ARR financing faces growing pressures

As technology businesses grew in favour, lenders adapted to a different type of financing – only to now see it come under scrutiny as interest rates rise and economic growth slows.

At around the time of the initial covid outbreaks in early 2020, technology emerged as a strongly favoured sector and was also a major beneficiary of the boom in M&A that followed in the latter part of that year. As we reported in our coverage at the time, lenders were keen to jump on the bandwagon and many did just that – even though for some of them it meant departing their comfort zones.

Such investing demanded courage, not just because the big publicly listed tech stocks were taking a bashing and therefore there was something of a reputational issue around the sector. The other unnerving facet was the type of financing used. Most lenders are accustomed to cashflow lending but, for young and fast-growing technology businesses, annual recurring revenue finance was seen as the most suitable option – placing the emphasis on back-ended repayments and short-term “payment in kind” given that these businesses may be short on profits in their early years, despite long-term prospects appearing compelling. It’s a type of finance that’s been around for a while in the US, but only been part of the European scene for a few years.

In exchange for what appeared to be a higher risk profile than for plain vanilla lending, ARR lenders were rewarded with a premium of typically somewhere between 50 and 75 basis points. The question now is, will the appeal of this type of financing survive the rising inflation and interest rate environment, combined with other market pressures?

A new study from KBRA, the rating agency, outlines some growing concerns around the ability of ARR-based financings to withstand higher interest costs from operating cashflow and suggest they may face major challenges from a slowing economy. KBRA says that, in the portfolio it assessed, most ARR companies were underwritten as B category credit risk and below, with many no higher than triple C. It speculates that if interest rate rises have been higher than anticipated (almost certainly the case, one would think), liquidity cushions could be eroded, and defaults and workouts become a common feature.

KBRA makes the point that some ARR companies are better placed than others: “Those… with the scale and ability to reduce expenses and redirect growth investment toward higher interest costs will fare better than smaller or earlier stage companies.” So some kind of collapse of the entire market segment appears unlikely. Nonetheless, some observers may wonder whether ARR is a trend that became just a little too fashionable.

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