What data centre construction delays mean for debt holders

America has been booming, at least in part because of all the economic activity caused by data centre construction. But, as Oracle has been finding out, there’s a big difference between starting construction of a data centre and finishing one.

Increasingly, execution risk matters for the bondholders who’ve gone out on a limb to finance these things. Behold this stunning map of current and planned data centres in the US, courtesy of clever MainFT colleagues:

The red bubbles are completed data centres. There are a lot of them, but they’re all pretty small. The biggest dots on the map — the mega data centres, some the size of Manhattan — are turquoise. And this signifies that they’re either still on the drawing board or are in the process of being built.

And data centres that are being built can . . . stop being built. Holes in the ground are not known for throwing off the kind of cash needed to service the debt raised to finance their construction, so delays don’t sound great.

And community backlash against data centre construction is becoming an ever bigger deal because, as Chris Mooney, an analyst at S&P Global, puts it:

. . . concerns include energy costs, power grid strain, water scarcity, air pollution, noise pollution, and disruption of natural resources. Data centres have also become a focal point for broader social impacts around AI, as the physical location of servers and chips.

. . . concerns include energy costs, power grid strain, water scarcity, air pollution, noise pollution, and disruption of natural resources. Data centres have also become a focal point for broader social impacts around AI, as the physical location of servers and chips.

A series of statewide moratoriums have now been imposed in places like Texas and New York to pause permits and grid connections for new projects and pause all discretionary environmental permits respectively. Moreover, local government bans have been enacted across 40 states and over half of state legislatures have legislation or pending legislation tackling data centre-related issues, according to the rating agency.

S&P Global counts 146 delayed or cancelled projects, with three quarters of them explicitly tied to local opposition. Here they all are:

S&P Global bothers to keep track of this stuff because one of the biggest risk to data centre credit ratings would be severe construction delays. And that’s precisely what S&P is increasingly seeing, it said in a recent report:

Most projects have financial penalties including rent credits and tenant termination rights for milestone delays, which could substantially deteriorate credit if exercised. . . Moratoriums and other policy shifts can trigger a cascade of credit risks, including cost overruns, revenue shortfalls, and liquidity strain. In the most extreme scenario, they may also lead to tenant termination rights.

Most projects have financial penalties including rent credits and tenant termination rights for milestone delays, which could substantially deteriorate credit if exercised. . .

Moratoriums and other policy shifts can trigger a cascade of credit risks, including cost overruns, revenue shortfalls, and liquidity strain. In the most extreme scenario, they may also lead to tenant termination rights.

Not great. But as anyone who has had a new bathroom fitted will know, construction delays are not exactly uncommon. So most standalone data centre construction projects have a debt service reserve account buffer to deal with setbacks lasting three to six months.

Investors Alphaville spoke to were pretty relaxed about the credit impact of short hold-ups. Edwin Wilches, co-head of securitised products at PGIM said that “if the delay is three months, it’s within reason. If you thought you had governmental approval or electricity and no longer do, this is a much bigger deal. It’s all quite idiosyncratic.”

Capacity under construction and fully-permitted is typically out of reach of development moratoriums, so government rug pulls are off the table for those projects, at least for now. But still, tenant termination rights that accrue from delays stretching just a bit too long are the big kahuna of data centre developer risk.

Here’s what S&P Global’s Mooney told us, with Alphaville’s emphasis in bold:

If a termination right were triggered and exercised, it would cause significant credit stress to the issuer and could even result in a default. A data center developer would need to find a replacement tenant on similar terms. This would depend on market conditions, location, and asset quality. It could also require a costly redesign if the new tenant has different power and rack density requirements. In many cases, the project may not have sufficient liquidity to absorb such circumstances.

If a termination right were triggered and exercised, it would cause significant credit stress to the issuer and could even result in a default. A data center developer would need to find a replacement tenant on similar terms. This would depend on market conditions, location, and asset quality. It could also require a costly redesign if the new tenant has different power and rack density requirements. In many cases, the project may not have sufficient liquidity to absorb such circumstances.

Right now it looks like there’s a shortage of compute, so any tenant exercising their termination rights can probably be subbed out for another. But credit investors are a sceptical bunch, whose investment upside is limited to the timely repayment of principal and interest. They care about all possible futures, particularly those in which they’re not made whole.

As Lofti Karoui, a multi-asset strategist at Pimco, told Alphaville:

. . . the biggest risk as a debt investor is that you end up in a world where there’s over-investment and that today’s compute shortage flips in the other direction. Where, four years from now, there is more supply and not enough demand for compute.

. . . the biggest risk as a debt investor is that you end up in a world where there’s over-investment and that today’s compute shortage flips in the other direction. Where, four years from now, there is more supply and not enough demand for compute.

As such, it’s all about getting into the weeds of the docs, understanding the cavalcade of execution risks, and working out who’s left holding the bag in the bad scenario. Unfortunately, we’re told that the docs vary wildly. Here’s an indication from the S&P report:

As the table above shows, penalties for delays vary by project, kicking in at different times, and culminating in differing termination rights.

Force majeure clauses appear in most commercial contracts, but S&P analysts poring through data centre deal docs have found “no standard definition”. That means that the credit impact of the same kind of delay at four different projects could have very different consequences for each set of creditors.

Moreover, there are usually three parties to a data centre build: the contractor, the developer and the tenant. Permitting risk is usually the developer’s risk, and permitting delays could trigger force majeure clauses not only among tenants, but also constructors. However, rent credit extensions might exist in contracts that protect the developer if, say, they result solely from power connectivity.

When a force majeure clause is triggered, something has obviously gone wrong. But this wrong thing could turn out to be credit positive for a tenant and negative for a developer, or maybe vice versa. Analysing all this stuff takes a tonne of resources — drawing on real estate, technology, energy, utility and legal expertise — which is maybe one reason data centre debt deals have offered a so-called complexity risk premium.

When you’ve set out to build city-sized mega-projects there are a lot of things that can go wrong. Something invariably will. But when you’re debt-financing a build-out — and haven’t got it swaddled with guarantees from a fortress balance-sheet hyperscaler — it’s the creditors who will ultimately be on the hook if too many things go wrong at once.

And as pricing of loans attached to the development of the giant Project Jupiter site attests, there’s real money at stake when the rubber hits the road:

Further reading:
— America’s $10tn AI infrastructure boom is starting to fray (MainFT)
— Investors dump data centre bonds as AI borrowers face ‘Darwin moment’ (MainFT)
— Texas puts a brake on its data centre boom (MainFT)