Securitization: The principles of data center financing

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Intro: Hello and welcome to Tech Law Talks, a podcast brought to you by Reed Smith's Emerging Technologies Group. In each episode
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We will provide practical observations on a wide variety of technology and data
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Claude: Hello, everyone, and thanks for joining us for Tech Law Talks and the latest
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in our data center series.
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Now, if you've been reading the papers or listening to the news,
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you will be aware of the explosive growth in data centres.
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And certainly, we've explored some of the reasons and the issues relating to
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data centres in previous episodes of this series.
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However, as always, these things need to be financed.
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And although there are a varying number of means by which you can finance the
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construction and operation of a data center.
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One of them is the securitization.
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This is a form of financing, which is proving increasingly popular,
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not only for data centers, but also for the digital age generally.
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So it will probably be helpful if we start by looking at where this market developed
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in the context of data centers,
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which is the United States, and
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how that history has come forward and the drivers behind that moving on.
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So I'd like to ask my colleague here, Jeff Stern, perhaps if you can give us
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a bit of background to this and how the markets come into being and how it's growing. Jeff.
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Jeff: So, as Claude had noted, there has been a remarkable growth over the last several
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years and continuing on for the foreseeable future in data center development.
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There are several drivers of that growth. One of them is the migration of enterprise
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workloads to the cloud. That's a primary driver.
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Naturally, another one is the remarkable growth of generative AI and large language models.
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That area in particular has a dramatic increase in the demand for high-performance
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computing and storage, and AI is in fact projected to represent roughly 60%
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of the total growth in data center power demand through 2028.
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And the last major driver for growth of the data center development area is
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digitization of business processes, so e-commerce, software as a service,
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digital content delivery, etc.
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As Claude noted, the U.S. has been the global leader in data centers.
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As of January of this year, the U.S. had about 60% of the world's installed
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data center infrastructure, with Northern Virginia being its principal data center order.
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There were over 5,000 data centers in the U.S. as of Q4, 2024.
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There are a number of reasons for the U.S.'s outsized role in the growth of data center.
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One of the most significant of those is the presence of major hyperscalers in the U.S.
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Amazon, Apple, Google, Microsoft, Meta, Oracle.
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There is, in general, stable and affordable energy, robust connectivity,
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and a favorable regulatory environment.
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I'll mention, among several other initiatives, the Stargate initiative by President
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Trump. that seeks to invest a minimum of $500 billion into AI data center infrastructure
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over a four-year period.
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It bears mention on a related note that the regulatory environment for foreign
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direct investment in U.S.
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Data centers has tightened significantly.
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So the Committee on Foreign Investment in the United States,
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CFIUS, is quite focused on data center transactions, particularly if they're
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located near sensitive sites or involved in critical technologies.
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Just looking ahead in this market, again, talking about the development of data centers,
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the top six hyperscalers are due to spend over $380 billion on CapEx this year,
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and that should rise to about $540 billion in 2029.
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So very, very significant investments by the major hyperscalers.
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2025 has also been a record year
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sort of migrating in the direction of financing 2025 has been a record year
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for data set of financing with about 11.5 billion of abs and 7.4 14 billion
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of cmbs so that total is predicted to double next year so very very rapid growth in the financing.
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Claude: Clearly, with those sort of numbers, particularly in the financing need,
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the developers and operators of
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these data centers will be looking at all available sources of financing.
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And as you've already touched upon cmbs
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and rmbs as commercial mortgage-backed securitizations
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and residential mortgage-backed securitizations offer
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some building blocks which have been well developed in
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the market and established over time for sectors other than data centers but
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even within the securitization of data centers there's a number of different
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models of how to go about constructing the financing.
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And Simon, who is one of my colleagues, Simon Hugo, based here in London.
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Simon, perhaps you can start off by talking about how securitizations are particularly
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relevant to the design, build, and operation of data centers.
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Simon: Yeah, I mean, at its heart, securitization is a financing method that allows
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the pooling of assets and income streams to create and fund securities and returns to investors.
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Now, in the context of a data center, data centers are particularly suited for
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this type of transaction, particularly given they're real estate centric with regular cash flows.
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And they'll be familiar to many real estate asset class investors.
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They have, to a certain extent, income stabilization, which is required for an ABS.
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And it's also a cost-effective way to refinance existing bank debt,
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which some real estate assets are particularly reliant on at the moment.
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We've seen the increased demand for data storage and processing capabilities
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and the expansion of development of data centers that Jeff's mentioned,
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really accelerating that growth in the different financing tools and the expansion
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into different methods.
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In terms of those methods, typically data center securitizations are structured
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in one of two ways, either as an ABS or an asset-backed security structure.
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This is where the debt is backed by the lease revenues from the data centers,
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as opposed to a CMBS or commercial mortgage backed securitization where the
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debt is backed by loans to data center operators secured on the data center property.
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So, you know, here we have two different structures which may be suited for
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different investors and different operators alike.
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So from a market perspective, I think Europe isn't as mature as the US,
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but it's growing rapidly and forecast to grow significantly over the next few years.
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We've had two significant deals done so far.
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One's a securitization of two data centers in Cardiff, who recently had a TAP
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issuance and refinancing in the last few weeks.
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And another one was a securitization of four data centers in Berlin and Frankfurt.
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These notably were all data center ABS deals, and we expect to see a lot more
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European data center ABS coming out of Western European cities,
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including London, Dublin, Paris,
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Frankfurt, Amsterdam, and potentially some emerging hubs as well.
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Claude: Thanks, Simon. Jeff, you know, given that the U.S.
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Is leading the way in the data center construction, I think it's reasonable
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to assume that you're also leading the way in the securitization market for data centers.
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So what are you seeing over in the United States? Jeff: It certainly has been an extremely
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active market over the last several years.
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You've seen a fair amount of both CMBS and securitization.
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I would note that securitization, broadly speaking, offers much greater flexibility
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than CMBS. It typically allows for upsizing and changing in the collateral pools
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so that increases revenue and leverages costs.
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ABS also notably includes an incentive to refinance after about five years,
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but the issuer is not required to refinance until the final maturity date,
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which is typically 24 or 30 years.
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By contrast, CMBS is normally a fixed pool and has typically a hard maturity
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of five years. And so at maturity, you must refinance or face forced liquidation.
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So the securitization allows greater flexibility both in terms of the duration
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of financing and not having a hard maturity at such a short period of time,
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but also allows for growth of the pool through a master trust structure.
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As you can imagine, securitization of data centers is considered an esoteric
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asset and is typically executed in a 144A or 482 private placement offering
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in the U.S. rather than a public offering.
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An interesting point is that with a 482 placement, not only have I gotten some
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market feedback that you're seeing larger checks written for 482 placements,
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which is a little bit surprising.
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It may actually allow for easier execution, but it also may be easier to share
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detailed information about the tenants in a 482 deal where there is a more limited
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pool of investors and where leases may have strict confidentiality provisions
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that can only be shared with a limited number of people.
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So that's an interesting point without a 482 placement.
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Just a few words about the structuring of a securization of data centers.
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The typical form is
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a master trust so that leases are subject to
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eligibility criteria and rating confirmation because as i mentioned you may
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have a a pool which changes over time and and allows for the addition of additional
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leases it often employs variable funding notes to align with the dynamic nature
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of lease agreements and the portfolio again final maturity is typically 30 years,
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but it generally includes an anticipated repayment date, not a hard maturity
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of around five years, and there's an incentive to refinance at that time because
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it's to create an increase of interest at that five-year period.
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These deals commonly include DSCR performance triggers, that is,
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debt service coverage ratios.
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A breach of the ratio can trigger cash reserves, cash traps, and amortizations.
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For hyperscale data centers, leases are generally long-term and utilization
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approach is 100%, so DSCR triggers may be less relevant.
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But for enterprise data centers, with many customers, contracts are shorter,
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and that creates a repricing and cash flow risk.
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So I'll just finish on this sort of overview, talking about what the collateral
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is for securitizations.
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As Simon mentioned, they are
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typically leases. There are also separate accounts set up for the SPVs.
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There are rights under the customer contracts. There may be,
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if the sponsor owns the property,
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there may be also a grant of the data center itself so that the rating agencies
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may be able to look to residual value for purposes of their ratings.
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There's typically a reserve account as well as a collection account.
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And there's typically a pledge of the equity of the issuer and the other SPVs,
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including an asset SPV and a lockbox SPV that are set up.
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So that's a general overview of the structure and the differences between CMBS and ABS.
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Claude: Great. Really interesting point there about the identity of the lessees in there.
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One of the things when the first data center securitization occurred in Europe,
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which is the one in Wales that Simon mentioned earlier on, was that it was subject
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and had approval under the Green Bond principles.
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That attracted a lot of interest partly
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because it was novel to see those principles applied
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in the context of a data center and secondly it prompted the question why that
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was the case for a data center because I think the environmental and social
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concerns relating to data centers have been well flagged in the public domain.
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I mean, obviously, the size of these things makes their construction quite a
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large-scale undertaking.
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And so sustainable construction is sort of key, particularly in Europe,
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of building these things in a way that doesn't impact adversely on the environment.
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But I think the operation of them probably raises more issues in that,
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clearly, they take a lot of energy.
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It's well accepted that the large language models and the AI programs that Jeff
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highlighted earlier on take a lot of energy to run and operate.
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So a huge drain on the local energy market.
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But of course, not only do you need to pull the power in, but you need to be
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able to transmit the data into the data centers and also,
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more importantly, the data centers out so there's a large sort of demand for
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energy in any data center no matter what its size relative to any other activity.
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As always, the processing operations within a data centre generate a great deal of heat.
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And while some of that can be addressed by air conditioning,
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thus adding to the amount of energy consumption in most of the data centres,
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water cooling prevails.
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And so water consumption is another environmental impact of large scale data centres.
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Because of the needs to
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get close to power and data transmission
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there is always a debate about whether you have a
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greenfield site development which is clearly easier
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for construction or a brownfield development which although more expensive often
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places you closer to the power sources and the water cooling sources that you
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need although one would think that these data centers would be great for the local economy,
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certainly in the construction phase.
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It transpires that there's limited social benefits when it comes to their operation.
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A high degree of automation and the fact that the data centers are full of self-maintaining
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or minimal maintenance technology means that employment is relatively low,
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really focusing on a number of operators and supervisors,
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and in many cases, the security around the site.
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But actually, as areas of high employment, they don't feature large.
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So in reaction to all this, the approach of making data centers subject to a
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form of green labeling, whether that's green bond principles or some other generally
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accepted means of marking them as a problem,
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environmentally and socially acceptable certainly helps make them more attractive
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and marketable to investors and helps to allay or maybe dispel the perceptions
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that they do create large-scale ESG issues.
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And certainly the use of sustainable energy is something that's being actively
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pursued by the UK government at the moment in developing an ambitious plan for
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securitization construction.
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Which I think really leads us all on to where does this market go from here?
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We all know that technology is a fast-moving and fast-changing environment.
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And so where do we see this market going?
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Increased demand for computing power, yes. But on the other hand,
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is there a built-in obsolescence?
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So perhaps we can, all three of us, just think now and share with our listeners
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the way we see some of the challenges and issues on the market growth of data
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centers and the securitization of their financing.
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Jeff: Simon, you've raised some fascinating points about some of the challenges facing the market.
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Data center energy issues are clearly front and center, and they raise both
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supply and environmental issues.
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For what it's worth, U.S. data center electricity consumption is predicted to
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more than double by 2030, so the challenges are quite significant.
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One development that seems to offer promise is the emergence of a small modular
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reactor market in the U.S. and elsewhere.
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I know a number of the hyperscalers are actually dedicating significant investment
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energy and funds to developing that technology and executing on them.
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The other big issue that I think is worth mentioning, and you touched upon it as well, is water use.
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Water use is a huge issue because the data centers need to be constantly cooled.
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Roughly 40% of the energy electricity used in a typical data center is used to chill water.
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I just note that in June, China began to build a wind-powered underwater data
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center to address just this issue.
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And the project is expected to use at least 30% less electricity.
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So that's an interesting development, not one that probably can be replicated
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in a lot of locations. But again, an interesting and innovative way to deal
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with both cooling, water demand and energy constraints.
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Maybe the last point I'll raise, which I see as a challenge for the marketplace,
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is a strain on supply chain, critical equipment and skilled labor.
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However, there's been such a demand that the labor,
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you see sort of bidding wars for certain leading figures in the space,
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but also you have many projects that face timelines that exceed three years
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because of the durations required to order and receive the equipment needed
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to build these things out.
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Simon: I suppose from my perspective, just maybe touching on a European perspective
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and where there are some headwinds,
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I think in particular at the moment, there are fewer larger portfolios and some
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quite marked difference in the concentration risk in Europe as opposed to the
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US and fewer of the large scale operators in the market.
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That said, there are many facilities under construction and as sort of M&A activity
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in the data centre space continues, we expect there to be some more opportunities in the market.
00:20:11.862 --> 00:20:17.562
Again, the data centre funding has traditionally been with bank debt.
00:20:18.333 --> 00:20:23.933
Though private credit interest is increasing, which sort of allows for more
00:20:23.933 --> 00:20:26.953
interest in private securitizations of data centers.
00:20:27.213 --> 00:20:32.873
One of the challenges with any European securitization is perhaps,
00:20:33.153 --> 00:20:36.653
particularly in this context, where there are portfolios which might be spread
00:20:36.653 --> 00:20:39.033
out in different jurisdictions in Europe,
00:20:39.273 --> 00:20:44.453
is the different number of legal jurisdictions across that portfolio.
00:20:44.693 --> 00:20:49.873
Now, there are structures that certainly work from a pan-European perspective,
00:20:50.133 --> 00:20:55.873
but they're not as easy to implement as portfolios within one jurisdiction.
00:20:56.173 --> 00:21:03.533
I think the improvement in rating methodologies and investor comfort will do
00:21:03.533 --> 00:21:10.493
a lot to ensure that the market advances and investors get more comfortable
00:21:10.493 --> 00:21:12.553
with a more standardised product.
00:21:13.013 --> 00:21:17.773
Now, the structuring challenges within an ABS, particularly from a European
00:21:17.773 --> 00:21:24.513
perspective, are related primarily to sort of insolvency remoteness requirements,
00:21:24.513 --> 00:21:27.313
where you have issuers and prop codes.
00:21:27.633 --> 00:21:33.373
If prop codes are within the group and also have shared services that are introduced
00:21:33.373 --> 00:21:35.413
in the additional element of risk.
00:21:35.713 --> 00:21:42.533
Similarly, where you have to move out employees and ring fence different vehicles.
00:21:42.533 --> 00:21:44.213
It adds to some of the complexity.
00:21:44.793 --> 00:21:49.493
None of this is insurmountable and has been achieved on the data center securitizations
00:21:49.493 --> 00:21:51.433
that have been done in Europe.
00:21:51.653 --> 00:21:54.933
And from a European perspective, I would expect that.
00:21:55.531 --> 00:22:01.711
That these issues become more standardised in the mitigants that are employed to overcome them?
00:22:02.671 --> 00:22:08.011
Claude: I mean, I think at the back of any investor's mind will always be the two trends
00:22:08.011 --> 00:22:15.051
that we've seen, not just in data centres, but in technology generally in the last 50 to 70 years.
00:22:15.311 --> 00:22:18.951
One is the risk of technological obsolescence.
00:22:19.131 --> 00:22:22.391
At the moment, we're seeing a wave of data centres being
00:22:22.391 --> 00:22:25.411
built which are all pretty much all one
00:22:25.411 --> 00:22:29.331
vintage but you can already see the signs of
00:22:29.331 --> 00:22:32.431
newer technology producing newer vintage
00:22:32.431 --> 00:22:35.451
data centers and that not only
00:22:35.451 --> 00:22:38.791
produces cheaper and more efficient technology
00:22:38.791 --> 00:22:43.731
within the data centers but also poses a question as to whether the size and
00:22:43.731 --> 00:22:48.831
scale of this vintage of data centers will carry on or whether there'll be a
00:22:48.831 --> 00:22:55.531
reduction in the size of the instructions in which these operations are housed.
00:22:56.314 --> 00:22:59.914
I suppose the other point is that with technological developments,
00:22:59.934 --> 00:23:06.374
we also see changes in the future data and computing demands.
00:23:06.714 --> 00:23:13.414
I mean, clearly data sensors are a reaction to the explosion in the need for
00:23:13.414 --> 00:23:19.474
data processing, but also a reaction to AI developments.
00:23:19.474 --> 00:23:25.554
But already we're beginning to see AI models that are less processing intensive
00:23:25.554 --> 00:23:28.474
require less energy consumption.
00:23:29.434 --> 00:23:34.474
And on top of that, the technology occurs in both the mechanical space.
00:23:34.474 --> 00:23:39.274
So, for example, in-chip cooling, which is being developed, will,
00:23:39.394 --> 00:23:44.014
to reflect Jeff's point about underwater data centers with wind power,
00:23:44.554 --> 00:23:49.014
reduce the water demand or certainly the water cooling demands.
00:23:49.474 --> 00:23:56.134
For data centres over time. I think the regionalisation of data centres will
00:23:56.134 --> 00:24:04.254
also encourage governments of the countries in which they're situated to lobby hard,
00:24:04.254 --> 00:24:10.554
not only for favourable regulatory treatment to help them develop them as an economic tool,
00:24:10.734 --> 00:24:18.274
but also to encourage the construction of more efficient data-related infrastructure,
00:24:18.274 --> 00:24:20.874
be that water or be that energy.
00:24:21.494 --> 00:24:26.834
And already, to Jeff's point about the small modular reactors, the SMRs,
00:24:27.334 --> 00:24:33.014
the UK government's paper on the development of its data technology strategy
00:24:33.014 --> 00:24:39.334
alludes to SMRs being built to power data centres locally to them.
00:24:39.334 --> 00:24:44.554
And clearly, whilst the hyperscalers may have the financial wherewithal to construct
00:24:44.554 --> 00:24:47.534
their own SMRs, alternative power sources.
00:24:48.214 --> 00:24:55.854
A lot will be looking at the government of the region to be able to help create an infrastructure.
00:24:55.854 --> 00:25:01.974
And I don't think it's any accident that the UK government has very recently
00:25:01.974 --> 00:25:07.034
announced that the first SMR in the UK will be constructed in Wales,
00:25:07.234 --> 00:25:12.434
when you only have to look across and see that the first UK data centre that
00:25:12.434 --> 00:25:14.494
was securitised was also in Wales.
00:25:14.494 --> 00:25:18.434
So I think there is a lot of potential,
00:25:18.434 --> 00:25:24.974
but I think there's also a lot of challenges in a fast-moving market,
00:25:24.974 --> 00:25:31.774
which is based heavily on technology, which is moving as quickly as the demands
00:25:31.774 --> 00:25:38.414
of the world's population for data processing and the use of technology increases.
00:25:38.414 --> 00:25:41.254
So i think that brings us
00:25:41.254 --> 00:25:44.434
to the end of this broadcast uh thank you
00:25:44.434 --> 00:25:51.294
to everyone who's tuned in to listen and i hope you found it informative both
00:25:51.294 --> 00:25:57.074
Jeffrey Simon and I are very happy to take any follow-up questions that you
00:25:57.074 --> 00:26:03.414
may have you can find us all on the Reed Smith website Jeffrey Stern,
00:26:03.674 --> 00:26:09.294
Simon Hugo or Claude Brown and you can ask us any questions through there and
00:26:09.294 --> 00:26:11.734
we will get back to you as soon as we possibly can.
00:26:12.302 --> 00:26:17.762
So this concludes the data center securitization, which is part of our data
00:26:17.762 --> 00:26:20.022
center series on Tech Law Talks.
00:26:20.182 --> 00:26:24.782
And I hope it's been both informative and enjoyable. Thank you for listening.
00:26:27.342 --> 00:26:31.982
Outro: Tech Law Talks is a Reed Smith production. Our producers are Ali McCardell and Shannon Ryan.
00:26:32.342 --> 00:26:35.982
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