As excitement around the expanding use of AI drives demand for data center capacity, investors and operators are looking for innovative ways to continue funding development, including through the structuring of yieldcos. Matt O’Brien investigates how these capital structures can facilitate the capex spending the industry requires to meet demand.

A creation of the power industry in the early 2010s, yield companies, or yieldcos, took the renewables industry by storm only to fade away just as quickly. Thanks to the Sun Edison bankruptcy in 2015, a rout in the public equity markets saw the demise of a USD 17.8bn industry, which lost half of its value.  

But what was once thought long dead and buried, yieldcos have risen from the grave. 

This time around, digital infrastructure investors are resurrecting these structures to raise tens of billions of dollars to build AI-supportive computing capacity. Thanks to ever-increasing demand for this flourishing technological advancement, builders’ thirst for capital seems endless, industry executives have said.  

Not a day goes by without headlines about industrial businesses employing the use of AI applications to lower costs and wring out operational inefficiencies. Demand seems certain and that demand needs to be fed with more data center capacity. 

“The industry’s consensus view is that critical data center power capacity will double over the next five years,” said Michael Hochanadel, Harrison Street’s managing director and head of digital assets. “Based on our estimates that will likely require investment of USD 25bn in capital per year to support that kind of development – and that is just the US market alone.” 

Harrison Street has been one of the more active investors in the data center industry, registering seven deals since 2020, according to data compiled by Infralogic.

Obtaining funds through a traditional capital raise process or via a stake sale for these seemingly ever-growing companies – be it a wholesale or enterprise outfit – is challenging, given the check sizes investors need. This has forced executives and their financial backers to get creative about recycling capital to bring money in the door to fund capex, said industry executives interviewed for this report. 

For over a year now, panel conversations at well-attended digital infrastructure conferences have often dwelled on how executives are turning to asset-backed security issuances, project finance, preferred equity and other structures to attract much-needed capital.  

Like the renewable energy firms before them, data center companies’ thinking appears to follow a similar pattern: build facilities and lease them up into cash-generating machines that are regarded as “stabilized.” Need cash to build more? Form an affiliate, a bankruptcy remote vehicle, on paper and then capitalize it with third-party money. Then, with that money, the investor team buys stabilized assets from the sponsor that then drops down into the yieldco. The structure reminds many investors of traditional master limited partnerships where in the case of data center yieldco’s the parent is the GP. 

Operators lower their cost of capital and obtain equity to build high performance compute-enabled data centers while investors get access to steady cash flows backed by long-term contracts with the likes of a Microsoft, Facebook, Amazon or Google. 

And such capex has exploded over the past few years. According to data compiled by Infralogic, the amount of det raised for greenfield projects reaching financial close has steadily climbed from USD 262m in 2018 to over USD 17bn year-to-date. Infrastructure project sponsors have incorporated a mix of traditional commercial bank debt and capital market transactions to fund some of these initiatives.

Pricing strategies

Several data center operators and their investors have enlisted external advisors to consult on how to raise funds for upcoming capex requirements and many of these companies are resorting to yieldcos, including KKR and GIP-backed CyrusOne, publicly traded Iron Mountain, and Argo Infrastructure Partners supported TierPoint. 

“Everyone is looking at it as an option,” said an industry banker. 

Sponsors have been looking to price pure stabilized yieldco deals anywhere from a 4% to 7% cap rate depending on the quality of the assets while responding to investor appetite to achieve internal rates of return in the high single-digit to low double-digit range, said Steven Sonnenstein, DigitalBridge Group’s senior managing director.

DigitalBridge is one of the most prolific data center investors in the world, controlling iconic firms Switch and Scala Data Centers while maintaining stakes in several more like Vantage Data Centers.

For optimal hyperscale properties, cap rates can hover in the 9% to 10% range while the assets remain directly owned by the operator, a third infra investor said. Once stabilized assets are “dropped down” into the yieldco, those rates can range in the area Sonnenstein described.  

Other industry executives generally concurred with those figures, though the investor felt a 10% IRR was the bottom of the range buyers should settle on.  

“I think sellers should not be that stingy… that focused on what the exact cap rate is going to be, whether its 5.7% or 6.3%, because I think it’s important for them to get the money back quickly so you can put it into new development more quickly in order to do more,” the investor said. 

Yieldco cap rates have supposedly grown over 200bps since the first deal was done with Vantage Data Centers in 2020 as net operating income figures – positioned as the numerator in the cap rate formula – have gone up thanks to built-in contractual escalators tied to consumer prices.

“I’ve heard market rumors that pricing achieved on successful yieldco processes have been consistent with outright sale transactions and in some cases, I’ve heard of pricing that sounded like it was maybe a little bit better than what a sale would have generated,” Hochanadel said. 

While a second industry banker could not confirm such outcomes, he did say it was a possibility. 

“It’s a sale process in drag… no one’s going to pay you a growth multiple, so I guess that’s true from that perspective,” the banker said.  

And yet, some operators have sprinkled in development assets in recent yieldco deals to juice returns. 

“People have recently increased the velocity of structured deals. They have generally taken two main forms: one, they are structuring it as a straight yieldco with limited, no upside, just stable, boring and predictable cash flows. Like a bond alternative. Two, they are packaging yieldcos with some development upside,” Sonnenstein said. “With the latter, a situation may develop where a hyperscaler who initially takes down an anchor lease for a portion of a facility initially, may eventually, over the years, seek to expand at that facility or location – either on a pre-contracted basis or through an option. Therein lies the growth-upside potential.” 

For vanilla yieldcos, or ones containing development assets, pricing can vary. 

Cap rates can fluctuate from the low 5% range to above 8%, depending on the property. The broader interest rate environment and the tenant’s credit ratings all influence yieldco pricing, executives said.

Outside influence

The Federal Reserve’s decision to continue lowering rates or stay pat will weigh on yieldco investors. 

“Investing in yieldcos is no different than participating in the bond market, so if you have a bond yielding 5% and then the 10-year goes to 6.5%, that bond doesn’t look so good anymore,” Hochanadel said. 

Aside from potential challenges with the rate environment, other obstacles have surfaced over the last year or so. 

A third industry banker and a second investor said “a bunch” of data center portfolios across the globe have tried to execute on devco-yieldco structures but have flopped either over concerns about the assets or valuations, or both. The two sources did not provide further specifics.  

If data center companies operate multi-tenant facilities or do not own the real estate outright, structuring a yieldco deal could prove extremely difficult as those conditions present additional complexities, executives said. 

Despite the risks and potential for aggressive pricing, investor demand is expected to continue for these deals and assets.  

Many institutional investors are still learning about AI and even the datacenter industry and concluding that they lack exposure to the market or have “backed the wrong horse,” so investor demand will not abate anytime soon, Sonnenstein said. 

“Many investors will end up doing deals with the operators and financial sponsors they are most familiar with because of those firms’ experience,” he said. “Those financial sponsors and/or operators who lack experience with development or a track record will find it very difficult to attract capital.  

“Data centers platforms are not toll roads. They require leaderships, relationships, development, ongoing operational maintenance and a deep understanding the nuances of the market.”