Sustainable private equity investing in the digital infrastructure industry

Introduction

Given the rapid digital transformation of the global economy, private equity funds such as KKR & Co. Inc. and Blackstone Inc. are increasingly targeting the data center industry as an investment segment capable of generating above-average revenue and capital gains. Given their sustainability commitments, PE funds are considering environmental stability as a significant part of their investment equation. Several recent acquisitions highlight this trend, with the acquired company either already having made climate commitments under the Paris Agreement or making such commitments immediately after closing.

Like other operators in the financial industry, PE funds are under political, regulatory, societal and market pressures to integrate sustainability considerations into their investment strategies. In particular, many limited partners are increasingly committed to adhering to environmental, social and governance standards for their investments in PE funds. Funds investing in the data center industry are likely to select companies with high environmental standards — and to help enhance the sustainability footprint of the target company during the holding period — as a means of increasing value and improving risk-adjusted returns.

Assets under management by PE funds are projected to increase from the current $5.9 trillion to $9 trillion in 2025. As such, the environmental engagement of these funds will be critical in supporting the transition to a low-carbon economy as established by the Paris Agreement. Due to pressure from investors and customers alike, data center providers are responding with meaningful measures to decarbonize energy consumption and mitigate unnecessary energy use.

Context

In a typical PE deal, an investment manager (the general partner, or GP) pools money from investors (limited partners, or LPs) to purchase an operating company. Then, after a certain number of years, the PE fund exits its stake from the company by selling it in either the public or the private market to earn returns on the exit multiple and capital gains. An increasing number of large PE funds have targeted public and private data center companies in the past couple of years.

For example, in May 2022 DigitalBridge Group Inc. announced its acquisition of Las Vegas-based data center REIT Switch Inc. in an all-cash transaction valued at $8.4 billion ($11 billion enterprise value). After closing the deal, the fund plans to take Switch private. DigitalBridge manages 25 portfolio and affiliated companies operating in the digital infrastructure industry, which provide data network and data center services through tens of thousands of active tower assets and small-cell nodes, more than 100 data centers and a fiber network with over 135,000 route miles and more than 130 edge facilities. DigitalBridge and Switch have both committed to achieving net-zero greenhouse gas, or GHG, emissions by 2030. Therefore, DigitalBridge conducted its acquisition strategy in compliance with decarbonizing the fund's portfolio.

In March 2022, PE funds KKR & Co. Inc. and Global Infrastructure Management LLC closed the acquisition of data center operator CyrusOne Inc. in an all-cash transaction valued at $15 billion. The target company was delisted from the Nasdaq and taken private. Environmental sustainability was also a critical issue for all parties involved in the transaction. KKR is a leading member of the Private Equity Working Group recently formed by Ceres, an influential nonprofit focused on sustainability issues. The working group aims to effectively address the impacts, risks and opportunities of climate change while aligning the investment practices of PE portfolios with the goals of the Paris Agreement. In 2020, CyrusOne announced its commitment to become carbon-neutral by 2040.

Another large deal focused on reducing GHG emissions in the data center industry was closed in August 2021, when affiliates of Blackstone Infrastructure Partners LP (Blackstone Real Estate Income Trust Inc. and Blackstone Property Partners) acquired QTS Realty Trust Inc. in a transaction worth $10 billion. As with the previously mentioned deals, the acquired company was taken private, with environmental sustainability representing a core strategy for both parties. Earlier this year, QTS committed to slashing its enterprise-wide emissions by at least 50% by 2032.

Ahead of the QTS deal in 2021, Blackstone had announced its Emissions Reduction Program and started implementing a new goal of reducing Scope 1 and Scope 2 carbon emissions for new assets globally by 15% in aggregate over the first three years of ownership. To gain deeper expertise in environmental sustainability strategies, Blackstone acquired Sphera Solutions Inc., a provider of ESG software, data and consulting services, in September 2021.

Why PE funds should consider environmental sustainability

Environmental sustainability considerations are becoming critical for PE investment strategies in the data center industry and in other sectors. Overall, PE funds should consider environmental sustainability for various reasons, which we can broadly divide into four groups.

Environmental regulation — New regulations around sustainability are expected to come into force over the next few years. In the U.S., for example, the ESG Disclosure Simplification Act of 2021 requires the Securities and Exchange Commission to formulate ESG metrics to help public companies make ESG-specific disclosures in their SEC filings. Consequently, improving the environmental metrics of a company during the ownership period will become critical for the success of PE transactions expected to culminate in an IPO.

Similarly, in June 2021, the European Commission adopted a Corporate Sustainability Reporting Directive proposal that requires all large financial and nonfinancial corporations to release periodic reports on their environmental and social impact activities. In February 2022, the U.K. Department for Business, Energy and Industrial Strategy issued guidance — its mandatory climate-related financial disclosures by publicly quoted companies, large private companies and LLPs — to help businesses understand how to meet the disclosure requirements under the Companies Regulations 2022 and Limited Liability Partnerships Regulations 2022. Finally, the International Financial Reporting Standards Foundation recently started developing a new global framework for sustainability risk.

Pressure from limited partners — LPs invest money on behalf of individuals and companies. Institutional investors have a fiduciary duty to ensure that the capital they commit to PE funds is managed properly and in line with their customers' interests and corporate policies. More than 4,000 institutional investors with over $120 trillion in AUM have signed on to the UN Principles for Responsible Investment since the initiative's launch in 2006. In recognition of the growing importance of sustainability to fund investors, in 2021, Bain & Company estimated that 80% of European PE funds and 45% of American PE funds were committed to the Principles for Responsible Investment, the Net-Zero Asset Owner Alliance or the Task Force on Climate-related Financial Disclosures.

Sustainability is value-enhancing — ESG initiatives used to be "nice to have" goals that won businesses favorable press coverage, but now the implementation of a solid ESG strategy is viewed as necessary for value creation. For PE funds investing in the data center industry, enhanced environmental sustainability means improved operational efficiency — potentially bringing cost savings around operating expenses and superior financial performance.

Sustainability improves risk management — A holistic ESG strategy for PE funds investing in the data center industry means accounting for the needs and interests of all stakeholders: clients, employees, communities, savers and regulators. Targeting an investee company with solid environmental credentials or pursuing a concrete sustainability strategy during the ownership period would help protect investors from the risks involved in the transition to a low-carbon economy. Achieving high environmental sustainability for a data center means minimizing the risk that the asset held by the PE fund would become unable to operate — or be "stranded" — due to changes in environmental-related regulatory, societal and business practices.

Conclusion

Environmental considerations are becoming critical in all stages of the PE life cycle. During the fundraising stage, LPs usually favor GPs with higher ESG credentials or "more sustainable" investment strategies. Target companies operating in "brown" industries or with deficient environmental performance are more exposed to transition risks that may translate into financial risk, making them less appealing during the due diligence phase. During ownership, the fund can focus on improving the investee company's environmental footprint. This improvement is then critical to achieving maximum results during the exit stage.

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