Data Centre Investments

In recent years, the global investment landscape for data centres has reached record-breaking levels, with the market being largely dominated by US-based players, particularly private equity firms. This surge in investment reflects the critical role that data centres play in today’s digital economy.

The dynamics of the data centre market are diverse, encompassing colocation, hyperscale, and edge data centres. Colocation facilities allow multiple businesses to rent space for their servers and other computing hardware, whereas hyperscale data centres cater to the vast needs of major cloud providers. Edge data centres, on the other hand, are smaller facilities located closer to end-users to reduce latency and improve service speed.

Drivers of demand

The demand for data centres is anticipated to grow rapidly, driven by several key factors:

1. Internet of things (IoT): The proliferation of connected devices generating massive amounts of data.
2. Artificial Intelligence (AI): Advanced data processing and storage capabilities are essential for AI applications.
3. Advancing technology: Innovations across work, life, and entertainment require robust data infrastructure.
4. Autonomous vehicles: Self-driving cars depend on real-time data processing and low-latency communication.
5. 5G connectivity: The rollout of 5G networks boosts the need for data centres to handle increased data traffic.

Challenges and concerns

Despite the booming investment and growing demand, the data centre industry faces significant challenges. The high costs of energy and concerns over CO2 emissions are major issues. Data centres are notorious for their substantial energy consumption, leading to a considerable carbon footprint. As the world shifts towards sustainability, finding ways to reduce energy usage and environmental impact is crucial for the industry’s continued success.

Market dominance and components

The market dynamics are heavily influenced by a few dominant cloud providers, with hyperscale entities accounting for 50% of global server sales. These large-scale operators significantly shape the industry’s direction and competitive landscape.

The essential components of a data centre include:

• Servers: Perform computing tasks and process data.
• Storage: Store vast amounts of information securely.
• Network infrastructure: Ensure seamless connectivity and communication, including access to networks and the internet.

Efficiency and key success factors

The efficiency of data centres has improved over time, particularly in terms of power usage effectiveness (PUE), which measures the energy efficiency of a data centre. Additionally, the IT workload per rack has increased, meaning data centres can handle more computational tasks within the same physical footprint.

Access to reliable internet and electrical power is vital for the success of any data centre. These facilities must be located in areas with robust infrastructure to ensure continuous and efficient operation.

Types of data centres and their investment appeal

Each type of data centre presents unique advantages and opportunities for investors. Hyperscalers offer stability and global reach, colocation provides cost efficiency and scalability, and edge data centres meet the growing need for low-latency, distributed data processing. Together, these diverse data centre models form a compelling investment landscape in the digital era.

Hyperscalers

Hyperscalers are large-scale cloud service providers that operate vast and highly efficient data centres, offering cloud computing services, storage, and other related services on a global scale. These entities possess immense computing infrastructure and serve millions of users and businesses worldwide.

Attractiveness for investors:

1. Global reach: Hyperscalers have a global presence, providing a diverse market for investors. Their ability to operate across different regions ensures wide market coverage and reduces regional risks.
2. Stability and growth: The sheer scale and prominence of hyperscalers offer a stable investment opportunity. As digital transformation continues, the demand for their services grows, ensuring sustained business expansion.
3. Long-term contracts: Often engaging in long-term contracts, hyperscalers provide investors with a predictable and stable revenue stream.
4. Technological innovation: Investing in hyperscalers allows investors to be at the forefront of technological advancements, as these companies continuously innovate to maintain their market position.
5. Strategic importance: Hyperscalers are crucial in shaping the digital landscape, making them strategically significant and valuable investment assets.

Colocation data centres

Colocation involves hosting data centre equipment, servers, or computing hardware in a facility provided by a third-party, known as a colocation provider. Clients share the physical infrastructure, including the building, power, cooling, supply of electricity, and network connections, while maintaining control over their own servers.

Attractiveness for investors:

1. Cost efficiency: Colocation offers a cost-effective alternative to building and maintaining a private data centre, reducing capital expenditure for businesses.
2. Scalability: Businesses can scale their IT infrastructure as needed without significant upfront costs, making colocation a flexible and scalable solution.
3. Focus on core operations: By outsourcing data centre management, organisations can concentrate on their core business activities, improving operational efficiency.
4. Flexibility: Colocation facilities provide flexibility in terms of space, power, and connectivity options, accommodating diverse business needs and growth.

Edge data centres

Edge data centres are facilities designed to process data closer to the point of origin or consumption, reducing latency and improving performance for end-users. These centres are strategically located near the "edge" of the network, enhancing speed and efficiency.

Attractiveness for investors:

1. Low latency: Edge data centres address the increasing demand for low-latency services, crucial for applications like IoT, gaming, and real-time analytics, providing a competitive edge in these fast-growing markets.
2. Distributed architecture: They support a distributed network architecture, making them suitable for applications requiring geographically dispersed data processing, thereby enhancing network resilience and performance.
3. Growing demand: The rise of IoT and edge computing applications drives the demand for edge data centres, presenting significant investment opportunities.
4. Adaptability: Edge data centres offer adaptability to changing technology landscapes and the evolving needs of industries relying on edge computing, ensuring long-term relevance and profitability.

The case for and against investing in data centres

Investing in data centres offers substantial opportunities due to growing digital demand, technological advancements, and the strategic importance of these facilities. However, potential investors must also navigate significant challenges, including high initial costs, rapid technological changes, and regulatory complexities. Balancing these factors is key to making informed and profitable investment decisions in the data centre sector.

Advantages of investing in data centres

1. Growing demand for digital services The increasing reliance on digital services, cloud computing, AI, and the proliferation of connected devices (Internet of Things) contribute to a growing demand for data centre infrastructure. As more aspects of daily life and business operations move online, the need for robust and scalable data centres continues to rise.
2. Cloud computing growth The expansion of cloud computing services, driven by major providers, fuels the need for scalable and reliable data centre facilities. These hyperscale cloud providers rely heavily on advanced data centres to support their vast networks, ensuring a steady demand for data centre investments.
3. Global connectivity needs Data centres play a crucial role in providing global connectivity, enabling businesses to reach audiences and operate seamlessly across borders. This global reach is essential for multinational corporations and enterprises looking to expand their digital footprint.
4. Hyperscale and edge computing opportunities The rise of hyperscale computing and edge computing presents unique investment opportunities. Hyperscale data centres cater to the needs of large-scale cloud providers, while edge data centres focus on localised processing, reducing latency and improving performance for end-users.
5. Technology advancements Ongoing technological advancements, such as the implementation of 5G, artificial intelligence, and the Internet of Things, drive the demand for robust data centre infrastructure. These innovations require sophisticated data processing and storage capabilities, which data centres are uniquely positioned to provide.
6. Critical infrastructure status Data centres are considered critical infrastructure, contributing to the resilience and continuity of essential services in various industries. This designation highlights their importance and ensures continued investment and development to support essential functions.
7. Stable and predictable cash flow Long-term leases and contracts with tenants often result in stable and predictable cash flows. This financial stability provides a level of security for investors, making data centre investments an attractive option for those seeking reliable returns.
8. Investment by institutional players Major institutional investors and private equity firms show significant interest in the data centre sector. Their involvement indicates confidence in the long-term viability and potential returns of data centre investments, further legitimising the market.

Challenges when investing in data centres

1. High initial capital expenditure Building or acquiring data centre facilities requires a significant upfront investment in land, infrastructure, and technology. This high initial capital expenditure can be a barrier for smaller investors and may impact short-term profitability.
2. Rapid technological changes The fast-paced evolution of technology necessitates continuous upgrades and investments to remain competitive. Data centres must keep up with the latest advancements, posing a challenge for those unable to adapt quickly to changing technological landscapes.
3. Operational complexity Managing and operating data centres can be complex, requiring expertise in areas such as security, network management, and regulatory compliance. The operational demands can increase costs and complicate management strategies.
4. Market saturation in certain regions In some well-established markets, such as certain regions in the U.S., market saturation may occur, making it challenging to find optimal locations with favourable returns. This saturation can limit growth opportunities and increase competition.
5. Dependency on major tenants A reliance on a small number of major tenants, such as hyperscale cloud providers, can pose risks if those tenants reduce their space or relocate. The loss of a major tenant can significantly impact revenue and occupancy rates.
6. Energy consumption concerns High energy consumption is a characteristic of data centres, leading to concerns related to environmental sustainability and rising energy costs. These concerns can impact the attractiveness of data centre investments, particularly in regions with stringent environmental regulations.
7. Regulatory and compliance challenges The complex regulatory landscape, especially concerning data privacy and security, poses challenges for data centre operators. Ongoing compliance efforts are required to meet legal standards, which can increase operational costs and complexity.
8. Market vulnerability to economic downturns Economic downturns may impact the demand for data centre services, particularly from sectors experiencing financial constraints. During periods of economic instability, businesses may reduce their digital investments, affecting data centre revenues.

Navigating the legal maze of data centres

Investments in data centres encompass a range of legal considerations, both as part of due diligence when acquiring data centres and when setting up operations. Implementing structured processes, our practice groups coordinate to leverage synergies and deliver the best possible results for our clients. Here are some of the key legal challenges to consider:

Real estate

1. Due diligence of potential acquisitions Before acquiring a data centre, thorough due diligence is essential to identify any potential legal or financial risks. This includes examining property titles, zoning laws, and any existing liens or encumbrances.
2. Review, draft, and negotiate SPAs The Sale and Purchase Agreements (SPAs) must be meticulously reviewed, drafted, and negotiated to ensure all terms are favourable and clear. This process safeguards the interests of both buyers and sellers.
3. Drafting and negotiating leases Leases with users and potential colocation clients need to be carefully drafted and negotiated to define the terms of use, maintenance responsibilities, and other critical aspects, ensuring a mutually beneficial agreement.

Mergers & Acquisitions (M&A)

1. Due diligence on acquisitions Conducting due diligence for share deals or acquisitions of data centre service providers is crucial to uncover any hidden liabilities and assess the true value of the target company.
2. Draft, review, and negotiate M&A agreements M&A agreements must be precisely drafted, reviewed, and negotiated to clearly outline the terms of the transaction, including purchase price, representations, warranties, and indemnities.

Finance

1. Review existing financing set-up Reviewing the existing financing arrangements helps identify any risks or areas for improvement in the current financial structure of the data centre.
2. Structure and negotiate financing agreements Structuring and negotiating financing agreements ensure that the data centre has access to necessary capital under terms that are both favourable and sustainable.
3. Monitor compliance with covenants Ongoing monitoring of compliance with financial covenants is essential to avoid breaches that could lead to penalties or defaults on loans.

Regulatory

1. Compliance with industry regulations Ensuring compliance with industry-specific regulations, such as those related to data protection, environmental standards, and building codes, is vital for lawful operations.
2. Environmental and zoning laws Adhering to environmental regulations and zoning laws can be particularly challenging, given the significant energy consumption and specific location requirements of data centres.

IP/IT

1. Compliance with data protection legislation (GDPR) Ensuring that data centres comply with data protection laws, particularly the General Data Protection Regulation (GDPR) in Europe, is crucial to avoid hefty fines and legal repercussions.
2. Evaluate and secure intellectual property rights Evaluating and securing intellectual property rights related to data centre technologies and services protect the innovations and competitive edge of the data centre.
3. Draft and negotiate contracts Drafting and negotiating contracts, including service level agreements (SLAs), is essential to define the scope, quality, and terms of the services provided, ensuring both parties are clear on their obligations.

People & Rewards

1. Employment and labour law compliance Ensuring compliance with employment and labour laws, including fair employment practices, workplace safety, and employee benefits, is critical for maintaining a productive and legally compliant workforce.
2. Data protection for employees Protecting employee data in accordance with data protection laws (such as GDPR) is not only a legal requirement but also crucial for maintaining trust and avoiding potential lawsuits.

Navigating the complex legal landscape of data centre investments requires a comprehensive and coordinated approach. By addressing these legal challenges through diligent review, strategic negotiation, and ongoing compliance, investors can mitigate risks and optimise their returns in the thriving data centre market.

Our practice: market-leading data centre expertise.

We regularly support companies and investors on the set up of data centres (including commercial agreements relating to data and joint ventures) in jurisdictions worldwide, helping our clients to navigate complex foreign ownership restrictions, compliance with relevant data regimes, as well as managing sizing, sustainability and business continuity risks. 

In addition to our corporate and commercial specialists, we are able to call upon our global real estate, finance and tax teams, who advise on a wide range of property investment and development financings and their tax implications. We have a strong track record of supporting clients on data centre financings, including advising on development, planning and zoning commercial arrangements and permits, lease agreements, innovative financing arrangements, connectivity infrastructure, and tax solutions and exemptions. 

Our teams would be more than happy to support you on your data centre journey and discuss any aspects with you. Please feel free to contact your usual Freshfields contact or one of the key contacts here if you have any questions.