Ep13: How Investors Think About Data Center Risk and Opportunity

(upbeat music) Joining us today are Scott Troller and Aaron Richardson from Expedition Infrastructure Partners or XIP. Scott is a co-founder and managing partner of XIP. He has decades of experience investing across the capital structure and digital infrastructure, power and communications adjacent businesses. And Aaron serves as principal at XIP and works across principal investing opportunities and strategic advisory medits. Welcome to the show, guys. How are you? - Thanks for having us. - Good, thanks for having us. - It's great to have you. I always like to start off the show, just talking a little bit about the guests, their background, how they got here, what motivates you. You guys wanna start just by talking a little bit about that? - Sure, I'd be happy to. I've been kicking around the investment universe now for about 30 years. And so I've had a pretty long and varied career in a lot of different sectors, arranging from, starting my career at JP Morgan. And then was at a private equity firm called VSS for about 16 years. Then went into a Fertry Partners and co-founded a couple of businesses and then launched XIP about a year and a half ago. So had a pretty broad background and investing in businesses across both in the power side of things as well as digital infrastructure and technology businesses before that information services, communications and things of that nature. - Thanks, Scott. My background has been varied. I've spent time in Baton as well on the buy side. I've had so much really experienced and ended up Scott for a long time. So when we had a chance to put this together and try to get around this ecosystem of the convergence of power and digital and the next generation of some of these assets and the business surround them, especially with the power of emerging banking model that was so really exciting. So it's been a fun ride so far. We're happy to be on the show. Thanks for having me. - Happy to have you, Ron. For those who are listening who might not know about XIP, what can you tell us about XIP? - Sure, we're a merchant bank and we've got a strategic partnership with the Hunt companies and we have both an advisory practice and a principal investing practice. We focus on basically the next generation of infrastructure and the principles of XIP have deep backgrounds and both power development, building power plants both renewables as well as traditional as well as individual infrastructure whether it be towers, fiber, data centers and that kind of thing. And so we just kind of happen to have a group of people that actually have backgrounds in both of these sectors which are converging both from a advisory standpoint as well as an investing standpoint. And so we have a pretty active advisory practice right now. We have a number of clients that we've been representing both raising capital and selling businesses. We also raised a SPAC. And so we have a public SPAC that's focused on any kind of downstream service or any upstream service or we're input to data center buildouts. And so that's called OTGAU and we're partners and then with West Cummins from applied digital as well as Steve Caesar from Oakland State and Sandler and I service CEO that business. So we're currently looking for business and ecosystem to take public and we have a couple of active things we're working on right now on the private side from an investment standpoint as well. So we're pretty active in a lot of different areas right now and a growing team and it's a pretty interesting environment right now. Yeah, I want to talk a little bit about that environment. So if you guys sit at the intersection of advisory and principal investing, how does that dual lens change? How you look at the data center ecosystem today? Most things in the data center ecosystem are pretty large quite frankly. And when we focus on the lower middle market from a advisory standpoint. And so where our lens kind of tends to shift a little bit is that on the advisory side, we're focused very much on the assets that I had capital raising and on the services business. On the principal side, we're much more focused on, I would say, probably more in the smaller end of the services side of the business and much more opportunistic. We're not looking to have a traditional fund. We're really looking to capitalize on our knowledge of these sectors in a much more bespoke basis. But from an advisory standpoint, as we think about everything that's going on, we're very much playing more on the power availability side of the equation from our backgrounds being, we came out of a lot of renewable type background. We're very large in batteries, for example, and so that naturally kind of dovetails into things like powered land and everything that goes around the development of the power input for data centers. - And is that the part that you think is, I guess what's different about this cycle of digital infrastructure growth versus powerways as a power piece or is there anything else that you think is different this time around? - I think it's more than just power quite frankly. I think if there's an entire supply chain bottleneck that's occurring because the scale and complexity of a lot of this stuff is very, very different than prior cycles. The speed at which it's changing is very different and the amount of materials and services that go into these things is very different. And so I think you have a lot of different constraints converging all at once that makes these projects particularly difficult and challenging, but also makes them more valuable, right? Because if you can bring those things together, there's a premium for that because the marketplace is a premium on speed. And so I really think it's quite different than in past cycles really because of just, you know, how dynamic it is and all the different things you have to take into account and the premium that's really being put on speed right now. - When you're talking, when you're advising folks, whether it's on the buy side or sell side, is there something that you think that folks are underestimating or overestimating when it comes to their valuation or how they're looking at valuing companies? - Yes, to all. (laughs) - Yes, yes, all. - Yeah, what I would say to that, I'll let Aaron give his take on this is that, I think to a certain extent, you know, people are overestimating their valuation and underestimating their risk involved in some of this stuff. And I think what you have on the capital provider side of things is people wanting to get involved in this and place a lot of bets. Not all those bets are gonna work out. And then on the key input side, the people who actually are paying the bills, they're talking to everybody, but they're somewhat selectivists who they ultimately partner with. And so I think what you see is a lot of things that may happen but may not will happen is the question, you know, people wanna get paid for them, like, you know, that they're actually gonna happen. We see that a lot on the powered landside, for example, where, you know, there's lots of guys who have, you know, quote, unquote, projects and they're in the queue and, you know, they've got land and an option and all the things you want. But until you actually have an end customer, that's gonna pay the bill and then the credit quality of that customer and whether or not that customer is just kind of just, you know, making their own kind of, you know, optionality or whether it's real, is really hard to discern sometimes. And so that's where a lot of the gray area is right now is there's a lot of activity, a lot of projects. But the ones that actually move forward with a customer and that actually can actually get off the ground are somewhat limited, especially right now, given some of the constraints of the supply chain and stuff like that. And so I think that that's where sort of the gap exists between sometimes value expectation and what's reality and it makes it particularly risky for capital providers because there's also, I think, a lot of pressure to get involved in this super cycle, you know, given the growth that everybody, you know, for C's. And so it's sort of cocktail of a lot of uncertainty right now and how it plays out as anybody's guess. - Yeah, I think that's why I would understand one place which is even when you get to the universe of developers and the platforms that do have, you know, some level of advanced and where you have an ally that's with a tenant or for someone to purchase it, even if that allies with one of the big hyperscalers. The reality is that those organizations have such vast resources and have such a quickly and dynamically evolving for a footprint of, you know, need and type of compute that they will place lots and lots of bets sort of on the table relative to a particular area including, you know, real resources out there, you know, I mentioned the first milestone payments, things like that. But the reality is they're converting from an ally and even the first milestone, it's really my first milestone and there's something much more material where there's a real return on the investment. It's hugely videos to crack. And the cost of the hyperscaler of leaving projects behind, even with some resources exposed is relatively low. And so I think people can get over their schemes and overvaluing and overweight what they think they have, even if they have to do a place of some level commercial and management versus what can really defend a lot of capital going in behind it. >> Yeah, we see a lot of these, you know, power plant deals. And I always, like, looking at these deals and I think to myself, like, how does hyperscaler pick one and over the other? Because at some point, if you've got the land, if you've got the interconnection, to me, for my lens, it just seems like, okay, well, not to sort of monetize. Like, it doesn't seem to me to make a difference. I'm doing part of it, part of it, but how are you guys looking at those deals and thinking, like, oh, this deal or this company is more likely to move forward with hyper-skiller for some other data center developer because of, you know, XYZ reason? Is there anything that stands out to you guys in those situations? It's hard to see behind the lens of why these guys make the decisions they do because there's there's their own chessboard that other people are not playing and where they need resources and a domino effect of them choosing, you know, one site versus another and there's so many different things. But that's one of the reasons why I think it's so uncertain is that it's really hard to know what we do see, though, is that, you know, once somebody is in that ecosystem and has actually gotten something done, there's a trust factor as well that builds up. And then those people tend to, you know, have a better chance of moving forward on other things as well. And so I think that they're, it's hard to generalize in this, right, because there's projects which are, you know, using the grid, there's projects that are doing islanded power, there's projects that are doing both, there's different size parameters, there's guys who are doing the mega projects, there's people coming down market, doing much, much smaller projects. And so each one of those has a really different dynamic to it in terms of, you know, what the opportunity is, the risk factors and, you know, the players. And so I think it's really hard to generalize and, you know, that's one of the things I think is really important is that what I've noticed in my career, when you get into these cycles is people start painting everything with the same brush and lose differentiation. And that's eventually looking back in hindsight, where problems arose or things didn't go as well as planned. And it's really in those details that things are super important. So it's important to have people that are experienced that have done this before who, you know, have lots and lots of reps under their belt because whenever you have these, these kinds of cycles, you get a lot of tourists who now show up and start, you know, painting the same brush across everything and it's really very, very different. Yeah, I have two thought questions to that. One is, is there a deal structure that you're seeing become like the more prominent deal structure type? Because when we're out there, it seems like everything is relatively bespoke and there doesn't seem to be like commonality, but curious if you guys are seeing anything different? No, nothing different at all. I think it's completely bespoke. And I think that gets back to what we're saying before it's moving so rapidly and the players are changing and there's new entrance and there's new ways of doing things and new ways of people providing credit support and, you know, it's just a, you know, very, very complicated of all of the system and so coming up with, frankly, new and bespoke structures and ways to tackle things has a lot of value. Now, as this goes forward at some point, like we've seen every other, you know, industry that's gotten large, things will standardize and will get there. But I don't think we're really near that point yet. I think that's right. If you unpack it, right, you think about when you get to standardization around structure usually means you've got some metric of, of like, evaluation that you can sort of get aligned on. And yeah, at a top line, respecting about dollars per megawatt compute, but not every megawatt is created equal, partly any more, both in terms of underlying economics and what it would be used for. So until you get to a place where the actual market is more commoditized, we're not going to see any of that. And then it's fast when we're nowhere near that. And any evolution continues to be broad and fast. Yeah. I think the only trend that I've noticed over the last, it really, it's only been like maybe three to six months is that because of the uncertainty that you described Aaron around the hyper scalers and their plans and their constantly evolving plans, I'm seeing I think those same hyper scalers take on a little bit more risk up front with the capital that they're providing to fund, for example, that of XOR like an interconnection deposits, something like that. Seeing more of that than we've previously seen with various offerings for both sides really to be able to walk away of plans change, but especially with hyper scalers. We hear a lot about AI driving demand, but where are you guys seeing the second order of effects, particularly in services, construction and enablement? Well, I think AI is maybe driving the demand as it relates to the centers themselves and the need for that. And then that dives into power and other things, but we're seeing a lot of the bottlenecks or the people who are actually constructing, building, providing the services, the manpower, the equipment, the products, everything that goes into these things. And that's creating a lot of issues and we think it's going to actually create a lot of delays. But we're hearing a lot of from people or things that are just not happening as fast as they thought. And there's a lot of backlog in these things. And if you think about it, and you just kind of be rational about it, I mean, it's amazing. But there are a whole host of companies that were considered quote-unquote mom and pop providers of basic services that have quadrupled a couple 10 times their size in the last couple of years and got this massive backlog. And all of a sudden, they're trying to become a much, much larger company because of this massive demand, which has hit. And the pressure that puts on labor, management, the entire supply chain is incredible. And I think that that's one of the things that people don't appreciate is really holding this up because there's been a massive amount of capital committed from very, very large players, unprecedented amounts of capital. But all that capital goes to deliver and product. And the number of people delivering that end product, that industry is not large enough yet to do it. And these things don't happen overnight. And so I think what you're going to see in the next couple years, maybe next, you know, called 12 to 24 months, one of the themes I think is going to come up is delays in these things. You know, that for certain, but just based on, you know, what we're hearing and talking to people, I think it's highly likely that it will take longer for these things to come on board. So given what you said about those constraints, especially in the construction services part of this industry, is that an area where you guys are interested, especially in investing? Highly interested, in fact, that's one of the areas where for our SPAC, we're primarily interested in is, we think there's going to be a lot of opportunity and look, this is a lot of people have been doing this. We're not the only ones who see this opportunity, but, you know, in the services side of the business and those more people-oriented businesses that actually are the nuts and bolts that go into this. So kind of the picks and shovels, if you will, of the data center industry is we're looking from an investment standpoint. And we sort of referenced this earlier, but the whole speed to market thing, you know, you see it. My link did at least, you know, the algorithm must know what I'm interested, but the speed to market conversation is all over my link, then, and it's a complicated issue because it's not just about the supply constraints, you also have trade, like import export issues, all sorts of supply chain issues up and down the chain. Are there trade-offs that investors, you know, operators are being forced to make that they wouldn't be making five years ago? I think the biggest trade-off is, you know, there's pretty juicy margins if you can actually be a guy at the front of the line who can get something done. And so right now, I think you're seeing profitability of people who are in this ecosystem at really, you know, attractive rates for what they're actually doing. And I think that will change over a long period of time. But I think in the interim, you know, basic services that you would think was low margin businesses are now, you know, getting rates of return they haven't previously seen because they're valuable, they used to be commodity and they're not a commodity because there's not enough people who can do it. And so that's one area, that's the biggest trade-off I see is that, you know, is what people are willing to pay for certain things and the margin they're willing to give other providers for speed. So what people are willing to pay and what people are willing to give, are you seeing situations where people are over-promising and under-delivering? That's a hard question to answer because I don't think people are like misleading anybody. I remember when the renewable industry was growing rapidly and I had a part in that I actually co-founded a business called S-Power and we became, you know, very large. We ended up building, I don't know, one and a half gigawattes about operating projects and had a seven gigawatt pipeline and we used to laugh because people had, they called braggowattes, right? And they would basically claim they have all this stuff but most that never materialized, I think you have a lot of that, especially on the powered landside, but that's no different than any other developer, right, looking at the glasses half full and type of thing like that. people on the ground, you know, boots on the ground doing things are doing the best they can and they're giving, you know, when, you know, that's why I say I think I started seeing some delays because they're just not going to be able to get all the stuff done that they need to get done because this stuff just takes a certain amount of time, right? When you you mentioned all the stuff about people aren't even thinking about like, you know, the regulatory aspect of things, the trade aspect of things, you've got taxes, you've got tariffs, you've got moving regulations, you know, you've got supply chain issues and, you know, the people on the ground are dealing with it every day. I think that when somebody says, "Hamm, I'm going to do this," right, they say, "Oh, of course I can do this," here it is, but when everybody tries to do the same thing at once, someone's got a gift and that's really where I think the issue is. Yeah, I'm curious too from the capital markets perspective, where, what are underwriters focusing on right now? Yeah, I think this goes to the point Scott's making, right? There's obviously a huge opportunity in this, you know, this pressure cooker that's arise from the, you know, the lack of supply of critical skill and labor and execution to actually deliver this stuff, and that's where there's a lot of interesting things to be done at the same time. These smaller and lower market businesses that have all the sudden jumped a couple levels in the league table and scale have, you know, huge valuation expectations. And I think there's some danger there because, you know, the devaluation that I think some of these things are commanding and some people are paying for, you know, defending that required believing in the permanence of the scale they've got, you know, in their sites right now. And when you have big up cycles like this and people go really fast, inevitably, you know, not everybody holds at that threshold. I think as you go forward in time, the supply chains begin to figure themselves out. Just Scott's point, I think we'll take longer than you think. I think there's going to be, there's going to be real, some real winners and losers around where valuation gets struck today for things that have grown very fast and gotten big backlogs quickly versus where they end up three, four, five years ago. And I can't, that's hard, that's hard to add again, because again, you know, it's coming as well earlier. You have posted that want to play in the space, we want to play in the space. There's folks wanting to play sped, but it's really hard to defend some of these valuations when they got to go out and actually access you and live in the set of real world circumstances that are there. Yeah, one element that has been kind of difficult to predict and that keeps kind of evolving on a daily basis here is the regulatory friction and the community friction that these projects are encountering. We're seeing now local level elections being decided on the issue of whether or not some of these supports data centers. And interestingly, there are also reports coming out, including Bloodloop back in Bloomberg. Let me go over and I had something about this recently. They're saying that there's a lot of this course that's being created by effectively with our Chinese bots, with the goal of trying to slow down the growth of AI in the United States versus in China. And that's stirring up a lot of, you know, negative sentiment online that's been translating to communities like, what are your guys thoughts around this friction and the impact that it has on investment decisions and long-term growth? Sam, you raise a really good point, and I'm glad to raise because this is something which, you know, I've been in the back of my mind, you know, saying, you know, for a number of years now and I think it's going to, you know, come to fruition and that is that, you know, at the end of the day, the price of power is going to become a national strategic imperative and a national security issue. Because if you think about what drove the economies and the last several decades right, there was a labor trade, right? And if you think about electrification, automation, right, labor is no longer obviously the key input, right? And you want to bring manufacturing to this country, which I know is a big push here, obviously a lot of that's going to be automated, increasingly so. And so having the, having cheap electrons is going to basically become, you know, the key to being competitive on a worldwide stage. And so, you know, right now, I think that our country has a lot of competing, you know, forces in terms of policies that are actually hurting that. And at some point, I do think that, you know, the government's going to get more involved in some way, shape or form, to, by the way, I have no idea what form that's going to take. But I think that one of the things that I would expect is that there's going to be some massive government intervention and some way, shape or form to actually help with power prices and create cheaper power in the country. Now, how that happens and who wins in that argument of what form is anybody's guess right now? And, you know, unfortunately, America is a great country. I think our political system is a little bit in a quagmire right now. And I'm sure we'll figure it out. But it doesn't surprise me, you know, that you see this big turning in such a big issue where you'd have bots trying to slow us down from basically getting stuff done on this. It just goes to like how important this is going to be. And who's going to win is I think are going to be the countries that actually can produce power of the cheapest. Yeah, I, I fully agree. I want to talk a little bit about the XIP. I mean, you started this not very long ago. It seems like you guys are having a great success. What separates management teams that can skill a business like this? It's us away from those that kind of stalling. You're afraid to XIP? Yeah. Look, myself and my partner, Rob Stern, have all been, you know, in these industries for about 30 years now, right? And so we've, we've seen a lot of different things and like anything else, you know, experience and scar tissue and things, seeing things done sort of right and wrong helps. And then, you know, from there, it's just driven by people. And, you know, we're fortunate enough to actually had made a lot of really good contacts, a very talented people that we've been able to bring into this. And as a result, you know, we've been able to, you know, get a number of people who have worked with us in the past and who, you know, are trusting us to, you know, work with them now, you know, based on things we've done in the past. And that's given us a really good start is, is really, you know, having done, you know, good and successful work with, you know, other parties in the past. And having that, you know, essentially, you know, built-in business and contacts is really, really important. Makes sense. What do you guys see as, you know, the next big trend for the next three to five years that we can expect from this whole data-centered ecosystem? I hate to sound repetitive, but I think we touched on both of them. I think one is, is that things are going to not materialize as fast. And you're going to have winners and losers in that. And I do think that you're going to see a lot more government intervention to pave the way for this to actually to happen faster and combat some of the big constraints that exist right now. You know, if somebody asked me, you know, two things that I would expect, I would say, you know, especially over the next two to three years, I would say that. I also think the other theme that's going to come out is that, you know, there's a lot of, I think there's a lot of nasayers out there, you know, basically saying that, you know, maybe this is overhyped. And like we saw with, you know, lots of these other ways and the.com boom and everything else, right? It might have just been a little early, but it wasn't overhyped in terms of it's happening. I do think that the speed at which this technology starts to impact everything is going to be faster than people think. And so I think that the man for the infrastructure is going to be there. I think you're going to have winners or losers because not everybody's going to win, but I actually think that the need for the infrastructure and that scale, which seems kind of unprecedented, is going to look back and see that actually it was needed because of the use is going to be embraced so rapidly. Yeah, I think so, Scott, I think one of the themes I've been paying a lot of attention to recently, and we've looked at some stuff in this spaces, no matter what the type of computer or the size of the data center or any one of the particulars of input factors or circumstances, there's the area of technology and equipment and services that manage the flow of power, particularly volatile flows of power through high-voltage equipment through generating equipment through transmission distribution infrastructure at the site. That is probably the biggest technical problem we see, and I think there will be real winners in figuring out how to make that stuff, how to make that process easier to tolerate and more efficient, because the more that you can manage that specific technical problem, the ripple effects on what you need to power data center, how complex and how sort of how damaging wear and territories on the things you are using, how much balancing can either, there's sort of countless ripple effects of what happens if you can better versus not as good manage that part of the system. And so that's a super in the weeds sort of note, but there's a ton of money and technology chasing that. I think whoever figures out the next One or two or three mouse traps there is going to make a lot of money for a long time. I have no doubt it'll be you guys. I appreciate you being on the show. I appreciate you sharing your perspective and I look forward to continuing the discussion. Thank you very appreciate it. 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