The theme of alternative funds in the doghouse was the subject of my last column, examining the cavernous discounts on music royalty funds. I’m returning to the doghouse again this week but focusing instead on the two digital infrastructure funds, Digital 9 (DGI9 ) and Cordiant Digital Infrastructure (CORD ).

For a long time both funds traded at chunky premiums to their net asset values (NAV) as investors lapped up the idea of investing in mobile phone/broadcast towers, fibre optic and data centres – I am an investor in both funds. The pitch seems – and I think still is – compelling. You buy into infrastructure assets that produce a steady income but there’s also a capital growth opportunity.

That NAV growth comes from two distinct sources. The first is that many of the assets were bought at valuations in the 10 to 15 times earnings level. That’s a fraction of the multiples attached to the big, listed tower and data centre operators such as Crown Castle, American Towers and Equinix – where multiples of 35 to 45 (or even as much as 60) times earnings are common. These mid-market assets as they’re called in the private equity world simply need scaling up to boost valuations.

The other driver of potential return was constantly increasing demand and the insatiable need for data. You’ve all seen the charts showing an endless upwards, exponential curve because we are all using endless amounts. That will require new data centres, more fibre optic networks, more mobile towers, more everything data related.

(By the way, an interesting catch is that power consumption by data centres is also rocketing. That’s a subject I will return to next month when I look at how to creatively address the energy requirements of that constantly increasing need for more data.)

But for now, let’s segue to what went wrong with that perfect pitch I described earlier. Cordiant now trades at a 25% discount while DGI9’s discount has shot up to 40%. Part of this unravelling was fund specific. Take DGI9 for instance where the launch manager left a few months ago. This unnerved investors already concerned by the large amounts of debt that had been taken on by the fund as it acquired the mainly British Arqiva business, whose vast portfolio of cash-generating assets includes most of the UKs broadcast infrastructure.

Cordiant also has debt but much less at the fund level, but these concerns coincided with a deeper structural driver common to both funds – rising interest rates. As first US and then UK interest rates started to rise and that kickstarted a big sell-off of all infrastructure-related funds. One concern was of course that debt payments would increase although most infrastructure funds hedge out the interest rate risk.

Another way higher rates might impact the funds was via the discount rate applied to the funds assets. Back last year for instance Cordiant increased its discount rate by 45 basis points to a range – depending on the underlying business – of between 7.86 and 9.88%. With Digital 9 the weighted average discount rate increased very slightly from 12.56% to 12.64%. If these discount rates increase even more, that will inevitably have an impact on the share price of the funds.

Yet another way that interest rate increases hit investor sentiment was via those income payments – dividends. Both funds have always emphasised their income and growth credentials but DGI9 emphasised its generous dividend payout from the get-go – Cordiant has been increasing its payout from a lower initial level.

As with the music royalty funds, suddenly a yield of say 4% looked less than attractive given rising bond yields – forcing investors to focus more on the potential for capital growth. But even a higher yield was no insurance against cashflow concerns – DGI9’s current net yield is running a shade under 8% but the dividends are uncovered (or covered just 0.4 times by earnings), although management reckon that cover can improve to 1.4 if inflation moderates in the near term.

I’m not too sure those original premiums to NAV were ever truly justified but once you add up all the concerns you can begin to understand why sentiment has soured, to a degree, with the digital infrastructure funds. That said I also think that the current discount levels are also unjustified. Put simply, discounts of between 15 and 30% imply that both funds have structural growth and cashflow problems. That doesn’t sync up recent numbers coming from both funds.

Take Cordiant first. In its recent trading statement, it confirmed that aggregate portfolio revenue increased 8.8% to £146m. Its three core businesses made solid progress: its Polish broadcast infrastructure business Emitel signed sales orders worth £485m, (five times annual revenues); its Czech business CRA saw a big increase in data utilisation while its fast-growing data centre business Hudson InterXchange signed two marquee customers, including a large US telecoms company and a US TV and satellite operator.

With all three businesses now in the Cordiant portfolio, most of its revenues come from operating towers – for broadcast or mobile telecoms – with long-term contracts as standard. Crucially many of those contracts have inflation protection. According to the fund managers, around a quarter of all contracts are totally indexed to inflation, roughly half have some inflation protection and only a quarter of contracts have no inflation linkage – but the business could still increase prices if it chose. 

As for DGI9, headline earnings and revenue growth wasn’t heart stopping last year. Investee company revenue rose 2% to £409m and earnings (ebitda) added 1% to £206m – but the underlying NAV total return for the year gained 10.4%, pushed up by an uplift in the value of that Arqiva business and the core sub-sea cables outfit Aqua Comms. Crucially demand for its environmentally-friendly Nordic data centre business Verne is growing fast.

On a side note, the weighted average remaining contract term for recurring revenue is 7.1 years, with overall gearing running at 28.3% or 40.5% if you include a vendor note used to fund the Arqiva business. As for inflation protection between 65 and 70% of Arqiva’s revenues are inflation linked.

I think investors have to ask themselves whether they can see a pathway to increasing revenues during a more inflationary new normal with increased cash flows? I’d say, without hesitation, we can given these recent numbers. As for dividend cover Cordiant is 3.3 times covered by earnings and 1.4 times covered by free cash flow, with the fund managers believers in the idea of progressive dividend payouts.

DGI9 post the Aqiva deal has its financial challenges but the core businesses are churning out cash and full dividend cover within the next year or so looks completely achievable.  To repeat the point – these businesses haven’t gone ex-growth and there is every possibility that dividend payouts could increase.

As for valuations both funds discount rates look fairly sensible and I would repeat another earlier point – most listed businesses in the towerco and data centre space trade at far, far higher valuations. The German listed Vodafone towers business named Vantage Towers – where private equity giant KKR has bought a huge slug of the business – is trading at over 42 times its forecast earnings.

The argument about fund valuations could easily be validated if one of the funds were to sell a large stake in their businesses to another big institutional investor. My finger-in-the-air guess is that DGI9 might sell a slug of its fast-growing Verne Global business which operates Nordic data centres powered by renewable energy. This could not only prove the valuation but also provide extra capital to fund future growth.

So, stepping back from the detail it seems to me that although a discount to NAV is probably warranted for digital infrastructure funds, the current levels are arguably overdone. Many of the renewable infrastructure funds with equally proven track records have also fallen out of favour but still trade within a 10 to 15% discount range – that seems more than appropriate for both funds.

My hunch is that Cordiant’s should be towards the bottom end of that range given its deeply experienced fund management team and sound finances while D9I does have a bit more risk given the absence of a fund manager, but that role should be filled imminently. At that point DGI9 could possibly see its discount tighten to well under 20% if all the stars align.

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