As you might just be aware, it’s not been a great few months for most UK and US shares outside of the energy and resources sector. In particular, tech stocks have had a dismal first half for all the obvious reasons. That said, there have been some upbeat segments of the market, not least London’s two listed digital infrastructure funds, Digital 9 (DGI9 ) and Cordiant Digital Infrastructure (CORD )
Since the start of the year Digi 9 is down just under 1% in value while Cordiant is down a shade over 1% as of Monday. By comparison, the S&P 500 is down 13.9% in local currency terms, according to SharePad. Arguably the more relevant benchmark is the relative performance of the big US listed digital infrastructure giants operating in the same mobile tower, data centre and broadband space as Digi 9 and Cordiant. Since the beginning of this year American Tower is down 7.4%, Crown Castle has fallen 13% and Equinix has slumped 16.8%.
The UK market has dallied with this digital infrastructure space in the past. For instance, Arqiva, which runs most of the UK’s broadcast digital infrastructure and Digi 9 has just invested in, toyed with its own listing a few years back. Some of the big conventional infrastructure listed funds such as International Public Partnerships (INPP ) have also made small investments in this space. But Digi 9 and Cordiant offered a focused way of buying into sector which has been, until now at least, dominated by private equity firms.
Private equity rules
I’ve been invested in both the digital infrastructure funds here in the UK since they launched over the last couple of years and it’s easy to see why investors have got excited about this space. Imagine a demand curve, showing perhaps data usage per person, over the last few years and into the immediate future. I think you can imagine which direction that curve is heading and that’s before we get to the rise of the internet of things and 5G.
We’ll be needing lots more digital infrastructure in all shapes and sizes – more mobile phone towers, more data centres, more fibreoptic cabling above ground and undersea. A recent research note by Shonil Chande at investment bank Liberum nicely summed up these mega trends. The note pointed out that most of the actual customers for these kinds of digital infrastructure are well-known names such as Google or Amazon who are willing to sign inflation-proofed contracts. And of course, margins are high – the vast majority of publicly quoted players int this space have margins that average more than 50% on pre-tax profits.
But Chande also made what I think is a much more salient observation: this is a business segment where private equity (PE) rules dominate. And that means facing up to the brutal reality that PE is awash with debt and high valuation multiples. One can wax lyrically about the great digital transformation but at the end of the day what matters is what price you pay for these valuable assets and how much debt you end up with.
The good news, according to the Liberum analyst, is that the two UK-listed funds have acquired their operating platforms at reasonable EV/EBITDA multiples of 11-14x. This common private equity valuation multiple compares a business’ enterprise value (EV) including debt to pre-tax profits (EBITDA). That’s been possible because they have concentrated on what are called mid-market deals in the £50m to £500m range. To be specific, Digi 9’s portfolio has been acquired at an attractive EV/EBITDA multiple of 13.9x. Cordiant’s platform investments were acquired at less than 12x EV/EBITDA.
So far so good, but the next stage will probably be harder: private equity has very definitely woken up to the potential. Deals are emerging thick and fast, even in this market, and that means that we could see a massive increase in investment in new data centres and generally more digital infrastructure. That could mean greater competition for contracts and the worst-case scenario is that those big customers, especially cloud giants like Amazon and Google, decide to build and buy their own digital infrastructure – cutting out the PE folk.
A more sober assessment
Ben Newell, a fund analyst at Investec, has drawn together many of these concerns through another investment report which looks at Digi 9, in particular. The catalyst for this more sober assessment was its recent mega deal in June, when the fund took a big stake in Arqiva.
On paper this deal ticks many boxes for Digi 9. Arqiva, which transmits from broadcast towers and reaches 98.5% of the UK population through Freeview, is a steady business with steady cashflows. The total enterprise value for the business as a whole is £2.7bn. Using financing, the fund purchased 48% of the business for £300m in cash. The acquisition price was 8.3x EBITDA (versus recent multiples of comparable transactions of around 12x).
However, unsurprisingly, this deal has also come with lots of debt in Arqiva. Newell is particularly concerned about £625m of junior bonds maturing in September 2023, which could prove problematic if credit markets start to close up. He’s also concerned by a slug of vendor loan notes Digi 9 used to pay for the deal, which increases gearing and potentially raises a concentration risk – the fund has an agreed policy that no single investment is more than 25% of adjusted gross asset value. Newell suggests that if the vendor loan note is included in the calculations, the actual exposure to this one asset – Arqiva – amounts to over 33% of the fund.
Needless to say, Digital 9’s management takes a different view. On the refinancing, the trust says: ‘We are confident in the Arqiva credit, the management team and the refinancing plan that is in place for the September 2023 bonds.’ As for that concentration concern, Digi 9’s manager argues that the fund ‘will have less than 25% investment exposure to the Arqiva investment. This is expected to reduce even further over time as our investment into our other growth assets in Nordic datacentres and subsea fibre continues to accelerate….’
The managers add that the fund is unlevered about from the Arqiva debt, and a current undrawn revolving credit facility. On Arqiva they add: ‘The long-term debt structure is supported by the long dated revenues and demonstrated strong cash generation leading to a strong deleveraging profile.’
What this debate does expose is that digital infrastructure funds are very much investing in mid-market private equity structures, but using publicly listed vehicles to fund the purchases. There’s nothing remotely wrong with that but it does make the resulting structures very much more complicated than simply investing in, say, a stand-alone operating business like Vantage Towers, the German listed spin out which owns Vodafone’s towers and masts. Leverage, concentration risk, liquidity issues and the rising cost of funding makes analysis more challenging, despite that upward sloping demand curve I mentioned earlier.
The villains of the piece
If all that wasn’t enough to think about, a recent Financial Times article raised another concern: is there enough power to go around in the south east of the UK? Data centres, in particular, are sprouting up all over the country and they eat up huge amounts of power, especially in certain regions such as West London and out into the suburbs. The FT reported:
‘The Greater London Authority wrote to developers this week warning them that it might take more than a decade to bulk up grid capacity and get developments under way again in three west London boroughs — Hillingdon, Ealing and Hounslow. In those boroughs, “major new applicants to the distribution network…including housing developments, commercial premises and industrial activities will have to wait several years to receive new electricity connections”, according to the GLA’s note, which has been seen by the Financial Times. A recent applicant to the distribution network was told that there is not “sufficient electrical capacity for a new connection” until up to 2035…’
The villains of the piece? You guessed it: data centres. So, not only do you have to worry about financial structures and PE, but you also need to think about sustainability issues around all the power being used. That’s less of an issue for solar-powered mobile phone towers, more of an issue for power-hungry data centres.
I raise these issues not because I think the bull case for the digital infra funds is undermined. In my view, it isn’t and I’m happy to keep adding to my position. I have no reason to think Cordiant’s target of 9% annual net asset value (NAV) growth and Digi 9’s 10% NAV growth are unrealistic – the demand is clearly there. But for underlying investors to see these kind of returns, much more sensible share price premiums or even discounts will be required – maybe even the latter if the funds keep raising fresh capital. Cordiant shares now trade at a modest 1% premium, while after a sharp slip, Digi 9 is back trading at an 8% premium.
Whenever you see a chart showing exponential growth in demand and revenue, think through the downsides and risks, and try to figure out who has the smartest pitch in a crowded trade – and then try to buy at the right price.
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