Growth of Data Centre Industry

The data centre industry has experienced unprecedented growth in recent years, especially in jurisdictions such as Virginia (which is the number one data centre hub in America). This has been driven by the global surge in digital transformation, cloud computing, adoption of AI technologies and the increasing demand for data storage. As the need for scalable data centres has skyrocketed, so has the need for efficient cost of capital. One of the biggest trends with respect to financing data centre growth has been the adoption of asset-backed securitisations.

Securitisation provides owners/operators access to large amounts of capital at lower costs by leveraging their long-term, stable revenue streams from customer contracts. Although securitisation has long been utilised as a financial tool for nearly every segment of society (credit cards, student loans, auto loans/leases, residential and commercial mortgages, etc), securitisation as a financing method in the data centre industry has rapidly grown over the past half decade and is becoming a prevalent means of financing.

This chapter of the guide will explore the use of securitisation as a tool being widely utilised by data centre owners and operators, located in Virginia and beyond, and give a brief overview of some of the key structural components, safeguards and items to be cognisant about as owners/operators contemplate whether this type of financing vehicle is right for them.

Structure

Data centre securitisations are typically structured as revolving master trusts. The beauty of a master trust structure is that as assets become stabilised, they can be added to the collateral pool. This increase in value permits the issuer the capacity to issue additional notes all backed by the same collateral pool. Moreover, subject to certain limitations and prepayment parameters, an issuer can also dispose of a data centre. This allows the master trust to be a living, breathing investment vehicle that can accommodate a growing and changing business.

Multiple series of notes (of varying classes) can be issued out of the same indenture. The capital stack can be as complex as needed, including series notes issued simultaneously or at intervals with different anticipated repayment dates, and can include sequential pay notes and fully subordinated notes. A common feature is to also include a variable funding note component to the master trust, so that draws can be made and repaid on a revolving basis giving the issuer an open line of credit.

As noted, notes are backed by the same pool of shared collateral, which means that prior to the issuance of additional notes, certain structural safeguards have to be satisfied (including loan-to-value percentages, debt to service coverage ratios and, if the transaction is rated, rating agency confirmation); but the objective of this structure is that once established, an issuer can easily tap the market and do multiple financings relatively quickly.

The transaction can be rated or unrated, privately placed through a 4(a)(2) transaction or more widely syndicated through a 144A transaction. What drives this decision is predominantly the make-up of the underlying collateral. If customers are investment grade and if the data centres are built-to-suit, then a rated 144A transaction would make sense. However, if there are hundreds of customers, many of which are not rated and if the data centres are retrofitted with ongoing capital expenditures needed for repairs, an owner/operator may consider doing a private transaction with investors so that the investors can directly diligence the assets and financials.

S&P, DBRS and KBRA have historically rated the majority of data centre transactions (KBRA rating the colocation sector and S&P and DBRS rating the hyperscale sector), but earlier this year both Moody’s and Fitch also released their digital infrastructure securitisation rating criteria for data centre securitisations. This is a positive sign that the market is moving away from being just an esoteric asset class and into mainstream ABS. 

Parties

A key component to any securitisation is bankruptcy remoteness. This is achieved by isolating the assets that comprise the collateral from those of the sponsor/parent. The notes issued are thus non-recourse obligations to the parent/operator and the noteholders are looking solely to the underlying assets for purposes of debt service and ultimate repayment. By removing the bankruptcy risk of the sponsor/parent and instead focusing solely on the quality of the underlying assets, an issuer can obtain cheaper cost of funds because company operation risk has been greatly mitigated.

To achieve isolation, the collateral is transferred to the issuer through a series of steps. Despite being a series of transfers among affiliates, each transfer and contribution is done on an arm’s-length basis and on terms that would be entered into by independent third parties.

The sponsor/parent will form a guarantor. Assets will be transferred to the guarantor prior to being transferred to the issuer. The guarantor is a special purpose entity that owns no assets other than the equity interests in the issuer. The guarantor grants to the secured parties a security interest in all the equity interests in the issuer.

The issuer is a special purpose entity that owns no assets other than the equity interests in the asset entities. The issuer is the legal entity that will issue the debt bond to the underwriters, initial noteholders or investors, as applicable.

The asset entities are either newly created or recycled entities that own the actual data centres. If a recycled entity, then the rating agencies will require the delivery of an officer’s certificate, certifying, amongst other things, that there is not outstanding debt held against the asset entity and that there are no existing liens against the asset entity (other than such indebtedness or such encumbrances that are being put in place as part of the financing that they are rating).

With respect to the guarantor, the issuer and each asset entity, their organisational documents are amended and restated for purposes of bankruptcy remoteness and independent directors are appointed so that no material action (including an insolvency action) can be taken without the independent directors’ consent.

While the assets are isolated, the day-to-day operations of the data centre company are not significantly impacted. This is because, as part of the securitisation, the party that manages the daily operations of the data centres is appointed the “manager” and paid a market rate for their services. This permits the parent’s/sponsors’ business to proceed uninterrupted. The fee the manager is paid is set at a level where, if the manager needed to be replaced, an independent third party would generally be willing to accept the successor role for the same amount. Such fees are paid to the manager through the priority of payments from available funds prior to the repayment of any principal. This arm’s-length arrangement is also important for the integrity of bankruptcy remoteness.

Underlying collateral

The essence of any securitisation is that noteholders are investing in a pool of self-liquidating assets. In any securitisation programme, the customer contracts/tenant leases will need to be carefully reviewed for certain key provisions such as early termination rights, limitations on mortgaging the property or restrictions on assignments by the asset entity, among other provisions, and if such key provisions will need to be disclosed to the rating agency and to investors. Furthermore, depending on the customer contract/tenant lease, the asset entity may be required to seek a subordination, non-disturbance and attornment agreement from the applicable customer/tenant so that the mortgage lien securing the securitisation will have lien priority over the lien of the lease.

With respect to the guarantor, issuer and the asset entities, all asset UCC filings will be filed, and the notes will be secured in part by security interests in personal property. The creation and enforceability of liens in most forms of personal property in respect of which a security interest is granted are governed by the Uniform Commercial Code of the jurisdiction where the filing is made.

Mortgage instruments will also be filed in the jurisdiction where the data centre is located. In connection with these instruments, there is also an assignment of rents. Local counsel will deliver legal opinions regarding the legality, validity and enforceability of the mortgage under the governing law of the applicable jurisdiction.

A mortgage instrument creates a lien upon, or grants a title interest in, the real property interest covered thereby and represents the security for the repayment of the indebtedness. In the United States, there are generally two types of mortgage instruments depending on the state in which the property is located – mortgages and deeds of trust. There are two parties to a mortgage – a mortgagor (the borrower and usually the owner of the subject property) and a mortgagee (the lender). In a mortgage, the mortgagor grants a lien on the subject property in favour of the mortgagee.

A deed of trust is a three-party instrument, between:

• a trustor (the equivalent of a borrower);
• a trustee, to whom the real property is conveyed in trust; and
• a beneficiary (the lender), for whose benefit the conveyance is made.

Under a deed of trust, the trustor grants the property to the trustee, in trust, irrevocably until the debt is paid, and generally with a power of sale.

The mortgagee’s authority under a mortgage and the trustee’s authority under a deed of trust are typically governed by the provisions of the related mortgage instrument and other loan documents, the law of the state in which the real property is located, certain federal laws and, in some deed of trust transactions, the directions of the beneficiary.

Securitisations are non-recourse financial vehicles that are backed solely by the underlying collateral and therefore foreclosure rights are a critical protection that noteholders rely upon. Foreclosure is a legal procedure that allows the lender to recover the indebtedness secured by the mortgage instrument (which typically includes the lender’s costs of recovery and any applicable default interest), by enforcing its rights and available legal remedies under the mortgage instrument.

If the borrower defaults in payment or performance of its obligations under the note or mortgage instrument, the lender has the right (but not the obligation) to institute foreclosure proceedings to sell the real property or, if the borrower holds a leasehold interest in the real property, to terminate the lease and sell the leasehold interest.

Foreclosure procedures vary from state to state. Two primary methods of foreclosing a mortgage instrument are judicial foreclosure, involving court proceedings, and non-judicial foreclosure pursuant to a power of sale granted in the mortgage instrument. A debtor may also have the right to challenge in court a non-judicial foreclosure proceeding by seeking to stop the sale for alleged lender defaults. If challenged, the non-judicial foreclosure would also be subject to court delays and litigation.

Appraisals

A key component of a data centre securitisation is the appraised value of the data centre. The appraised value of any data centre is the most recent as-is fair market appraised value of such data centre determined pursuant to an independent, full narrative (complete summary) or limited scope (limited restricted) MAI (Member, Appraisal Institute) appraisal provided to the trustee and servicer of the securitisation, or obtained by the servicer or another third party in accordance with the Uniform Standards of Professional Appraisal Practice (as recognised by the Financial Institutions Reform, Recovery and Enforcement Act of 1989). Such appraisal must take into account the leased fee value of the related buildings and land of such data centres, consistent with industry standards. In order to issue notes, appraisals must be relatively recent, generally no more than six months old. In addition, as a protection mechanism for the benefit of the noteholders, the servicer may, no more than once every three months, obtain new appraisals with respect to the data centres owned by the asset entities at any time. This allows the noteholders to have confidence that their investment has not deteriorated in value.

Title policies

An important legal protection for noteholders includes the title policies that they receive at the closing of each note issuance. To be eligible collateral for purposes of the securitisation, the issuer must provide to the secured party a title policy with respect to the data centres. A parent/sponsor should bear in mind the lead time and expense required to have these title policies in place. Moreover, if there is ongoing construction at any of the data centre sites, mechanic’s lien coverage on the title policy will need to be discussed in detail with counsel to the noteholders, and the title insurer will impose additional requirements to the issuance of the title policy.

Conclusion

For an owner or operator of data centres, or a sponsor thereof, looking for an efficient way to fund the business, securitisation may be a prudent option. As power and land constraints continue to impact the industry, competition will be seen to rise and those businesses who are tapped into the securitisation market will likely have an advantage given their ability to easily access necessary capital.

While a data centre securitisation is complex and an inaugural issuance can take multiple months to launch, once the programme is up and running, the benefits are significant as leverage multiples are high, and cost of funds is low by comparison to more traditional financing options.