Jacob Schtevie: Technology was the most active sector for M&A and loan issuance in North America in 2020. Why has this sector been so resilient?
Jennifer Kloud: From April 2020 until the beginning of July, new deal flow in the middle market virtually shut down. While the market has reopened, technology deals bounced back especially quickly. This was driven by the fact that most of these deal targets maintained very high levels of recurring revenue, even during the worst of the shutdowns.
So many software platforms have become mission critical to the operation of businesses. Companies need these systems to run, so they prioritize paying license fees and royalties.
From a banking perspective, the consistent and reliable cash flow makes technology a good sector for lending. Existing software businesses that were already in our portfolio have also performed very well through this period of disruption.
Mitchell Kinastowski: Another reason for the sustained deal activity in technology is the fact that it has now become prevalent across all industries. All companies now have to become technology companies, in some form or fashion. Operators rely heavily on integrated technology-based tools to enable visibility into the various aspects of their business. It’s become a necessity for those who want to compete effectively and efficiently.
You see businesses across essentially every sector turning to technology in order to help them differentiate and maintain margins. Aside from the fact that these tools are essential to the back office, they have also become essential to business models.
Schtevie: Is a technology deal easier to finance in the current backdrop than a deal in another industry?
Kinastowski: While BMO Sponsor Finance has industry verticals with broad areas of specialization, the team as a whole looks across all sectors. We don’t have a specific sector filter that will exclude a company because of its industry.
The way we approach credit is to look at the fundamentals of each business—regardless of sub-sector and market focus—and make an evaluation on that basis. There are many good companies that have carved out attractive niches that we would be interested in backing.
Kloud: What has been interesting is how different sub-sectors under the general technology umbrella have performed through the past 12 months.
For example, we have a number of payments processing businesses in our portfolio and while there was an initial dip in that sector as the economy was locked down, those bounced back very quickly. On the other side, if you are providing enterprise resource planning software to an industry that was particularly hard-hit by the pandemic, it is going to be tough.
Outside of the technology space, insurance brokerages have been another strong area. We have a number of mid-market insurance brokerages in our portfolio and those have been very resilient.
Overall, we have focused on lending to standout businesses that enjoy consistent demand across all sectors.
Schtevie: How have you struck the balance between working on new deals and focusing on supporting the portfolio though this period?
Kloud: We focused on supporting our sponsors and our portfolio in April, May and June, when there wasn’t much new deal flow. In July, the markets picked up and we started to look at new deals again. Since then, we have been flat out with new deal opportunities.
There is pent-up demand, so deals that didn’t launch because of COVID-19 are now landing, in addition to transactions that would have come to market naturally at this time.
BMO Sponsor Finance posted a record first two months to start our fiscal year. Sponsor demand and lender demand are both back. I think everyone has figured out how to operate in the new normal and the market has become comfortable with the associated risks.
Schtevie: Coming back to technology credits specifically, when taking into account sponsor appetite for tech deals and the sector’s strengths, has that enabled tech borrowers to secure more attractive terms and pricing relative to other industries?
Kinastowski: It still comes down to the fundamentals—if the credit fundamentals are strong, then the terms are going to be more sponsor-friendly by virtue of greater lender interest in that asset.
We have seen certain sectors display stronger credit attributes through the pandemic. You could make a broad generalization that if enterprise software credits are stronger, then they're going to receive more favorable terms than businesses with a lower mix of recurring revenue.
However, several other factors come into play, such as the size of the company, the sponsor backing the deal and what stage it is at in its growth cycle. There are other considerations that decide the structure and pricing of any given credit. There will be tech businesses garnering very attractive terms, but strong industrials companies will be doing the same in many cases.
Kloud: I would add that one of the more unique features of technology deals is recurring revenue lending. This is a newer product set that finances businesses investing heavily in sales and marketing and software development, and keeping their profitability at just weighted levels.
Lending ranges from businesses with US$20 million in recurring revenues up to those with recurring revenues of US$200 million-plus, so it spans the mid-market and the larger cap market. This is a unique feature of lending into the technology sector.
Kinastowski: We have been very active in the recurring revenue space and it is a growing market. Appetite for this product has prompted entry of a number of new players, so there are many options available to borrowers. Pricing and structuring is bespoke, so you will now see a wide range of terms and pricing data. Early on, when the market was smaller, there was a tighter set of terms.
Schtevie: You hit on this a bit earlier, but how much of a factor is the financial sponsor behind a tech deal when deciding on whether to finance a credit?
Kinastowski: We want to partner with financial sponsors that have expertise in a particular sector. The complexity of the underlying deal will play into that evaluation. When the financial sponsor has deep experience in the tech sector, it is easier for us to get comfortable with a given situation and trust the sponsor’s judgment, as opposed to a fund that doesn't necessarily have tech experience.
Kloud: For all sectors—not just technology—the relationship with the financial sponsor is very important. The best relationships are tested and forged in hard times, and we have seen the fruits of investing in relationships during the last year.
Private equity sponsors want to see a lender who acts rationally and understands the company, understands the situation and understands what needs to be done. We want to see our relationships come out on the other side of a recession or pandemic stronger than they were going in.