Data centre boom drives surge in derivatives hedging activity
The data centre investment boom has been one of the main themes driving US financial markets this year as Silicon Valley has committed vast sums of capital to power its ambitions in artificial intelligence.
It’s also providing a fast-growing line of business for investment banks underwriting record amounts of debt for these mega projects, often paired with bespoke derivatives hedges.
Banks had financed at least US$72.8bn of public data centre loans this year as of September 24, according to PFI data, already 31% higher than last year’s total and up from just US$9.6bn in 2022. Banks have been able to supplement that rise in lending with an equally steep increase in derivatives sales as developers look for ways to manage the financing costs associated with these jumbo loans.
It's common practice for investors in infrastructure projects to use derivatives to fix the interest rates on their loans in advance of drawing them down. Many data centre developers are following the same playbook and adopting deal contingent derivatives as their financing hedge of choice, leading to a surge in activity.
“Data centre financings have grown considerably over the past year and should become among the largest sources of paper in the debt financing sphere. That’s led to a sharp increase in the need for deal contingent hedging,” said Gregg Geffen, head of North America corporate and private-side rates at JP Morgan.
“While the market has financed data centres for some time, the scale of the financings has grown considerably in the last 12 months. Data centre financings are quickly becoming one of the largest areas of deal contingent hedging,” he said.
Staggering sums
The staggering sums of capital that tech firms and investors are mobilising to power the expansion of AI is without precedent in recent history. Morgan Stanley forecasts around US$3trn will be spent on data centres between 2025 and 2028, with around half expected to come from debt markets.
Institutional investors are joining banks in ramping up their financing of these projects. Meta Platforms, for instance, has reportedly tapped bond giant Pimco to lead a US$26bn debt financing for data centre projects.
Only banks can provide the derivatives that many lenders need to lock in interest rates on these mammoth, floating-rate loans, however, and thereby shield themselves from a potential rise in financing costs further down the road.
The typically long-dated debt backing infrastructure projects such as data centres often stretches into the decades. That, combined with the sheer size of the loans, means developers are vulnerable to any move higher in interest rates that could increase their debt repayments. Lenders, as a result, often require a significant amount of this debt to be hedged as a precondition for providing the financing.
“These loans are very big and long-dated and therefore interest rate volatility can have a massive impact on the developer’s business plans,” said Antoine Jacquemin, global head of fixed income and currencies sales for corporates at Societe Generale. “If the developer knows they will have to hedge no matter what on deal completion, they might want to take a significant portion of this risk out of the equation as quickly as possible.”
The perfect hedge
Deal contingent hedges have long been favoured by investors and companies looking to protect themselves against changes in funding costs or foreign exchange rates between the time a corporate event is announced, such as a merger or acquisition, and when it completes. The best part for the buyer of the derivatives – and the riskiest feature for the banks selling them – is that the client can walk away without paying for their hedge if the underlying transaction falls through.
Once associated primarily with M&A, deal contingents have become increasingly popular on infrastructure and real estate projects as investors have looked to lock in the economics on their transactions. Jacquemin said the heightened uncertainty over long-term interest rates – with yields this year sometimes swinging more than 10bp in the space of a day – has also shown clients the value of these products.
“The client is paying a few extra basis points to lock in interest rate levels in advance without running the risk that if, for some reason, the deal doesn’t close then you’re committing to a long-term derivative,” he said. “You sometimes see the market move more than that in the space of a single trading day.”
For projects like data centres, the underlying interest rate swap will become active once the developer draws down on the loan. That dynamic can make these derivatives less risky for the banks that sell them than, for example, a deal contingent on a public M&A transaction that can fall through if it fails to secure the necessary regulatory and shareholder approvals.
These contracts nevertheless present a different set of risks for banks and require a detailed understanding of the processes surrounding the underlying projects. Mark Beaumont, head of European risk management at advisory firm PMC Treasury, said banks will often require longer lookback periods to protect themselves “against borrowers deliberately delaying the closing of the loan facility to secure better terms on their rates hedge”.
Many expect the market to continue to grow, given the enormous amount of data centre investment in the pipeline. Benoit Duhil de Benaze, managing director for hedging and capital markets at advisory firm Chatham Financial, said demand for data centre capacity is expected to triple by 2030 from current levels.
"That is a huge amount of financing and capital that needs to be deployed that will come with an equally large amount of interest rate risk that needs to be hedged,” he said.
