After a year of red-hot moves in the tech sector, markets have cooled down in 2022, as inflation and rate hikes prompted many investors to prioritize investment in safe haven asset classes.
Global M&A activity in the technology, media, and telecom sector dropped from US$617.4 billion in Q2 2021—the highest quarter for the sector on Mergermarket record—to US$349.9 billion in Q2 2022.
The sector has seen a similar drop on the financing side. In the US, technology and computer-related leveraged loan issuance in Q2 2022 came in at US$28.9 billion in total, down 37% year-on-year from US$46 billion. In the smaller Western and Southern Europe market, leveraged loan issuance in the sector reached just US$1.2 billion in Q2, down from US$9.2 billion in Q2 2021.
Recurring revenue attracts attention
While this slowdown is not unique to technology companies, the impact has prompted many lenders to recalibrate the provision of finance to the sector, with recurring revenue loans one area where banks and private debt providers are pausing to take stock.
In the US, loans intended specifically for tech-based, growth-stage companies with a recurring revenue business model have been available for several years. They offer financing options to companies with predictable revenues that are not yet EBITDA positive or are yet to generate earnings that are at a level sufficient to comply with typical leverage ratios. They also fill a funding gap that was once covered by equity or, in some cases, topped up by pricier venture debt.
Given the EBITDA levels of candidate borrowers, recurring revenue loans do not come with standard leverage ratio tests. Instead, debt packages are sized as a multiple of recurring revenue. This has usually been in the region of 2.25x recurring revenue, but at the peak of the market there were signs that this had increased as lenders became more comfortable with the product. Multiples of between 2.5x-3x recurring revenues (and in some cases even higher than 3x) were seen in the market at one point, although these have been pushed back down through the course of a volatile 2022.
These terms are not indefinite—they will typically flip after a period of two or three years from a recurring revenue test to a standard EBITDA leverage test as the borrower transitions to positive earnings. In the US, however, some sponsors have pushed for permanent recurring revenue leverage ratios through the life of a loan.
There are also examples of loans with a permanent toggle option in place, where the company can either opt to keep the loan on recurring revenue terms for the life of the loan or choose to switch into the EBITDA leverage base earlier if they so choose. This is by no means a standard feature but it has been seen in some smaller deals.
Loans like these have their limitations. Prior to conversion to standard leveraged loan terms, recurring revenue loans are less flexible than traditional leveraged term loans—the more generous covenant tests for paying dividends, prepaying junior debt, making investments or restricted payments are only available once the loan has flipped. A sponsor may choose to exercise a toggle early if it is able to negotiate with lenders for this feature in its documents. Although baskets are still available on recurring revenue loans prior to conversion, fixed dollar baskets typically do not have a grower component until after conversion. Unlimited baskets for investments, restricted payments and restricted debt payments are typically not available until after conversion as they are based on a standard leverage test.
There can, however, be good reasons for sponsors to push out the flip date or avoid it altogether, even if it means less flexibility. For example, if a portfolio company's revenue growth continues to exceed its earnings performance, then being forced to flip after two years may negatively impact the business when leverage ratio tests commence.
Another variation in the market is the introduction of financial sponsor guarantees. This involves the venture capital, growth equity or private equity fund backstopping the loan by providing a guarantee on the underlying debt of the portfolio company. If the company's growth falters and fails the recurring revenue test, then the fund will draw capital down from its investors to cover the loan. That de-risking for the lender can be enough of a concession to permit greater flexibility under the loan documents.
Deals structured with guarantees, however, have increasingly become the preserve of traditional banks and investment banks, as the yield has become less and less attractive for private debt players. The provision of a guarantee brings down pricing materially when compared with a traditional recurring revenue loan without a guarantee from the sponsor.
Europe pressing ahead
Recurring revenue loans are also increasingly common in Western Europe, largely centered on the UK, albeit with fewer features. One difference is that, in the US, there more flexibility in the determination of company revenues. 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 month of trading. In other instances, LTM (last 12 months) revenue is the benchmark.
In Europe, the preceding financial year is used as standard and, for the time being at least, there is no option to maintain the recurring revenue terms for the life of the fund—although borrowers can flip to the standard leverage-based tests early if they so choose. There are benefits to this, such as improved pricing, more generous baskets and other standard features that borrowers expect when taking on leveraged loans. Because the European market usually lags the US market by around six to 12 months (or longer, depending on market conditions), terms that are on the table stateside will likely make their way across the Atlantic in the near future.
Uncertainty weighs on the market
After a period of growth through the bull market of 2021, the provision of recurring revenue loans has cooled in the face of the volatility that defined the start of 2022. Recurring revenue loans, by their very nature, involve riskier credits. Although these deals are more highly equitized, at levels of around 40% to 60% (and sometimes higher), they involve less mature, pre-profit companies, as reflected in the loan pricing, which comes at a premium of around 100bps-250bps to unitranche products.
Private debt funds are still active in the space, as they have higher risk appetites than traditional banks and, crucially, extend loans 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 have seized on opportunities, steadfastly maintaining their activity through the turbulence.
A good example of such perseverance is the Vista Equity Partners take-private buyout of US public company Avalara Inc., just signed in August and one of the largest accounting rate of return (ARR) financings of 2022. Vista secured US$2.75 billion in ARR financing to fund the acquisition, demonstrating that while private credit funds are being more selective and disciplined in the space, the ARR offering is not moribund. Some 20 private credit funds combined on the financing.
While recurring revenue loans opened up new avenues for lenders to deploy their abundant available liquidity during the peak of the market, appetite for the product is nevertheless subdued when compared to a year ago, particularly among private debt funds. Assuming market volatility continues, demand by lenders for recurring revenue loans, particularly those of the “recurring revenue for life” variety, is likely to continue to cool, only to re-merge in a more sophisticated form when markets turn upwards again.
