Data centers have come into view as the newest, hottest investment-grade sector in real estate. Particularly resilient during the Covid-19 pandemic relative to sectors such as office and hospitality, digital infrastructure continues to gain steam. Along with it, institutional investor interest continues to grow.

Let’s explore how sponsors of data center funds can steer their vessels to fundraising success without a map of well-defined market terms and structures.

Approaching a drawbridge – open or closed-end?

Semi-liquid and evergreen funds are always of interest to managers in illiquid sectors. These funds offer a way to build sticky, long-term capital in a single fundraise. Core and core plus investment programs tend to fit well within an open-end structure due to their focus on income generation, long hold periods, assets that can be readily valued, and relatively low development and leverage.

Not so fast – investors underwriting these investments may come to the table with a bias for closed-end structures that predominate in the real estate fundraising market. Confirming that your anchor/key investors are interested in an evergreen structure will be key before putting pen to paper. Identifying a seed portfolio of assets, and providing specific insights into how quickly initial capital will be deployed, are also essential components of an evergreen fund.

If the stars don’t align for an evergreen fundraise, traditional closed-end structures remain a well-worn path to launch your fund. And for strategies that involve significant development or use of leverage, a closed-end fund is the better option.

Entering international waters – global investing and global marketing

Data centers are being built in multiple geographies. Should managers seek to build a single product that can invest globally, or raise multiple funds that each invest in opportunities in a particular geography? Tax and regulatory considerations in each jurisdiction mean that the structures for investing in the US will vary widely from those for investments in Europe, Asia, or the Middle East. Investors may be more accustomed to allocating their capital in buckets based on geography and find it challenging to make a global commitment that can be deployed anywhere.

Funds are also increasingly being marketed globally to institutional investors across the US, Europe, the Middle East, and Asia – all of whom have shown interest in this sector. Building a flexible structure with the ability to add feeder funds, parallel funds, and use alternative investment or other special purpose vehicles to accommodate the tax and regulatory needs of various investors is also critical.

For managers choosing between a single global fund or multiple funds in specific geographies, have your cake and eat it too. It is possible to design a flexible structure for capital deployment that allows for both global commitments and specific regional commitments.

Designing a fund structure for global marketing seems to present a chicken-and-egg problem; structuring for particular investor types may be bespoke or complex, but the composition of your investor base will not be known at the outset.

For successful global marketing, first identify with your formation and tax teams the “minimum viable structure” in each geography to get the program going. Start by building this essential nucleus, and make sure your structure has the flexibility to build additional components on demand if investors who “come to the party” require a different structure to access the fund.

The captain-first mate dynamic – affiliated developers and managing conflicts

For developers in the space who are interested in raising capital either for their development activities or to provide liquidity for their stabilized properties, having an affiliated fund provides blind-pool capital where you might otherwise have had to raise capital on a deal-by-deal basis, or to sell stabilized properties to a third party.

How will investors react to an investment program that contemplates funding or buying projects from an affiliate? On the one hand, both investors and regulators are sensitive to the inherent conflicts of interest presented by transactions with affiliates. But on the other, with few developers in this emerging space, investing in an affiliated fund can be a great way to ensure an attractive pipeline of opportunities.

Navigating these conflicts requires mechanisms to give investors comfort that conflicts are being appropriately identified, addressed, and mitigated, but should not constrain the manager so tightly as to give the investors too much control over the basics of investment decision-making. A properly empowered LPAC (Limited Partner Advisory Committee) of key investors will be a critical tool.

Ahoy matey! Anchor investors

Fundraising for data center investments has often taken the form of a joint venture. With commingled fundraising on the rise, anchor investors—particularly for newer fund sponsors—may demand preferential rights that more closely resemble a joint venture, such as approving investments and consents over major decisions. How can they be accommodated in a commingled fund where granting these types of preferential rights would otherwise be off-market?

One useful tool for managers may be the use of a fund-of-one that generally invests alongside the commingled investors. This allows for the anchor investor’s terms to be self-contained. Disclosures to the main fund investors about any downstream effects of the anchor investor’s exercise of these rights must be carefully considered. This is particularly sensitive as the regulatory obligations surrounding preferential rights, and corresponding disclosures, are on the rise.

Blue waters – focus on sustainability

The power and cooling needs of data centers raise sustainability issues that many investors will be focused on during the diligence process. A well-developed ESG policy will address the ways in which a manager identifies these considerations and takes them into account during its investment process, with appropriate flexibility.

These policies are not without controversy or regulatory scrutiny. Managers must appropriately tailor ESG policies to their specific business and strategy, ensure that disclosures are complete, and make sure that practices described in disclosures are actually undertaken and documented.

Off into the sunset

For managers who are charting out their data center fundraise, there’s no reason to get lost on the high seas. With the right terms, structures, flexibility, and an understanding of the idiosyncrasies of the sector, smooth seas lie ahead. Bon voyage!