ARR financing: Tech lending faces growing pressures

As technology businesses have grown in favour, lenders have 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 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, in part because the big publicly listed tech stocks were taking a bashing and therefore there was 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 recent times, technology companies have arguably never had it so good when it comes to sourcing financing due to private markets’ appetite for fast-growing companies. Sponsors have increasingly become comfortable tying their loans to subscription-based revenue growth and minimum liquidity covenants.

However, as comparable public market software company valuations have declined in recent times, and recapitalisations slowed, sponsor and lender interest in advancing loans to companies on an ARR basis has either reduced or become more conservative.

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?

Higher costs

“Many ARR companies were financed when rates were low and may now find that their liquidity reserves
are insufficient”

KBRA report

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 suggests 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 by the various parties to a deal (almost certainly the case, one would think), liquidity cushions could be eroded and defaults and workouts become a common feature.

The KBRA report adds: “Many ARR companies were financed when rates were low and may now find that their liquidity reserves are insufficient to meet their higher floating rate interest costs.

Some observers may wonder whether ARR financing is a trend that became just a little too fashionable.