBridge has taken a different approach. “We have been pioneers in the securitisation market across all four verticals,” says Smithen. “We offer lenders the opportunity to securitise 10- or 15-year contracts with AA and in some cases AAA counterparties, and that has proven to be a significant source of alpha for us. Those securitised lenders aren’t as focused on whether the infrastructure is active or passive. They are focused on the receivables we are getting from the large hyper-scalers and investment-grade MNOs [mobile network operators].” Another key area of focus for digital infrastructure is energy consumption. It is estimated that data centres will consume between 8 percent and 13 percent of the world’s electricity needs by 2030. With attention focused on the global climate emergency ahead of this month’s COP26 conference, pressure is mounting.
“Digital infrastructure is typically ESG friendly,” says Smithen. “We provide connectivity and computing to billions of people around the world, with all the societal benefits that that brings.
“But power consumption is something that has to be watched. We are one of the largest hyperscale data centre operators in the world, with over 600MW leased to date across Europe, North America, Latin America and now Asia. Our LPs and our customers are increasingly focused on green data centres. We see huge opportunity in this market, both on the greenfield side and upgrading existing data centre platforms owned by third parties or the hyperscalers themselves.”
According to Shrotri, the good news is that the digital infrastructure industry is measuring energy consumption and carbon emissions with a degree of granularity that was not previously possible: “We can answer questions with precision. We can also accurately gauge the extent to which digital technology is displacing carbon-intensive activities such as transportation. Having those metrics is a positive development.”
“Our LPs and our customers are increasingly focused on green data centres. We see huge opportunity in
Shrotri adds that the topology of the internet is also changing: “More compute is taking place at the edge, meaning data can be stored and managed locally. That is important from a power consumption perspective, and from a data integrity perspective, as well.”
Nammar says there is a great deal of activity with respect to power usage effectiveness, or PUE: “It is all about the ability to create more computing capacity from the same amount of electricity. The PUE of data centres goes hand in hand with economic benefit. There is a convergence taking place between achieving a better carbon footprint and doing better as a business.”
Growing emphasis on the green credentials of data centres could lead to compression on returns, however. “This is a really important issue for our LPs and for customers, and I think we are going to see a lot of political pressure as an industry for net-zero solutions,” says Smithen. “At least in the near term, I think there will be lower returns generated on truly green data centres. People have to accept that there will be an economic cost to delivering on this critical initiative.”
Those economic costs not only involve the price of renewable power; they involve factors such as location. “If you are building a new greenfield site that is a long way from a fibre landing station, your overall costs for your customers could go up, even if power costs go down,” says Smithen. “And I am sceptical about how much of that cost will be passed on to customers. These hyperscalers drive a hard bargain. Going green is certainly a strategic priority for them, but the jury is out on whether they will be willing to absorb the extra expense or pass it on to their landlords.”
Although environmental considerations are critical, Shrotri believes other factors have a greater impact on customer decision making. “I see privacy, security and sovereignty as bigger priorities. Customers are primarily looking for data to be secured locally, in a controlled environment. I think that is more important to them in assessing what options to use than energy efficiency.”
“We… see increased willingness from incumbents to open up their assets. But they want to work with experienced investors”
Vauban Infrastructure Partners
A proliferation of protectionist policymaking in recent years has created an additional emphasis on sovereignty. “There is no question that public sector customers, in particular, are placing a premium on how and where their data is managed,” says Shrotri. “And they are increasingly scrutinising the entire chain through which that data has travelled. We are seeing those questions arising from every corner of the world and it is incumbent on us to be able to answer them. That may mean investing in local markets in a way that we wouldn’t have contemplated before.”
Smithen, however, says the real impact of protectionist policy is being felt in the hosting market – managed cloud – where infrastructure providers are managing the servers. “The vast bulk of what we do is just providing space and power,” he says. “Our customers handle the data themselves. We don’t touch it. I would add, however, that we do see some demand benefits as a result of this trend. Three years ago, almost all capacity in Europe was held in hyperscale campuses in the FLAP markets – Frankfurt, London, Amsterdam and Paris. Now, because of data sovereignty issues, our hyperscale customers are building and leasing large campuses in second- and third-tier cities, right across the continent. That has been a positive tailwind for us.”
Senior director, Vauban Infrastructure Partners
Elie Nammar is a senior director focused on the digital infrastructure sector. Prior to joining Vauban in February, he was an associate partner at Oliver Wyman and a group principal strategy manager at Vodafone. During his tenure there, he was a senior member of the TMT practice working with local and global companies to define their growth strategies, both organic and through M&A, and optimise their spend and returns.
Founder and managing partner, Digital Alpha
Rick Shrotri has been a technology and telecommunications investor for more than two decades. Prior to founding Digital Alpha, he was managing director of Cisco’s business acceleration team, where he focused on identifying and developing opportunities that required equity financing. He previously worked on Samsung’s external innovation strategy, including M&A and joint venture structures for the semiconductor and mobility divisions. Shrotri also worked in the merchant bank division of Goldman Sachs.
Chief commercial and strategy officer, DigitalBridge
Kevin Smithen has more than 26 years’ experience in the global communications services and digital infrastructure sectors and plays a key role in deal sourcing, fundraising and co-investment efforts at DigitalBridge. Prior to joining the firm in 2018, he worked in the equity research division of Macquarie Securities, most recently as sector head for TMT. He previously worked as a senior analyst and portfolio manager for Lazard.