Unearthing Infrastructure Returns -Why its the Application Layer that Holds the Gold

In the world of infrastructure investments, the race for returns often resembles the gold rush of the 19th century. Investors constantly seek the most lucrative opportunities, hoping to strike it rich. However, in today's digital economy, the gold mines are not at the foundational model layer but rather in the application layer and its essential picks and shovels. This post will explore why infrastructure returns are unlikely to be won at the foundational model layer and why the natural treasures lie above.

The Foundational Model Layer

The foundational model layer of digital infrastructure includes the basic building blocks of technology: hardware, data centers, GPUs, and network infrastructure. Historically, many investors have been drawn to this layer, considering it the bedrock of the digital landscape. While it's undeniable that these components are essential, despite Nvidia's record profits where it feels like one winner is taking all, there are other sources of substantial returns.

1. Commoditization: The foundational layer is highly capital-intensive and subject to fierce competition. As a result, profit margins tend to be thin, making it challenging to achieve exceptional returns. Furthermore, technological advancements have led to the commoditization of hardware, driving down prices and eroding profitability.
2. High Entry Barriers: Investing in data centers and network infrastructure requires massive capital expenditures and expertise. This high entry barrier limits the number of players in the space and the potential for differentiation and competitive advantage.
3. Limited Innovation: The foundational layer primarily focuses on maintaining and optimizing existing data centre infrastructure. While innovations like cloud computing have emerged from this layer, they are the exception rather than the rule. Most groundbreaking innovations happen higher up the stack.

The Application Layer: Where the Magic Happens

The application layer is where the real magic of technology unfolds. This layer encompasses the software and services that leverage the foundational infrastructure to deliver value to users and enterprises. Here's why it's the hotspot for infrastructure returns:

1. Innovation Hub: The application layer is where innovation thrives. It's the breeding ground for disruptive technologies like artificial intelligence, blockchain, and the Internet of Things. These innovations create new markets and redefine industries.
2. Higher Margins: Unlike the foundational layer, the application layer offers higher profit margins. Software and services can be monetized effectively with up to 90% gross margins, and the scalability of digital products means that profit margins can expand significantly as user bases grow, with a geo-agnostic footprint.
3. Customer-centric: This layer solves real-world problems and meets user needs. Investments in user experience, customer support, and continuous improvement are rewarded with user loyalty and revenue growth.
4. Diverse Opportunities: The application layer encompasses various industries, from healthcare and finance to entertainment and e-commerce. This diversity provides investors numerous opportunities to diversify their portfolios and capture value across various sectors.

The Picks and Shovels: Infrastructure Enablers

While the application layer steals the spotlight, the picks and shovels are another critical aspect of infrastructure investments. These are the enablers that support and facilitate the growth of applications. Examples include cloud infrastructure providers, cybersecurity firms, and data analytics companies.

Investing in picks and shovels can offer a unique blend of stability and growth potential. These companies provide essential tools and services that empower application developers and enterprises to thrive. As the demand for innovative applications grows, so does the need for the picks and shovels that make it all possible.

But while "picks and shovels" hold immense promise for infrastructure returns, certain factors defy this principle. Chip scarcity, energy scarcity, and geography are three significant challenges that have the potential to disrupt the seamless operation of the application layer. The need for microchips can impede the development and deployment of cutting-edge applications, while energy scarcity can limit the scalability and sustainability of digital infrastructure. Moreover, geography is crucial in ensuring equitable access to technology, with remote and underserved regions often left behind.

Visionary innovators like Starlink are actively addressing these challenges. Starlink's ambitious satellite internet project is already bridging the digital divide by providing high-speed connectivity to even the most remote corners of the globe. Doing so mitigates the impact of geography on infrastructure access, bringing the application layer's benefits to a broader audience and digital computing to the edge.

Known Unknowns

Talent Supply and Demand

Studying talent for the next decade and the complexities of geopolitics, two of the largest pools of talent are no longer available to us. We are less worried about making the technological investment but rather more concerned that we will need access to the human capital to help the team scale.

As the global landscape shifts, the race for deeptech talent becomes increasingly competitive. We must invest in technology and strategies to attract, retain, and develop the talent to drive our success in this rapidly evolving era. The ability to adapt and thrive will depend on the tools we wield and the people who wield them – the true catalysts of innovation and progress.

Climate Change

Nonetheless, another critical factor is looming on the horizon and threatens to disrupt the very foundation of digital infrastructure – and that is climate change. The physical security layer, which encompasses data centers, communication hubs, and critical infrastructure, is vulnerable to the increasingly severe impacts of climate change. Extreme weather events, rising sea levels, and other climate-related phenomena pose a substantial risk to these assets. Unlike other challenges that can be addressed through technological innovation or strategic investments, the effects of climate change are often beyond the control of any single provider or entity.

The potential for massive losses and stranded assets due to climate-related disruptions is a growing concern. As temperatures rise and extreme weather events become more frequent, the physical security layer faces unprecedented challenges. Infrastructure that was once considered resilient may no longer be a safe bet. This underscores the urgent need for climate adaptation and resilience measures within the realm of infrastructure investment.

Take back to work

While scarcity, energy resource availability, and data sovereignty drive willingness to pay, the safety, security, surveillance competencies, and service level commitment to delivering up to 99.999% performance for critical infrastructure and our smart cities will ultimately drive enterprise-level trust and deliver competitive advantage.

The ability to adapt and thrive will depend on the tools we wield and the people who wield them – the true catalysts of innovation and progress.

In conclusion, while the application layer and its underlying technologies hold immense promise for infrastructure returns, we must remain cognizant of the unique challenges posed by chip scarcity, energy scarcity, geography, and, most notably, access to human capital and climate change.

Innovators like Starlink are addressing some of these challenges, but the specter of climate-related disruptions to the physical security layer remains a formidable threat.

As globally responsible citizens and investors, we must prioritize climate resilience to safeguard the future of our digital infrastructure and ensure that the promise of the application layer can continue to be realized.

Only together can we accelerate impact.

#Emergingmanagers #Leadership #LessonsLearned #Datacentres

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Leesa Soulodre?is the General Partner of R3I CAPITAL ,?an investment firm specializing in artificial intelligence and emerging technologies, mobilizing impact towards sustainable development goals. She is a Board Advisor to the AI Asia Pacific Institute and has a portfolio of the world's leading AI scaleups, transforming our planet for impact.

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