Leveraged Breakdowns

Case Study: Blackstone Acquisition of QTS Realty Trust

Summary/Transaction Details

On June 7th, 2021, public data center REIT QTS announced that it had agreed to be acquired by Blackstone for $78 per share cash in a take-private deal. The $78 price represents a 21% premium to the stock price at the prior close and a 24% premium to the 90-day volume weighted average stock price. The acquisition values the total company at roughly $9 billion, excluding transaction costs and expected capital expenditures prior to deal close. The deal is structured with a 40-day “go-shop” period, where QTS has the right to solicit competing bids for the company through July 17th, 2021. Assuming that no competing bids emerge, QTS shareholders would vote on the deal and the deal would close in the second half of 2021.

A privatization of a public REIT is almost always a positive outcome for shareholders, as is the case here. Public REITs tend to get acquired for 10%-25% premiums to their publicly-traded values at the time. In this case, QTS is being acquired for a 20%+ premium and a price that is higher than its prior peak trading price of $72 per share. With REIT M&A, there tends to be considerable focus on a deal initially from the perspective of current shareholders, including whether the deal price is fair, what it means for private-market values, and which peers might get acquired next.

But what is not focused on as much is the deal from the perspective of the buyer, in this case real estate private equity firm, Blackstone. Reasons for this include 1) upon a deal announcement, public shareholders tend to sell the stock quickly and move on, 2) there often isn’t much disclosure upon a deal announcement, and 3) assuming the buyer is a private firm, the acquired company doesn’t have much relevance to market participants going forward.

We used the QTS acquisition announcement as real-time case study, reviewing the deal from the perspective of the buyer, Blackstone. We shine some light on the deal through examining the following topics, below:

  • Likely rationale for the deal
  • Estimated returns to Blackstone
  • What happens next?

Likely Rationale for the Deal

  1. Data Center sector fits well with Blackstone’s thematic-driven approach to investing

Blackstone’s real estate investments over the last cycle have been very thematic-driven. This is in part because they are so big and cannot afford to hunt for smaller, mispriced assets. Rather, they are more efficient putting out large amounts of capital by identifying macro themes that will positively affect real estate values over the next 5-10 years and paying a fair market price today. Over the last cycle, Blackstone has made big bets on the industrial and lab office sectors, two areas of the real estate market with strong secular tailwinds (industrial demand driven by e-commerce and lab office demand driven by rising R&D spending). For a deeper dive on the industrial sector, check out our Industrial Sector Series post here. One secular growth area that Blackstone has not been as active in is digital infrastructure and specifically, data centers. The QTS acquisition fills that gap for Blackstone, and also fits in nicely with their thematic-driven approach to investing.

More specifically, the data center industry is supported by the following secular tailwinds:

  • Long-term trend of enterprises outsourcing data storage to third-party data center companies (i.e. transitioning from company-owned servers to “storage as a service”)
  • Increasing adoption of the cloud for data storage and compute needs
  • Steadily increasing production and consumption of data globally
  • Increasing amount of connected devices globally (both people and also the “internet of things”)

All of these themes support demand for data storage and data center real estate. For a deeper dive on data centers including the macro demand drivers, check out our Data Center Sector Series post here.

  1. QTS is a high-quality asset that has historically been undervalued by the public market

QTS is the smallest public data center REIT, but has a strategic portfolio with some key advantages. A few years ago, QTS re-organized its business segments and got out of a problematic managed services business. Since then, QTS has organized its business around three main segments:

  • Hybrid Colocation
  • Hyperscale
  • Federal Government

Hybrid colocation is the largest segment, serving a well-diversified group of medium-to-large sized enterprises. This is a very steady segment producing average returns on capital. The hyperscale segment services mega-enterprises that sign the largest and longest-term leases on the market, sometimes occupying entire buildings. Hyperscale is the fastest-growing segment for QTS, but also yields the lowest returns on capital. The government segment is the smallest segment but also has the highest barriers to entry and yields the highest returns on capital (fewer competitors due to government data security issues). QTS’ blended segment approach has led to consistent and strong quarterly leasing results with minimal churn over the last couple of years.

QTS has further differentiated itself by developing a best-in-class software application that allows customers to easily interact with and control their data infrastructure without physically going to the data center. This was an industry “nice-to-have” pre-COVID that quickly became an industry “need-to-have” post-COVID. This point of differentiation vs. peers has helped QTS win more business and maintain pricing power, resulting in faster leasing growth and higher margins.

QTS has also focused more on future growth than peers, spending significant amounts of capital in recent years to build out a land bank and a future development pipeline. QTS has given up some short-term FFO/share growth in the process, but for a long-term oriented investor like Blackstone, this is a positive. Lastly, QTS scores very high marks around its ESG initiatives vs. peers in the data center space, something that is becoming increasingly important to clients and investors.

Because of its smaller size and higher leverage, QTS has rarely commanded a premium valuation when compared to its public data center peers. Size and leverage are issues that do not matter as much in the private market, resulting in an opportunity for Blackstone to acquire the company.

  1. QTS provides Blackstone a platform for future growth

The data center sector is not an area that traditional real estate private equity firms have been heavily involved in historically. This is mainly because it’s a specialized sector that is more operationally-intensive than other types of core commercial real estate. Thus, it’s important to have operational expertise or partner with someone who has expertise before entering the sector. Blackstone is acquiring a platform in QTS, and has plans to keep the senior management team and employees in-place post-acquisition. Similar to what Blackstone did with Gramercy Property Trust in the industrial sector several years ago, Blackstone will likely use the QTS platform as an operational base in the data center sector from which to expand upon.

Estimated Returns to Blackstone

In order to estimate pro-forma returns to Blackstone, we built a simple 5-year IRR model with projected future growth, margins, and terminal value. We assume that Blackstone will add significant leverage to the capital structure, as is typical when REITs go private (generally, the public market does not tolerate as much debt as the private market). Blackstone will likely use its size and cost of capital advantage to achieve favorable debt terms. Blackstone will then use the debt proceeds, along with future capital injections, to fund future development growth. This will result in healthy top-line growth and even higher bottom-line growth after factoring in leverage.

The analysis results in attractive estimated returns, detailed below (note that we also make available an Excel model with further detail to subscribers of the site):

  • Unlevered IRR: 8.7%
  • Levered IRR: 13.1%
  • Levered IRR with an upside exit value: 16.5%

The initial cash-on-cash return is on the lower side, estimated at a little more than 3%, but after a couple of years of growth and added debt, Blackstone should be able to get this number up to ~6%. The estimated 5-year unlevered and levered IRRs are attractive, especially given the upside optionality of a sector with strong secular tailwinds.

In reality, Blackstone will probably hold the asset in perpetuity, given that it is buying QTS into its perpetual-life funds, Blackstone REIT (BREIT) and Blackstone Infrastructure Partners. But for the purpose of modeling, we assume a terminal value in year 6, in order to compute an IRR.

What Happens Next?

After the 40-day go-shop period expires on July 17th, 2021, QTS will publish a preliminary proxy filing that details the transaction, including the order of events leading up to the deal. After the SEC reviews this proxy and provides comments, the QTS will address the comments, publish a final proxy filing, and begin the shareholder solicitation process. The company will then schedule a shareholder vote and QTS shareholders will vote on the deal. Assuming a majority of shareholders vote in the affirmative, the deal will proceed to closing which will occur in the second half of 2021. After closing, Blackstone will likely work with the QTS senior management team to refinance and increase the amount of debt in the capital structure, and lastly, get to work on future growth initiatives.

Conclusion

When public REIT privatizations happen, there’s generally a lot of focus on the deal from the perspective of the sellers, or the company shareholders, but not as much attention paid to the deal from the perspective of the buyer. Using the QTS acquisition as a case study, we consider the deal from the perspective of the buyer, in this case, Blackstone. We review the likely motivations for the deal, model estimated returns, and detail the steps following the deal announcement. Since this deal is happening in real-time (currently in the “go-shop” period), there may be future events to consider, in which case we’ll provide additional updates along the way.

Looking to learn more? Why not check out our educational resources! Whether you’re yet to begin a formal real estate private equity interview process or are crunching through real estate private equity interview questions at the last minute, we have what you need. All you need to bring is your effort.

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