DLR: Reading between the Lines for Signs of Risk

After the high tides of the dot-com era receded, revealing that many companies – from a corporate governance standpoint – had been “swimming naked,” the mantra among corporate general counsels has been “full disclosure.” 

As corporate bromides go, this is a palatable one. Among other things, it provides that investors be given all available information on the relationships between a corporation’s officers and directors and the companies they do business with. But that is not to say it’s perfect.

For example, an investor reading Fannie Mae’s 2003 proxy statement would, around page 30, discover this: Ken Duberstein, a board member and Republican political arm twister, had spent the previous 11 years providing “consulting services” to the company, with his most recent fees totaling $375,000. Yet, when the deluge came in 2004, investors seemed totally caught off guard.

This brings to mind Digital Realty Trust (NYSE: DLR), a San Francisco company that has been a darling of Wall Street for some time now. Digital Realty is a real estate investment trust that owns properties where large corporations in the U.S. and Europe store their data-backup and Internet networking equipment. The company’s reported results truly look quite handsome.

A walk through Digital Realty’s filings reveals something interesting, however: There is not a whole lot separating a San Francisco private-equity shop called GI Partners from Digital Realty itself. 

GI’s general partner, Rick Magnuson, is also the chairman of Digital Realty. Indeed, GI -- which stands for Global Innovation -- formed Digital in 2002 and had a large equity position even after the company’s 2004 initial offering. (GI sold off the last of that stock at the end of 2007.) 

GI’s management ranks virtually shuttle between the firm’s offices in Menlo Park and Digital Realty’s offices on Mission Street in San Francisco. Digital Realty’s CEO, CFO, head of acquisitions and head of corporate development all worked at GI or its operating partners. On a daily basis, every decision of consequence made about Digital Realty is carried out by a GI alum. 

In an email response to questions for this story, however, Digital denied any active connection to GI that extends beyond that involving Magnuson alone. 

The situation is rather complex. GI also owns the telx Group, Digital Realty’s sixth-largest customer, which provides equipment and space for corporations’ Internet network-connection equipment. Therefore, in a sense, telx is a smaller version of Digital Realty itself. (Jennifer Sauer, the marketing chief at telx, did not return a phone call seeking comments for this story.)

The nexus between GI, Digital Realty becomes clear when examining their business activities. For starters, GI acquired telx in November of 2006 and -- less than one week later -- Digital Realty announced agreements with telx to lease 10 facilities in the U.S. Moreover, based upon regulatory filings, GI should have little reason to worry in the future that Digital Realty’s management or board will act against its – as opposed to, say, for its own shareholders’ – best interests.

Specifically, Digital Realty’s latest 10-K states the following: We may pursue less vigorous enforcement of terms of certain agreements because of conflicts of interest with GI Partners. GI Partners and its related fund own a property on which we have a right of first offer. GI Partners Fund II, LLP, or GI Partners II, owns The tel(x) Group, an operator of “Meet-Me-Room” network interconnection facilities that leases 87,305 square feet from us under ten lease agreements. Richard Magnuson, the Chairman of our board of directors, is and will continue to be the chief executive officer of the advisor to GI Partners and GI Partners II. In the future, we may enter into additional agreements with The tel(x) Group or other companies owned by GI Partners or GI Partners II or other GI Partners funds. We may choose not to enforce, or to enforce less vigorously, our rights under these agreements because of our desire to maintain our ongoing relationship with GI Partners and Mr. Magnuson.

GI, as an owner, has not been shy about recouping its investment. According to telx Group’s S-1 filing (a pre-initial public offering document), through the quarter ended March 31, GI has taken $70.28 million in preferred dividends out of telx since 2007. Given that GI purchased telx in November of 2006 for $213 million, the firm has already recovered almost one-third of its original investment. (GI collects a $750,000 management fee from telx as well.)

In its pending IPO, via Goldman Sachs (NYSE: GS), telx seeks to raise $100 million and still leave GI as the majority shareholder of the company. So far, there has been no official date or price set for the offering. A GI representative declined all comment on telx.

Meanwhile, the deals already established between Digital Realty and telx structurally favor the first company. According to regulatory filings, telx rents about 1% of Digital Realty’s square feet but accounts for about 3.2% of the company’s annualized rent. Moreover, telx has locked itself into a lease agreement that – at 17 years – represents the longest lease of any executed by Digital Realty’s top 20 customers by far. For telx, Digital Realty has also become the landlord of choice, since the REIT owns 10 of the 14 properties where the company stores its equipment.

Other issues stand out at Digital Realty as well. Despite the company’s generous compensation packages – CEO Michael Foust earned $3.6 million last year, while CFO Bill Stein took home more than $2 million – Digital Realty insiders treat stock-selling almost like a lucrative pastime. (One of those insiders, director Kathleen Earley, also doubles as a director at Digital Realty client Switch & Data Facilities Company.) Over the course of the past two years, Digital Realty insiders have sold more than 1.63 million shares – or 2.1% of the shares outstanding – in the company. With 866,000 shares left, Magnuson currently ranks as the largest inside holder of the bunch.

Some experts believe that insider sales actually tell a lot less than do insider buys. At Digital Realty, however, insiders do not buy any stock. For this company, stock is currency – pure and simple.

This matter brings up yet another issue: Digital Realty is basically a share-issuing machine. The company has almost quadrupled its share count, from 21 million to 78 million, since going public less than six years ago. 

Still, that number could keep on climbing higher. In recent months, Digital Realty has proposed a new equity-sales approach dubbed ATM (short for At-The-Market) that would allow the company to sell up to $400 million worth of stock when market conditions allow. Utilizing this approach, which is faster than a traditional offering, Digital Realty sold 1.1 million shares of stock during the first quarter of this year. By doing so, the company bypassed not only the regular underwriting process but also the mounting shareholder questions that normally surface about the timing of equity raises. 

Granted, as a REIT, Digital Realty cannot realistically retain enough of its earnings to post the kind of organic growth that often fuels more traditional stocks. As a result, the company must rely upon the capital markets for its growth instead. Nonetheless, this much appears to be clear: Digital Realty will be issuing plenty of shares – and adding on no small amount of debt – in the future.

Despite everything, Wall Street absolutely loves Digital Realty. Of the 13 research firms following the company, 10 have some version of a “buy” recommendation on the shares. Whether the cycle turns for Digital Realty or not, Wall Street – which certainly respects the company’s demonstrated ability to generate fees – will be sponsoring the bullish story for a good long while.

This brings us back full circle to the Fannie Mae example. That long-ago disclosure, noting that a Washington insider was paid $375,000 to keep tabs on the right wing’s growing concern over the company’s growth – in addition to the hundreds of thousands of dollars in director’s fee he received – was indeed a sign, albeit a distant one. Basically, it sent the message that Fannie May’s management viewed the realm of back-room turf fights and brokered political negotiations as central to its existence. 

Duberstein almost certainly knew nothing about pass-through securities or the asset-backed securities market when he joined the board in 1998. He did, however, know which buttons to press to kill legislation or how to artfully stroke a key lawmaker’s ego.

In a way, perhaps the same holds true with Digital Realty (which, to be fair, clearly appears to suffer from none of the accounting or management problems that plagued Fannie Mae). After all, according to regulatory filings, precious little separates the interests of Digital Realty, GI and telx. To date, at least, that arrangement has worked out rather well for everyone involved. And if a situation ever arises in which the interests of Magnuson and GI diverge from those of the company, at least shareholders received a sign – even if, in the end, it was a hazy one.