Subscribe
Share
Share
Embed
Ropes & Gray attorneys provide timely analysis on legal developments, court decisions and changes in legislation and regulations.
Jason Kolman: Hello, and thanks for joining us today on this Ropes & Gray podcast. I’m Jason Kolman, a private funds partner in the asset management group. I’m joined today by Eric Requenez, a partner in the asset management group and the head of our real estate funds practice, and Chris Roman, a partner in our tax practice.
This podcast is the first in a series of podcasts relating to infrastructure, an asset class we’ve seen become increasingly popular in the past few years. Today, we’ll be focusing on considerations relating to private funds that invest in data centers. While data center funds raise many of the same issues encountered in real estate funds more generally, there are also some unique issues to consider. Eric, can you talk a little about what’s driven the increased interest in data center funds?
Eric Requenez: Thanks, Jason—happy to. I think there are a couple of factors at play here. First, the demand for data centers has been accelerating rapidly due to the widespread growth of technology-based platforms and systems, such as cloud applications and AI, as well as the expanding IT needs of larger organizations in the hyperscaler market. Based on what we’re hearing from clients and seeing in the market, it seems this demand is only going to increase with the proliferation of AI. Second, in the current fundraising climate, excluding the “megafunds,” we generally are seeing sponsors have more success with targeted strategies that play to specific strengths or asset classes, rather than broader generalist mandates. Data center funds fit nicely with that trend, given the specialized nature of the asset class.
It’s also important to note that the term “data center fund” can encompass a range of structures and ways in which sponsors can potentially access data center investments. Three of the key decision points include:
• First: how focused will the fund be on data centers? We see funds that only do data center investments, as well as funds where data centers are part of the broader real estate or infrastructure strategy, but not the pooled set. Targeted co-investment deals also can be an effective way to develop a track record and experience, before moving to a dedicated or more focused data center product.
• Second: what sort of strategy will the fund pursue? We see some funds that invest in developed data centers that are stabilized, core assets, and others that pursue a development-focused strategy where they buy a parcel of land that they work to develop over time with an operating partner with specialized expertise. As an additional wrinkle, some managers combine this with forming or investing in an operating platform to manage the data center investments for them.
• And third: what geographies will the fund focus on? While this is a concern for any fund, it is especially relevant for data center funds, as certain regions may have more physical capacity to accommodate data centers and their large footprint. In addition, the approval and permitting process for data centers and the associated environmental- and energy-related issues can vary widely from region to region and typically require specialized local expertise.
As with funds in general, we often see that the specific strategy can influence terms and structure. Jason, can you talk a little bit about how this can play out?
Jason Kolman: Sure, Eric. One area relates to the fundamental structure of the fund. While there are exceptions to this, in general, a focus on core or developed data center assets is more common for an open-end fund structure, as the assets should be easier to value, may have rents or other predictable cash flow streams that can be distributed to investors, and are more suited for a long-term hold. By contrast, a focus on development assets is more commonly seen with a closed-end fund model, as those deals will be harder to value and likely have a longer time horizon to become operational.
For funds that pursue a development strategy, there are also a few specific terms that often come into focus:
• For one, sponsors sometimes try to charge fees on budgeted amounts while the asset is under development. This can be a nuance on the more traditional fee base that is focused on committed or invested capital.
• Second, sponsors will want to make sure the fund documents are sufficiently flexible to permit the deployment of capital after the fund’s investment period to complete the data center’s development. This would often be addressed by the typical ability to make follow-on investments after the investment period, though that is often subject to a cap and time limit, which may need to be raised or modified.
• Finally, sponsors will want to consider increasing the core fund term to a longer period, such as 10-15 years, to account for the longer-term nature of development assets.
As data centers are service-intensive, there is also usually a lot of focus on the fund’s expected service providers. Eric, how is this typically addressed?
Eric Requenez: Since these services are highly specialized, LPs will typically be very focused on the capabilities, experience, and personnel of the service providers, including if their services will be used just for data center deals or for other investment types within the fund.
In addition, some managers establish or build out a platform or captive team to source and service data center deals. This has the obvious benefit of the manager knowing the team well, and the manager may feel an in-house team is better positioned to provide these services—and can be more easily monitored and managed—than a third party. That said, this arrangement raises various conflict-of-interest issues—including if the manager is engaging the affiliate to help increase the affiliate’s brand or presence in the space; if the economics and other terms are market or arm’s length in nature; and whether fees earned by the affiliate would offset fund-level management fees due to concerns about double-dipping on fees. Typically, however, there would not be an offset, since the affiliate fees would be in respect of different, asset-level services, but investors often request benchmarking and checks to ensure the fee terms are market, as well as periodic transparency and reporting rights.
Now, this is not a new issue for real estate funds, as real estate investments tend to require a variety of asset-level services, which are often provided by affiliates of the manager. However, given the specialized and critical nature of services in the data center space and potentially fewer market comps due to the newer and more bespoke nature of the asset class, it is an issue of key importance for managers in the data center space and their LPs. These concerns are typically addressed through some combination of disclosure, market checks, scheduling fee terms in the fund documents and limited partner advisory committee approvals.
Jason, can you tell us a little about the other unique issues managers should be prepared to address with prospective investors?
Jason Kolman: Sure, Eric. Data centers are an asset class that raises a couple of hot button issues for investors in the current climate. For one, data centers often have a significant environmental footprint due to their scale and intensive power requirements, including as to their cooling systems and potentially high requirements for water and other natural resources. Environmentally friendly energy sources, such as wind and solar, are typically not dependable enough to power data centers, and many data center operators are turning to nuclear power sources, such as small modular reactors. Given the increasing importance of ESG (or environmental, social and governance) issues to prospective investors in recent years, managers should be prepared for scrutiny of their ESG processes and questions on the expected environmental impact of their data center investments.
Finally, as mentioned earlier, the data center investment process can vary significantly between regions and geographies, and require a significant local presence to expedite matters, such as permitting and regional approvals. In addition to wanting to see evidence of the manager’s region-specific expertise, investors also often want assurances that the manager has a robust anti-bribery and corruption compliance program in place, given there can be extensive interactions with local officials as part of the investment process. Anti-corruption issues have taken on increased importance in recent years from a regulatory and investor perspective, so this will likely be a point of emphasis during the fundraising process.
Chris, what are some of the tax and structuring considerations that we often see arise with data center funds?
Chris Roman: As with any fund, the tax planning is going to be dependent upon the type of investments that the fund makes, and the type of investors that come into the fund. Taxable U.S. investors that come into a fund and public pension funds don’t need particular tax planning most of the time, but tax-exempt investors generally need planning to avoid recognizing UBTI (or unrelated trade or business income), which they generally pay taxes on.
From a non-U.S. investor’s point of view, they typically like to invest in funds that purchase corporations, so that they are not engaged in a trade or business in the U.S., which allows them to avoid filing tax returns, and paying those income-based taxes in the United States. Unlike many private equity investments where companies treated as corporations are bought and sold—and generally don’t raise significant tax issues, including for tax-exempt investors, and for non-U.S. investors—data center funds present some unique challenges.
Number one, their assets tend to be real estate heavy, and non-U.S. persons are subject to U.S. federal income tax on United States real property interest under so-called FIRPTA. And then, also, these investments tend to be bought and sold on a basis where the buyer can obtain a purchased or a stepped-up tax basis in the underlying asset. And one of the structures that tends to harmonize all these various needs and concerns of investors is a real estate investment trust, which is an entity that’s treated as a corporation for U.S. tax purposes, but provided it so elects and meets the requirements of the REIT rules, is permitted to deduct from its taxable income the distributions that it pays to its investors.
In addition, if that real estate investment trust is more than 50% U.S. owned, then a non-U.S. person generally does not recognize taxable income from a sale of the real estate investment trust shares. A real estate investment trust also generally blocks unrelated business taxable income for tax-exempt investors. So, it’s a very favorable structure. Finally, it also affords typically the buyer the ability to unwind the REIT and obtain a stepped-up tax basis in the underlying assets held by the REIT, all of which is very favorable, but comes with some trade offs. And those trade offs are that the real estate investment trust, generally, needs to hold property for investment as opposed to for prompt sale, where it can be subject to a 100% tax on sales of property in the ordinary course of business. And in addition, it needs to generate most of its income in the form of rental income and interest income on mortgages as opposed to other types of income.
The real estate investment trust structure does allow the REIT to create a taxable subsidiary corporation that is available to provide services to tenants but at a cost of being a regular taxable entity. So, we typically do see data center funds working with REITs to offer these various tax advantages, both to fund investors and, ultimately, to the purchasers of those REITs.
Eric Requenez: Thanks, Chris. We appreciate you tuning into this podcast, and please look out for future podcasts in our series on transactional, financing and other matters related to infrastructure and other data center investments. You can also subscribe to this Ropes & Gray series wherever you typically listen to podcasts, including on Apple and Spotify. Thanks again for listening.