Bitcoin Mining’s First Major Bankruptcy Creates Uncertainty For Key Partners, Opportunity For Others

What Happened

Compute North, the second largest bitcoin mining hosting provider in the US, filed for Chapter 11 bankruptcy last week. The company swiftly followed this filing with another court order requesting a 363 bankruptcy sale to liquidate assets to cover the roughly $140 million of debt it has accumulated.

The bankruptcy is perhaps the biggest bitcoin mining news to emerge in 2022’s down market. Compute North provides hosting services for $700 million worth of equipment for some 84 mining entities, including publicly traded companies such as Marathon Digital Holdings. Now, with the hosting provider looking to auction off its assets, these clients could confront a situation where their service agreements are rewritten under new management. Some miners may even be forced out of their hosting locations, while others may risk default themselves if their rates rise.

Broader Context: Brutal Economics Crush Compute North’s Margins

Bitcoin mining at scale is expensive. By now, most people know that it requires a lot of energy and costly machines, but miners also need very expensive electrical equipment (transformers, panels, power lines, and things of this nature) that scales with the size of their fleet, and they also need containers or warehouse space to store them.

Given the scale and cost, miners will often rely on hosting providers like Compute North to abstract away the cost and effort of building out a Bitcoin mining farm themselves. The miners supply the machines, and the host supplies the power. Under these agreements, the two parties sign a contract that locks in a hosting rate for a specific period of time. These contracts can vary, but typically, they include a set price for power, which may include a profit or revenue share agreement.

As the above graphic illustrates, Compute North has over 20 subsidiaries that operate the various aspects of this business. Most of these (the companies under the “Operating Companies silo”) are wholly owned by Compute North, while others are joint ventures with NextEra Energy and Marathon Digital Holdings. Additionally, CN Borrower LLC is now owned by Compute North’s primary lender, Generate Capital (more on this later).

Compute North’s contracts typically last 3-5 years and lock in a fixed power rate for the miner. The problem is that Compute North did not lock in its own power rate with its power providers via a long-term power purchasing agreement (PPA). Meanwhile in Texas, a state that hosts a significant portion of Compute North’s clients and in which Compute North is expanding most aggressively, average industrial power rates increased by 64% from July 2021 to July 2022, from $5.20/kWh to $8.21/kWh.

Per its Chapter 11 filing, Compute North said that a “typical [hosting service agreement] does not expressly allow it to pass increased energy costs through to customers,” so the hosting firm has to eat those rising power rates without recouping costs from clients.

And the revenue Compute North was earning was being eroded by Bitcoin’s bear market. Bitcoin’s hashprice – a measure of how much revenue miners can reap in a day’s work – has fallen 68% year-to-date.

So when Compute North’s primary operating cost (power) surged, its margins, which were already whittled down by market conditions, were effectively crushed.

Sensing Trouble, Compute North’s Primary Lender Triggers Technical Default

While Compute North does not state this in its filing, it’s probable that the company’s untenable revenue situation drove its primary lender, Generate Capital, to trigger a technical default.

Generate Capital opened up a $300 million credit line for Compute North in February, of which Compute North drew $101 million. Per Compute North’s bankruptcy filing, Generate Capital asserted that Compute North was in technical default, which shut off Compute North’s access to credit and gave Generate Capital the right to take control of two of Compute North’s facilities (one in Kearney, Nebraska and one in Granbury, Texas, as well as a $23.6 million bank account.

Outlooks and Implications: Compute North Facilities Operational for Now, But Will Soon Be Sold Off

With its primary credit line closed and its margins evaporated, Compute North filed for Chapter 11 bankruptcy. Commonly referred to as a reorganization bankruptcy, a Chapter 11 allows the company to continue operations while it devises a plan to satisfy creditors.

In terms of creditors, Compute North owes $99,809,696 to NextEra Energy, a power company that Compute North entered a joint-venture with for one of its Texas facilities; $21,013,027 to public Bitcoin miner Marathon Digital Holdings; $7,466,005 to Foundry, a subsidiary of Digital Currency Group; and $18,374,138 to some 30 other entities.

To pay down this debt, Compute North filed a motion with the US Bankruptcy Court of the Southern District of Texas to auction its assets in a 363 bankruptcy sale. If the sale is approved, Compute North could sell up to $1,000,000 worth of assets outside of the auction in a de minimis sale.

The lion’s share of the selling, though, will take place in an auction that would begin on November 1, 2022. This auction would include anything and everything Compute North controls, including bitcoin mining containers, bitcoin mining machines, and its data-centers, the last of which will be the most coveted assets.

Decision Points: What Happens to Clients If Compute North’s Business is Partitioned?

The asset auction is sure to draw bidders from every corner of the Bitcoin mining industry, including financial institutions and energy companies active in the sector. These actors will now have the opportunity to gobble up assets for pennies on the dollar.

It’s anyone’s guess right now where the chips fall with regards to buying, but depending on who ends up with which data center, it could mean headaches or hell for the clients operating on those sites. Given the fact that the current hosting service agreements are unprofitable, the new management will no doubt want to rewrite these agreements. Some miners may get pushed out of their agreements, while others may choose to leave.

Marathon Digital, for example, has already secured an agreement with Compute North competitor Applied Blockchain for another power and warehouse space to house the public miner’s current and future fleet of mining machines. With regards to the bankruptcy, Marathon Digital’s stock fell 10% on the day that the news broke, but the stock price has largely bounced back from this in the past week. It’s also worth noting that Marathon’s computing power, via its proprietary mining pool Marapool, hasn’t decreased in the last month in light of the bankruptcy.

In addition to Applied Blockchain, Bitcoin miners that could be ousted by the restructuring may look to Core Scientific, the largest Bitcoin mining host in the United States, for a new home. Core Scientific, though, lost $4.7 million from its hosting services in Q2, 2022, according to its 10-Q filing.

Without an inside look into Core Scientific’s operations, it’s impossible to say if this loss resulted from rising power rates and a lack of PPAs or if it stemmed from datacenter downtime during the summer’s heatwaves (Core Scientific has significant operations in Texas). That said, industry sources say that Core Scientific has the ability to pass on rising power costs to its clients in the event of power rate hikes.

The situation is a salient reminder that public and private miners which own their own power and data centers, even though it’s expensive, have one less thing to worry about in times of market uncertainty. Riot, Argo, Hut 8, Bitfarms, and Cleanspark, among others, don’t have to fret with the counterparty risk of hosting providers.

For those that use hosting providers, with mining margins thinning and power costs rising, uncertainty looms regarding hosting alternatives. It was not uncommon for Bitcoin miners over the past few years to forego long-term PPAs because power costs had been trending down, and hosting rates have been rising on average for the industry.

As such, Compute North clients could be stuck between choosing the best of two bad situations by either sticking with uncertainty in the midst of Compute North’s restructuring or seeking new uncertainty with another hosting provider.

It’s too early to tell whether or not the situation will evolve into credit contagion, but the bankruptcy’s effect on other miners will become clearer as Compute North’s datacenters are sold to new management.

Investors in these companies would be well-suited to understand the power source of portfolio firms to determine if reallocations or additional diversification is necessary.

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