In my humble opinion, one of the biggest challenges facing digital infrastructure businesses as well as funds is to find a way to get to talk to advised clients and their advisors. Institutions by and large understand the space as do many sophisticated private investors, especially the very active ones. But advisors tend to lump these digital assets into an alternative box alongside more traditional infrastructure assets and then treat with some suspicion, the suspicion of the ‘new’.
Yet there are signs that is changing and the example of a recently launched UK fund of funds might offer some useful clues as to what advisors might want from the digital infra sector. Gravis is a successful UK based infrastructure house that has also built up a fund of funds business that sells heavily to advisors. Its idea is simple. All these alternative investment ideas structured as funds (or opcos) are difficult to research for most advisors, so you need someone to build an overlay that finds the right funds (and single businesses) and then assembles them together in an income-oriented fund of funds. Over time its existing infrastructure and listed property equities fund have accumulated pretty big sums of money – as have rival offerings from peers – and now its launched what it thinks over time will be its biggest fund ever: a digital infrastructure equities fund of funds which invests in towers, data centres, fibreoptic networks, logistics warehouses. Or as the manager describes them physical structures, which are all tangible, and all have a bit of concrete poured in them, as well as contractual leases, producing high cashflow predictability.
In this universe, they’ve identified around 120 listed, global digital infrastructure companies although it’s interesting to note that within their definition the number of funds and businesses has doubled in terms of numbers over a decade and has increased more than six-fold in terms of aggregate market cap. More specifically Gravis analysis reveals that this universe has increased in market cap terms from £73.5bn in 2010 to £461.3bn in 2020. As for returns, between 2011 and 2020, returns have averaged c.18.9% per annum with volatility of 15.43%. From this growing universe, the Gravis team led by Matthew Norris has identified 29 businesses and funds for the portfolio which is now live and growing steadily in size.
Graphic : The growth of the digital infrastructure universe
Source: Gravis Capital Management, Ltd, 2021
As you’d expect the big sales pitch is one we’re all familiar with – as Norris observes “we’re living in the fourth industrial revolution” but the first key message from this fund is that it includes a very heavy helping of tech-enabled logistics park operators alongside the more expected tower cos and fibre operators.
According to Norris “If you go back in time, especially in the UK, data centres are actually born on logistic parks. One of the biggest owners, possibly the biggest owner of data centres in Europe is probably property business Segro, and that data centre is on the Slough trading estate. The Slough trading estate gave birth to Segro 100 years ago and then as good fortune would have it, they found themselves close to London as well as a big fibreoptics cable from the Atlantic plus it helps that there’s access to power.” Segro has its own power station.
It is easy to see why logistics park operators will appeal to professional clients. You have classic property-based assets, with long leases and lashings of technology. As a result, the Gravis fund is exposed 45% to logistics businesses with the remainder in classic digital infra: 25% in data centres, 25% in tower cos and 5% in another bucket that includes fibreoptic networks and battery storage.
The next big lesson is that Gravis, like many advisers I’ve talked to, likes tower cos and are overweight exposure to this sector compared to their universe weights. Norris echoes those who’ve called these businesses “the best business ever”. He likes the fact that the steel towers being put up last 25/50 years, and that according to one of the tower co operator’s maintenance capex on each is just 900 dollars per tower per year – “it’s a great asset, long-life asset”. And there’s also the increasingly obvious densification drive coming out of 5G especially in the US “where you have carrier neutral towers and the mobile network operators go to the tower codes and put their dishes on. We are likely to see co-tenancy on towers, so competing operators on the same tower- that’s great news for the owner of the tower.
The next useful insight is that the digital infra space needs to be more vocal about its intrinsic valuation strengths as an equity asset class and not run scared of those who argue the sector is overpriced and a bond proxy. On the multiples question, Norris points to businesses that have contractual cashflows, are earning steady money, paying dividends, and increasing those dividends on average between 2 and 3%. Unlike say classic property REITs , which produce higher yields, the digital infrastructure space has very obvious drivers of huge growth “over many, many sequential years, so what you might have to sacrifice in yield you should make up for in terms of dividend growth. “
As for the cacophony of voices that say these assets are bond proxies and will falter as interest rates pick up, Gravis reminds us that these are not in fact anything remotely like fixed-income assets. “We’re talking about growth income here,” observes Norris “and there are two types of growth that you get from owning a data centre and a tower co. One is your contractual rental growth. And then the second growth element is actually releasing up more space, growing the rental income, by hanging another dish on the same tower. So, my response would be I hear what you say but this is not fixed income, this is growth income, plus market growth.”
I also sometimes detect another variation on the bond proxy argument which is that although there are obvious growth opportunities, most digital assets do not have explicit inflation protection, unlike say classic public-private partnership infrastructure assets. It’s a fair observation but I’ve always felt it is a misguided one. Sure, there may not always be explicit CPI agreements in place but as Norris reminds us “as long as the income can grow in line or faster than inflation then it’s going to be inflation proofed. With tower cos and data centres their top line should be rising faster than inflation just because of the growth characteristics and their cost base should be rising at or below inflation, you should see some level of operating leverage coming through. So, I think those two sub-sections will perform very well.”
My own hunch is that these characteristics of the asset class are, in reality, fairly well understood but there’s another risk that is I think less so. Security.
I’ve visited more than my fair share of data centres and towers over the years and the first question I always ask is a security-related one. Cybersecurity tops many lists but in reality, that’s actually more of a risk for the tenant rather than the physical infrastructure owner. But physical security is very much a concern for everyone, especially the real asset owner. And here Norris at Gravis spies an opportunity, rather than a risk.
“I think that creates a barrier to entry, I think that’s why you and I wouldn’t be very successful at setting that kind of business up because you have to have a track record of building very secure, reliable centres. The ones that I’ve visited, especially the ones that have government servers in them, they literally do have those bollards around the centre to prevent terrorist attacks and when you enter the data centre you go in through one of those man trap scales that weigh you on the way in and weighs you on the way out. So, absolutely, security is an issue but also it creates a competitive advantage. If you are an established player in the market, you have the reputation. “
This brings us to the last key insight – ESG. I see it topping more and more financial professionals lists of concerns, and not always for the right reasons. ESG has become akin to a gateway drug that encourages all sorts of slightly inchoate concerns, mostly but not always based around energy efficiency. According to Norris “we have done a lot of research on this and, it’s much more efficient to have servers in a data centre, in a bespoke environment. Here at Gravis, we still have a server in the corner of our kitchen. That’s bonkers. That’s not the right environment to have it, so we waste energy cooling that server in the corner of a kitchen. If all businesses like ours put their servers into dedicated data centres, less power would be used….. I think there’s more work to be done proving the point that the place for your server is a data centre because you’ll use less energy”.
This I think is a key message. Rather than focus all the attention on digital infrastructure operators own ESG policies – important though they are – also try and remind investors of their own obligations, their own inefficiencies that make the problem much worse!