Funding the Next Phase of AI Development

Summary

Thoughts on the Market: Funding the Next Phase of AI Development

Hosted by Lindsey Tyler and Michelle Wang | Released on March 6, 2025

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Introduction

In the March 6, 2025 episode of Thoughts on the Market by Morgan Stanley, host Lindsey Tyler engages in an insightful discussion with Michelle Wang, Head of Investment Grade Debt Coverage in Global Capital Markets. Recorded live at the Morgan Stanley Technology, Media, and Telecom (TMT) Conference in San Francisco, the conversation delves into the evolving landscape of technology within the investment grade market, with a particular focus on funding the next phase of Artificial Intelligence (AI) development.

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Growth of Technology in the Investment Grade Market

Lindsey Tyler sets the stage by highlighting the significant growth of the technology sector within the investment grade market:

"Technology has grown from about 2% of the broader investment grade market about two decades ago to almost 10% now" (00:45).

Michelle Wang explains the historical underrepresentation of technology in investment grade debt:

"Technology is still a relatively young industry... investment grade debt is by definition a later-stage capital raising tool" (01:00).

She attributes the recent growth to two main factors:

1. Organic Maturation: As the tech industry matures, more companies achieve the scale and cash generation required for investment grade ratings.
2. Increased Use of Debt: Technology firms are leveraging debt as a cost-effective means to fund growth initiatives such as Research and Development (R&D), capital expenditures (capex), and mergers and acquisitions (M&A).

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Current View on Technology Credit

Lindsey Tyler shares her outlook on technology credit for the year, adopting a neutral stance amidst caution in the communications and media sectors:

"My view for this year on technology credit is a more neutral one. Against the backdrop of being more cautious on the communications and media space." (01:54).

She points out concerns regarding spread compression and the lack of market dispersion, emphasizing that financial policies related to investment, M&A, and shareholder returns will significantly influence credit spreads.

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AI Capex and Capital Expenditure Trends

The conversation shifts to the central theme of AI and its capital requirements. Michelle Wang provides a comprehensive overview of hyperscaler capital expenditures (CAPEX):

"In the past three years, total hyperscaler CAPEX has increased from $125 billion three years ago to $220 billion today and is expected to exceed $300 billion in 2027." (03:11).

She elucidates that hyperscalers are channeling these investments into digital infrastructure to support generative AI, citing their robust financial positions:

• Combined market capitalization: $9 trillion
• Balance sheet cash: $70 to $100 billion per company
• Annual free cash flow: $30 to $75 billion

Although these firms can fund a portion of their CAPEX organically, the unprecedented scale of AI investments raises the likelihood of external capital raising.

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The Rise of Private Credit and Bespoke Funding Solutions

Michelle Wang explores the avenues through which technology companies are raising capital, highlighting the emergence of private credit as a preferred alternative:

"Private credit pocket of capital driven by large pockets of insurance Capital is now north of $2 trillion and it has increased 10x in scale in the past decade." (05:17).

Key points include:

• Investment Grade Bond Deals: The conventional method for raising capital.
• Customized Funding Solutions: Tailored financing options that offer benefits such as favorable accounting treatments and specialized asset-level financing.
• Private Credit Advantages: Yields that are typically 150 to 200 basis points higher than traditional investment grade bonds, making them attractive for yield-enhanced investments.

The demand for such capital is driven by two megatrends in technology:

1. Semiconductors: The capital-intensive nature of building chip factories necessitates substantial investment.
2. Generative AI: The creation of data centers and digital infrastructure to support AI advancements requires significant financial outlay.

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Investor Perspectives on Customized Capital Solutions

Transitioning to the investor viewpoint, Lindsey Tyler emphasizes the importance of clear communication and understanding when it comes to complex financing deals:

"With deals that have this touch of extra complexity, it does feel that investor communication and understanding is all important." (07:12).

She highlights several critical factors for investors:

• Spread Pickup: The additional yield offered by private credit compared to traditional bonds.
• Insurance Capital: The substantial capital held by insurance firms acting as asset managers.
• Ratings Implications: How different financing structures impact credit ratings.
• Deal Terms: The specific conditions and covenants associated with bespoke financing solutions.

These elements are crucial for investors to assess the viability and attractiveness of customized capital deals.

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The Macro Environment and Its Impact on Funding Decisions

The discussion then moves to the broader macroeconomic environment and its implications for technology funding. Michelle Wang outlines three key components:

1. Rate Moves: Recent decreases in treasury yields by 50 to 60 basis points make debt issuance more attractive (08:04).
2. Credit Spreads: Maintaining tight spreads reflects the resilience of the investment grade investor base.
3. Uncertainty: Persistent uncertainty, particularly regarding regulatory issues and market conditions, influences corporate decision-making.

Lindsey Tyler adds that the regulatory landscape, especially concerning M&A activities under the new administration, adds another layer of complexity:

"Whether or not companies will make the move to maybe be more acquisitive with the current new administration." (08:39).

Michelle Wang further comments on corporate behaviors in uncertain times:

"Risk-off sentiment usually translates into lower treasury yields and more favorable cost of debt... companies will raise rainy day liquidity and park it on balance sheet." (09:44).

This behavior ensures that companies maintain adequate liquidity to navigate potential downturns, thereby driving debt issuance volumes even in uncertain environments.

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Conclusion and Key Takeaways

In wrapping up the conversation, Lindsey Tyler expresses gratitude for the insightful discussion:

"Appreciate all your insights... Thank you for taking the time, Michelle, to talk during such a busy week." (09:59).

Michelle Wang reciprocates the sentiment, underscoring the value of the dialogue.

Key Takeaways:

• Technology's Growing Role: From 2% to nearly 10% of the investment grade market over two decades, driven by industry maturation and strategic use of debt.
• AI as a Catalyst: Significant capital investments in AI infrastructure are propelling the need for diverse funding solutions.
• Private Credit's Ascendancy: Customized financing options are becoming increasingly relevant, offering higher yields and tailored terms to meet the unique demands of tech companies.
• Investor Considerations: Clear communication and thorough understanding of complex deals are essential for investor confidence and participation.
• Navigating Uncertainty: Companies are strategically raising capital and maintaining liquidity to mitigate risks associated with macroeconomic and regulatory uncertainties.

This episode provides a comprehensive overview of the intersection between technology advancements, particularly in AI, and the evolving mechanisms of funding within the investment grade market.

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Timestamps

• 00:02: Introduction by Lindsey Tyler
• 01:00: Growth of technology in investment grade market
• 01:54: Lindsey's view on technology credit
• 03:11: AI capex and capital expenditure trends
• 04:49: Rise of private credit and bespoke funding solutions
• 07:12: Investor perspectives on customized capital solutions
• 08:04: Macro environment and its impact
• 09:44: Corporate strategies in uncertain environments
• 09:59: Conclusion and key takeaways

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This summary is intended to provide a comprehensive overview of the podcast episode "Funding the Next Phase of AI Development" from Thoughts on the Market by Morgan Stanley. For the full discussion, listeners are encouraged to access the original podcast episode.

Transcript

[Lindsey Tyler]

Welcome to Thoughts on the Market. I'm Lindsey Tyler, Morgan Stanley's lead investment grade TMT credit research analyst and I'm here with Michelle Wang, head of investment grade debt coverage in global capital markets. On this special episode we're recording at the Morgan Stanley Technology, Media and Telecom conference and we will discuss the latest on the technology space from the fixed income perspective. It's Thursday, March 6th at 12:00pm in San Francisco. What a week it's been. Last I heard, we had over 350 companies here in attendance. To set the stage for our discussion, Technology has grown from about 2% of the broader investment grade market about two decades ago to almost 10% now, though that is still relatively a small percentage relative to the weightings in the equity market. So can you address two questions? First, why was tech historically such a small part of investment grade? And then second, what has driven the.

[Michelle Wang]

Growth since technology is still a relatively young industry? Right. I'm in my 40s and well over 90% of the companies that I cover were founded well within my lifetime. And if you add to that the fact that investment grade debt is by definition a later stage capital raising tool, when the business of these companies reaches sufficient scale and cash generation to be rated investment grade by the rating agencies, you wind up with just a small subset of the overall investment grade universe. The second question on what has been driving the growth twofold. Number one, the organic maturation of the tech industry results in an increasing number of scaled investment grade companies. And then secondly, the increasing use of debt and as a cheap source of capital to fund their growth. This could be to fund R and D or capex or in some cases M and A.

[Lindsey Tyler]

Right. And I would just add in this context that my view for this year on technology credit is a more neutral one. And that's against the backdrop of being more cautious on the communications and media space. And part of that is just driven by the spread compression and the lack of dispersion that we see in the market. And you mentioned M and A and capital allocation. I do think that financial policy and changes there, whether it's investment, M and A shareholder returns that will be the main driver of credit spreads. But let's turn back to the conference and on the, you know, I mentioned investment. Let's talk about investment. AI has dominated the conversation here at the conference the past two years and this year is no different. Morgan Stanley's research department has four key investment themes. One of those is AI and tech diffusion. But from the fixed income angle there is that focus on ongoing and Upcoming hyperscaler AI capex needs. There are significant cash flows generated by many of these companies. But we just discussed that the investment grade tech space has grown relative to the index in recent history. Can you discuss the scale of the technology capex that we're talking about and the related implications from your perspective?

[Michelle Wang]

Let's actually get into some of the numbers. So in the past three years, total hyperscaler CAPEX has increased from 125 billion three years ago to 220 billion today and is expected to exceed 300 billion in 2027. The hyperscalers have all publicly stated that generative AI is key to their future growth aspirations. So why are they spending all this money? They're investing heavily in the digital infrastructure to propel this growth. These companies, however, as you've pointed out, are some of the most scaled, best capitalized companies in the entire world. They have a combined market cap of 9 trillion among them. Their balance sheet cash ranges from 70 to 100 billion per company and their annual free cash flow. So the money that they generate organically ranges from 30 to 75 billion. So they can certainly fund some of this capex organically. However, the unprecedented amount of spend for Gen raises the probability that these hyperscalers could choose to raise capital externally.

[Lindsey Tyler]

Got it.

[Michelle Wang]

Now how this capital is raised is where it gets really interesting. The most straightforward way to raise capital for a lot of these companies is just to do an investment grade bond deal.

[Lindsey Tyler]

Yep.

[Michelle Wang]

However, there are other more customized funding solutions available for them to achieve objectives, like more favorable accounting or rating agency treatment, ways for them to offload some of their capex to a private credit firm, even if that means that these occur at a higher cost of capital.

[Lindsey Tyler]

You touched on private credit. I'd love to dig in there. These bespoke capital solutions, I have seen it in the semiconductor space and telecom infrastructure. But can you please just shed some more light? Right. How has this trend come to fruition? How are companies assessing the opportunity and what are other key implications that you would flag?

[Michelle Wang]

Yeah. For the, for the benefit of the audience, Lindsey, I think just to touch a little bit more some definition around what we're talking about.

[Lindsey Tyler]

Yes.

[Michelle Wang]

So the. I think what you're referring to is investment grade companies doing asset level financing, usually in conjunction with a private credit firm. And like all financing trends that came before it, all good financing trends, this one also resulted from the serendipitous intersection of supply and demand of capital on the supply of capital, the private credit pocket of capital driven by large pockets of insurance Capital is Now north of $2 trillion and it has increased 10x in scale in the past decade. So the need to deploy these funds is driving these private credit firms to seek out ways to invest in investment grade companies in a yield enhanced manner.

[Lindsey Tyler]

Right. And typically we're saying 150 to 200 basis points greater than what maybe an IG bond would yield.

[Michelle Wang]

That's exactly right. That's when it starts to get interesting for them. Right. And then the demand of capital, the demand for this type of capital that's always existed in other industries that are more asset heavy like telcos. However, the new development of late is the demand for capital from tech due to two megatrends that we're seeing in tech. The first is semiconductors. Building these chip factories is an extremely capital intensive exercise, so creates a demand for capital. And then the second megatrend is what we've seen with the hyperscalers and generative AI needs. Building data centers and digital infrastructure for generative AI is also extremely expensive. And that creates another pocket of demand for capital that private credit conveniently kind of serves a role in.

[Lindsey Tyler]

Right.

[Michelle Wang]

So look, I think we've talked about the ways that companies are using these tools. I'm interested to get your view, Lindsey, on the investor perspective.

[Lindsey Tyler]

Sure.

[Michelle Wang]

How do investors think about some of these more bespoke solutions?

[Lindsey Tyler]

I would say that with deals that have this touch of extra complexity, it does feel that investor communication and understanding is all important. And I have found that some of these points that you're raising, whether it's the spread pickup and the insurance capital at the asset managers and also layering in ratings implications and the deal terms, I think all of that is important for investors to get more comfortable and have a better understanding of these types of deals. The last topic I do want us to address is the macro environment. This has been another key theme with the conference and with this recent earnings season. So whether it's rate moves this year, the talk of M and A tariffs, what's your sense on how companies are viewing and assessing macro and their decision making?

[Michelle Wang]

There are three components to how they're thinking about it. The first is the rate move. So the fact that we're 50 to 60 basis points lower in treasury yields in the past month, that's welcome news for any company looking to issue debt. The second thing I'll say here is about credit spreads. They remain extremely tight. Speaking to the incredible kind of resilience of the investment grade investor base. The last thing I'll talk about is I think the uncertainty because that's what we're hearing a ton about in all the conversations that we've had with companies that have presented here at the conference.

[Lindsey Tyler]

From my perspective, also the regulatory environment around that M and A, whether or not companies will make the move to maybe be more acquisitive with the current new administration.

[Michelle Wang]

Right. So until the dust settles on some of these issues, it's really difficult as a corporate decision maker to do things like big transformative M and A or take your company public when you don't know what could happen, both from a market environment and as you point out, regulatory standpoint. The thing that's interesting is that raising debt capital as an investment grade company has some countercyclical dynamics to it because risk off sentiment usually translates into lower treasury yields and more favorable cost of debt. And then the second point is when companies are risk averse, it drives sometimes cash hoarding behavior. Right. So companies will raise what they call, you know, rainy day liquidity and park it on balance sheet just to feel a little bit better about where their balance sheets are.

[Lindsey Tyler]

Yeah.

[Michelle Wang]

Make sure they're in detail the maturities.

[Lindsey Tyler]

That they have right here in the near term.

[Michelle Wang]

That's exactly right. So I think as a consequence of that, you know, we do see some tailwinds for debt issuance volumes in an uncertain environment.

[Lindsey Tyler]

Got it. Well, appreciate all your insights. This has been great. Thank you for taking the time, Michelle, to talk during such a busy week.

[Michelle Wang]

It's great speaking with you, Lindsay, and.

[Lindsey Tyler]

Thanks to everyone listening in to this special episode recorded at the Morgan Stanley TMT Conference in San Francisco. If you enjoy thoughts on the market, please leave us a Review Wherever you listen and share the podcast with a friend or colleague today.

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