Private equity infrastructure funds are keen to add colocation data center companies to their portfolios, opening the door to potential market risks.
Private equity (PE) infrastructure funds are keen to add colocation data center (DC) companies to their portfolios. For public colocation companies, they become private; thus, eliminating the transparency public companies are compelled to provide and opening the door to potential market risks.
Private equity colocation acquisitions review
For many years, there have been a “Big 6” of pure-play colocation service providers (SPs), which is simply the largest US-based public colocation companies. Equinix, Digital Realty, CyrusOne, CoreSite, QTS, and Switch have held this honor for nearly five years. The landscape of public versus private has been changing quite dramatically of late. Here’s a brief review:
- QTS – Acquired in August 2021 by Blackstone for $10 billion and is now private
- CyrusOne – Acquired in March 2022 by KKR and GIP for $15 billion and is now private
- Switch – Acquisition pending by DigitalBridge for $11 billion and will become private at closing
- Coresite – Acquired in December 2021 by American Tower for $10.1 billion and now a subsidiary of a public company
- Cyxtera – Acquired in July 2021 by Starboard Value for $3.4 billion and is now public
PE firms began investing in earnest less than 10 years ago and have been picking up the pace aggressively in the last few years. The market has historically had a high-risk profile because of the hefty capital outlay to operate high-quality DCs, commonly framed as “high barriers to entry.” However, even amid extremely tough economic times, sustained revenue results and market fundamentals have emboldened faith in the sector’s long-term investment return viability.
Of particular interest in the transaction’s review above are those PE-backed acquisitions which subsequently turned a public colocation company into a private company. One of the unique characteristics of a PE acquisition is that PE firms can afford to pay a premium thanks to their significant investment scale. When Blackstone acquired QTS, it paid a 21% premium of $78 per share based on the share closing price on June 4, 2021. When KKR and Global Infrastructure Partners acquired CyrusOne, they paid a 25% premium of $90.50 per share on a share value of $72.57 as of September 27, 2021. From an EBITDA multiple perspective, the QTS acquisition was approximately 29.7x, and CyrusOne was roughly 23–25.5x.
In the most recent public-to-private acquisition, Switch entered into a definitive agreement with DigitalBridge and an affiliate of IFM Investors in May 2022 for $11 billion. Upon closing, Switch will become a private company. The share price premium is about 10%, but the EBITDA multiple is approximately 27.5x. Since the Switch announcement, several law firms have filed class action lawsuits against Switch for misleading investors. How this might affect the deal’s closing is unknown, but eventually, the deal will most likely close.
PE infrastructure fund acquisition risks
However, a broader topic is whether the PE acquisition of a public colocation company may pose a risk to either the acquired company or market stability. What kind of an owner will a PE firm be? Historically, a common theme for PE-acquired companies is that the acquired company is molded to maximize profit so the PE firm can exit with maximum return on its investment in the shortest amount of time. Doing this may require questionable changes to a company’s leadership, strategy, research and development (R&D) investment, etc., which may diminish the company’s strategic value upon acquisition.
PE infrastructure funds drive most colocation acquisitions/investments. These funds focus on digital infrastructure businesses like colocation, cell towers, and fiber networks, while other broader infrastructure funds may invest in utilities, power plants, shipping ports, etc. In general, these types of funds have commonly been good stewards of the acquired company, so the historical risk of a greedy PE investor flipping a damaged company is less likely, albeit not impossible.
The bottom line is that to be an infrastructure fund, investor demands a significant level of sophistication about these businesses because of the investment risk as infrastructure businesses are particularly capital-intensive. Additionally, PE firms don’t take capital risk lightly. Infrastructure businesses are appealing because they tend to have either sticky customers that are less likely to cancel or move out or captive customers that lack alternatives (think electric utility, for example).
The potential risk when a company goes private through a PE acquisition may be in the deep pockets backing. PE infrastructure investors are not stupid, so there isn’t a blank check or infinite pool of capital to be had. Still, there is a more significant opportunity for expanding the infrastructure footprint faster without the scrutiny a public company has to endure. Being a public company raises the bar on risk avoidance and scrutiny on capital management and net debt ratios. For a private company, those issues are simply an internal discussion. That said, many PE-owned colocation companies must still source their funding and are accountable to lenders in some form or another.
Given a broader opportunity to expand data center footprints, one of the many decisions about opening new DCs in any market is the potential of an oversupply dynamic, which can lead to price compression for deals or an extended delay in capacity uptake by customers. Success in the past does not guarantee success in the future, so an aggressive expansion plan can quickly turn into a challenging market. New York/New Jersey or London/Slough are relatively recent examples of the oversupply/price compression dilemma.
Without the scrutiny public companies are subject to from Wall Street and investors, the door is open to making decisions that may not be in the best interest of meeting long-term return on invested capital (ROIC) goals. This is not to suggest that PE firms are not good at keeping an eye on ROIC; instead, there are greater risks. For example, colocation operators over the years have become more sophisticated in their deal underwriting, walking away from deals where a minimum margin can’t be made. In a private company, it becomes a bit easier to swallow a 10% hit to the target margin to win a deal, potentially eroding overall margins and, over time, diluting ROIC.
For the remaining US-based public colocation SPs, Equinix and Digital Realty are unlikely to fall prey to a PE acquisition for various reasons, but primarily because of the acquisition cost. Cyxtera, on the other hand, is highly likely to be PE acquired and become private again as an acquisition price would be comparable to other recent acquisitions. Cyxtera likely has significant upside regarding expansion at low capital investment based on its telco legacy. Telco DCs built to accommodate colocation have often been significantly underutilized.
Assuming the Switch deal with DigitalBridge closes, that would be three major pure-play public colocation providers that go private in an unprecedentedly short period. For the calendar year 2021 (CY21), CyrusOne, QTS, and Switch collectively posted revenue of $2.4 billion, up 17.3% over the calendar year 2020 (CY20). That puts the collective group third in market share behind Equinix and Digital Realty. For perspective’s sake, Equinix and Digital Realty had combined revenue of $11 billion, up 11.2% in CY21 over CY20. The point is that the collective scale of CyrusOne, QTS, and Switch is enough to merit close attention to how their expansion plans develop over the next couple of years.
One of the more considerable risks to acquired companies is how management changes might be made. Management changes are welcome news in some cases, perhaps because of dysfunctional management teams. The potential risk is taking successful companies with management teams that understand the niche dynamics of their industry and replacing them with new management that does not have the same experience and understand the nuances. For example, replacing an executive with 80% DC acumen and 20% finance acumen with an executive that is the opposite can easily be catastrophic. Making decisions based on experience in different industry dynamics does not always translate. This is not to suggest that CyrusOne or QTS deals have resulted in this change or that the Switch deal will; instead, it’s a dramatic change to be wary of.
Looking back at how NTT, primarily a telco company, developed one of the more successful global colocation businesses, its approach is a compelling case study. Telco operators have been divesting their DC portfolios and colocation businesses for years, which were commonly based on a colocation company acquisition they expected would catapult them to success. In short, telcos assumed they could sell colocation like they sold telco services, and that shortsighted approach didn’t pan out as the colocation business is very different than telco services. NTT, on the other hand, acquired several successful colocation companies and essentially allowed them to retain the management teams and business models that made them successful in the first place. NTT is currently fourth in colocation market share with annual revenues of $1.5 billion.
Do private equity acquisitions pose a risk? They do, but it’s less likely that in today’s world, there would be chaos or turmoil in various markets because of mismanagement or a blatant disregard for the reality of market dynamics. PE infrastructure fund managers, by and large, have become sophisticated owners. Fund managers are risk managers; that’s their job. However, they also understand that reward comes through risk, so it’s a balancing act. The most likely adverse event would be DC expansions in a market where the unknowns of other operators expanding in the same market come to light too late, potentially leading to the oversupply/price compression dynamic.
In the end, the disclosures and transparency we’ve enjoyed have been lost with public companies that are now or will be private. It’s a wait-and-see game now as it will take time to see how it all plays out, so the lessons learned will have to wait.
Cloud & Colocation Services Tracker – 1H22 (July 2022)
Data Center Building Report – 2022 (June 2022)
Cloud Strategies: North American Enterprise Survey – 2022 (February 2022)
Alan Howard, Principal Analyst, Cloud & Data Center Research Practice