As Tech Sector Cools and Macro Headwinds Strengthen, Lenders Reassess Recurring Revenue Lending
After a year of searing moves in the tech sector, markets cooled in 2022 as inflation and rising rates prompted many investors to favor investments in safe-haven asset classes.
Global M&A activity in the technology, media and telecommunications sector rose from US$617.4 billion in the second quarter of 2021, the sector’s highest quarter on Merger market save—at $349.9 billion in Q2 2022.
The sector saw a similar decline on the financing side. In the United States, the issuance of technology and IT-related leveraged loans in the second quarter of 2022 reached US$28.9 billion overall, down 37% year-over-year from US$46 billion. In the small Western and Southern European market, leveraged loan issuance in the sector has just reached US$1.2 billion in Q2compared to US$9.2 billion in the second quarter of 2021.
Overall issue in value Q1 2020 – Q2 2022
Device type: Leveraged loans Use of profits: All
Location: Western and Southern Europe and the United States Sectors: Technology and IT
Recurring revenue attracts attention
While this downturn is not unique to tech companies, the impact has prompted many lenders to recalibrate the supply of funding to the sector, with recurring revenue lending an area where banks and private debt providers are stopping. to make a point.
In the United States, loans aimed specifically at growth-stage technology companies with a recurring revenue business model have been available for several years. They offer financing options to companies whose foreseeable revenues are not yet EBITDA positive or which are not yet generating profits at a sufficient level to comply with the usual leverage ratios. They also fill a funding gap that was once covered by equity or, in some cases, supplemented by more expensive venture capital debt.
Given the EBITDA levels of candidate borrowers, loans with recurring income are not accompanied by standard leverage ratio tests. Instead, debt pools are sized as a multiple of recurring revenue. This has typically been in the range of 2.25x recurring revenue, but at the height of the market there were signs that this had increased as lenders became more comfortable with the product. Multiples of between 2.5x and 3x recurring revenue (and in some cases even above 3x) have been seen in the market at some point, although pushed back in a volatile 2022.
These terms are not indefinite – they will generally transition after a two or three year period from a recurring earnings test to a standard EBITDA leverage test when the borrower transitions to positive earnings. In the United States, however, some sponsors have pushed for permanent recurring revenue leverage ratios throughout the life of a loan.
There are also examples of loans with a permanent toggle option in place, where the business can either choose to keep the loan on recurring revenue terms for the life of the loan, or choose to switch to the on-going basis sooner. EBITDA leverage if desired. This is by no means a standard feature, but it has been seen in some small transactions.
Loans like these have their limitations. Prior to conversion to standard leveraged loan terms, recurring income loans are less flexible than traditional leveraged term loans – the more generous covenant tests for payment of dividends, prepayment of junior debt, making investments, or restricted payments are only available once the loan is reversed. A sponsor may choose to exercise a changeover early if they are able to negotiate with lenders for this feature in their documents. Although baskets are still available on recurring revenue loans prior to conversion, fixed dollar baskets generally do not have a producer component prior to conversion. Unlimited Baskets for Investments, Restricted Payouts and Restricted Debt Payouts are generally not available prior to conversion as they are based on a standard leverage test.
There may, however, be good reasons for sponsors to push back the rollover date or avoid it altogether, even if it means less flexibility. For example, if a portfolio company’s revenue growth continues to outpace its earnings performance, being forced to turn around after two years can negatively impact the business when tests of leverage ratio begin.
Another variant of the market is the introduction of sponsorship financial guarantees. This involves the venture capital, growth capital or private equity fund backing the loan by providing security on the underlying debt of the holding company. If the company’s growth falters and fails the recurring revenue test, the fund will raise capital from its investors to cover the loan. This reduction in risk for the lender may be enough of a concession to allow for greater flexibility within the framework of the loan documents.
Transactions structured with collateral have, however, increasingly become the preserve of traditional banks and investment banks, with the yield becoming less and less attractive to private debt players. The provision of collateral significantly reduces prices compared to a traditional recurring revenue loan without sponsor collateral.
Europe is moving forward
Recurring revenue loans are also increasingly common in Western Europe, largely UK-centric, but with fewer features. One difference is that in the United States there is more flexibility in determining company earnings. Sponsors can push for this to be measured on an annualized basis, extrapolating from the most recent quarter and in some cases even from the most recent trading month. In other cases, LTM revenue (last 12 months) is the benchmark.
In Europe, the previous financial year is used as the standard and, for the moment at least, there is no option to maintain the recurring income conditions for the life of the fund, although borrowers can switch early to standard tests based on leverage if they so choose. This has benefits, such as improved pricing, more generous baskets, and other standard features that borrowers have come to expect when taking out leveraged loans. Since the European market typically lags the US market by around six to 12 months (or more, depending on market conditions), the terms that are on the table in the US will likely cross the Atlantic in a near future.
Uncertainty weighs on the market
After a period of growth during the 2021 bull market, the supply of recurring income loans has cooled in the face of the volatility that defined the start of 2022. Recurring income loans, by their very nature, involve riskier loans. Although these deals are more heavily equity, at levels of around 40% to 60% (and sometimes more), they involve less mature, non-profit companies, as evidenced by loan pricing, which has a premium approximately 100 bps to 250 bps. unitranche products.
Private debt funds are still active in the space, as they have a higher risk appetite than traditional banks and, importantly, lend on a “take and hold” basis. As such, they are not exposed to the vagaries of syndication, a feature of leveraged loan issuance in 2022. Loan and bond investors have intermittently sat on the sidelines while direct lenders seized the opportunities, steadfastly maintaining their business during the turmoil.
A good example of such perseverance is Vista Equity Partners’ takeover of U.S. public company Avalara Inc., which was just signed in August and one of the largest book rate of return (ARR) financings of 2022. Vista secured US$2.75 in ARR funding to fund the acquisition, demonstrating that while private credit funds are more selective and disciplined in the space, ARR supply is not moribund. Some 20 private credit funds have partnered on the financing.
While recurring income loans have opened up new avenues for lenders to deploy their ample available liquidity during the market peak, appetite for the product is nonetheless subdued compared to a year ago, particularly among equity funds. private debt. Assuming market volatility continues, lender demand for recurring revenue loans, particularly those of the “lifetime recurring revenue” type, should continue to subside, only to remerge in more sophisticated form as markets recover. will straighten again.[View source.]