How lenders and financial institutions fund colocation data center expansion

As technology trends such as cloud and edge computing become more influential in the way global companies conduct their business, the role of the colocation data center becomes even more critically important.

Today, most blue-chip businesses turn to colocation data centers to help manage much of their cloud and edge computing data processing needs.

451 Research projects that global colocation and wholesale market revenue will top $48bn by 2021. This remarkable growth is resulting from the convergence of three major influencers:

• A data hungry world where governments, businesses, and consumers show an increasing appetite for gathering, processing, and storing data of all kinds.
• Data center operators who provide facilities, sometimes on a hyperscale level, that house and manage all of the technology needed to sustain the global flow of data.
• Financing institutions who lend the funds to the data center operators in order for them to both establish and grow their businesses.

John Wilson, Director of Data Center - TMT Financing at SMBC Leasing and Finance, has worked hand-in-hand with colocation data center operators for over a decade. He recognizes colocation data centers as a very unique asset class. "A great proportion of what constitutes a data center is not really about real estate, it's more mechanical and engineering equipment, and all the associated costs of creating the data center environment," he said.

"As an asset class, the colocation data center business model is characterized by a strong recurring revenue stream from customers, and the operators have relatively fixed OpEx costs. Therefore, such a cashflow scenario is attractive to lenders with expertise in this space. If you can gain a firm understanding of the colocation provider's performance risk, (i.e. are they capable of offering the service that customers demand under their SLAs) then you should have a fundable business," he said.

Unique requirements and qualities of the colocation borrower

Wilson emphasizes that the financing of colocation businesses is not a "one size fits all" approach. Over the years, he has funded disparate data centers of various sizes and every transaction has been a little different.

"You learn from your previous experiences and you apply those lessons to the new opportunity or challenge you have in front of you – that experience can be the key between successfully closing a transaction for a client and not" he said.

From a funding perspective, the challenge for colocation operators is that most are fast growing businesses.

They require high levels of capital expense funding because the barriers to entry or continued expansion to meet investor aspirations can be very high. Access to sufficient equity to unlock competitively priced bank debt is important for operators since banks are rarely able to provide 100% financing.

This can be especially relevant if earnings are slowing and therefore not generating sufficient free cashflow alone to provide the necessary contribution that lenders typically expect.

According to Wilson, there are two overriding factors that determine whether a colocation operator will succeed in obtaining the required funding from a lending institution: the quality of the firm's economics and the quality of the operator's business value-add.

"The quality of the economics – which includes cash flows, the nature of the demand that drives those cash flows, the long-term contracts in place, the quality of the tenants – provides a sense for how critical the data center is perceived by the underlying customers. This sense of mutual dependence establishes the degree of importance that those customers place in pursuing their relationship with the operator. When we evaluate the quality of the operator's value-add capabilities, we look at the quality of the internal teams, the experience they've had in running these types of operations, and the location and the quality of the data centers they've built, among other determinants," said Wilson.

Flexibility is critical to the success of the lender

Lenders who work with colocation operators have to be flexible in terms of how they structure transactions and the types of financing instruments being used, since no deal is the same.

Operators are now no longer remaining in one geography, they are increasingly moving across borders to address the needs of their existing customers who in turn are looking to place their data in the most logical location depending on for example latency requirements.

"We don't just make a deal and walk away," said Wilson.

"It's a dynamic market so you never fully fund on day one what you might need over the next two or three years. We have an ongoing relationship with our clients. Often, if a five or ten year loan is initiated, rarely will that funding run full-term as an acquisition or re-financing will very likely occur before that time. That's the exciting and dynamic nature of the industry," he said.