Zoom is the classic example of a company that has providers of annual recurring revenue finance salivating. We don’t need to remind our readers of the impact the video conferencing firm made during the pandemic with the shift to remote working, as well as its ongoing relevance to hybrid home/office working. What it boasts is a compelling subscription model thanks to a product that countless businesses and individuals felt they could not do without.
It is also a poster child for the software sector, which grew in popularity among private equity firms and private lenders during the pandemic. But what these financiers came to appreciate was that many of the companies they were coming across were not suited to the type of financing they were most familiar with, in which the loan was based on a multiple of EBITDA. It’s not that these companies are not capable of delivering strong revenues and profits. The difference is that most of their capital goes into fuelling their rapid growth, much of it into sales and marketing activities. Lending based on EBITDA is not suitable in a situation where it is either low or even negative – and that’s where an increasingly popular solution known as annual recurring revenue (ARR) financing comes in.
According to a primer from law firm Ropes & Gray, ARR financing involves “an acknowledgment from the lenders that a borrower in this type of financing is likely generating a de minimis amount of positive cashflow while in growth mode, in exchange for an acknowledgment by the borrower and its related private equity sponsor that these types of financings create more credit risk than a traditional cashflow financing”.
But while acknowledging the need for tailored financing of this type is one thing, getting investors to embrace it is quite another. On the sidelines of our recent Germany Forum in Munich, one lender admitted to difficult conversations when it tried to persuade LPs of the merits of an ARR-type approach. Subsequent interviews suggest the lender was probably not alone in its experiences.
“It’s not easy for most lenders to analyse companies that trade on a multiple of ARR, as opposed to EBITDA,” says Chris Lund, a co-portfolio manager, institutional vehicles, at Chicago-based lender Monroe Capital, which has a dedicated software and technology ARR strategy.
“While these companies generate significant profits from their existing customer base, they often invest a majority of that margin in driving future growth given the stickiness of those future customers. That investment in growth can be quickly adjusted if and when the company chooses. We get good returns from what we think is a low level of risk, but you need expertise because this is a complex area. We’re seeing some generalists come in, but it’s not something you can just pick up overnight.”
Xenia Sarri, a managing director in the capital advisory group at London-based investment bank Lincoln International, says the characteristics of ARR-based loans can be difficult for investors to get to grips with. For one thing, there is typically no cash interest for the first year or two [given the focus on sales and marketing spend], with payment-in-kind used instead. For another, the covenants tend to be different. These structural idiosyncrasies do not necessarily mean investors will veto ARR deals, but they do mean that managers need to seek permission before simply going ahead and doing them.
“These characteristics [of ARR finance] were not contemplated by some alternative lenders when they were raising their current funds so now the managers either have to go back and ask for waivers or, in the case of new funds that are being raised, these things have to be taken into consideration and built in,” says Sarri.
There is still an education process when it comes to familiarising investors with the product. Timo Hara, founder and partner at Finland-based fund of funds Certior Capital, says he was aware of the concept of revenue-based lending being discussed three or four years ago. “We saw it as part of the venture debt market at the time, where some venture debt firms were lending to software businesses where the underwriting was more against the recurring revenues than for other businesses they were backing. Now it’s expanded and it’s a more broadly recognised theme.”
Mainstream funds interested
Despite any reservations, with the software sector having grown in popularity, lenders are realising that being able to offer ARR financing as part of their toolkit can be very useful.
“What has been interesting over the last six months is that the more mainstream debt funds, or those without an ARR background or pedigree in the US [where ARR financing is longer established] are now starting to come in off the sidelines and take a look at this,” says Francis Booth, a partner in the London office of law firm Hogan Lovells whose practice focuses on leveraged and acquisition finance.
“Some of these mainstream funds have now got ARR deals away and others are seriously considering them if they haven’t done them already.”
Booth points to an article explaining ARR finance that Hogan Lovells published earlier this year which “sparked a lot of interest. We must have spoken to around 15 different funds and advisers who wanted to know more about it. Technology was pretty resilient over the course of the covid pandemic, so people are more minded to consider dipping their toe in the water”.
Private Debt Investor recently had a conversation with a fund finance professional who confessed that he was not especially familiar with ARR financing but said that it sounded like a kind of EBITDA adjustment, in the sense of creative methods being used to allow leverage to be applied to situations that are perhaps riskier than they appear. Those more familiar with the product either partially or wholly disagree with that characterisation.
“It’s true that it’s used for companies that are not necessarily profit-making or are only making moderate EBITDA but, so long as the lender does its credit analysis correctly, these are companies that have strong growth potential on their recurring revenues and are predicted to be generating EBITDA soon and starting to be profitable in the relatively near term,” says Booth. “It’s not just a way of leveraging up an unprofitable company.”
Booth also points out that the loss-making period only tends to last for a relatively short period of time and that documentation for ARR deals will typically include a mandatory ‘flip’ from an ARR-based covenant to an EBITDA-based covenant after that initial period has passed – thus effectively disallowing the prospect of a company failing to make profits over the long term.
Sarri makes a forceful case in support of companies where ARR financing is applicable. “You have substantial IP value and strong gross profit margins. The reason EBITDA is limited or non-existent is because the business is growing quickly so it’s investing in sales and marketing and, if you stripped out that cost, you’d have a ‘steady state’ EBITDA with excellent cashflow characteristics. The moment you stop investing heavily in customer acquisition costs, growth will normalise and so will EBITDA margins, assuming retention is strong.”
Different methods, same result
Sarri goes on to describe how a ‘traditional’ EBITDA-based underwriting approach can sometimes be used to provide comfort to lenders contemplating ARR deals – even though it essentially (and some would say amusingly) arrives at exactly the same place as when using an ARR-based
“Once ARR structures started becoming popular in Europe, we saw some European lenders structuring financings off normalised EBITDA (stripping out all the growth investment) in an effort to compete with US lenders. Unsurprisingly, more often than not, they ended up at the same debt quantum as they would have done based on ARR,” she says.
Looking to the future of ARR financing, it seems natural to wonder whether the current negative sentiment around some of the larger, publicly listed technology stocks is likely to have an impact. After all, “big technology stocks are in the midst of their biggest rout in a decade”, as The Wall Street Journal recently put it.
Booth concedes that some ripples may be felt. “It will be interesting to see how things develop over the next few months,” he says. “In the first half of this year we’ve seen things get pushed somewhat in sponsors’ and borrowers’ favour in ARR deals because the market has become a bit more competitive, so advisers are able to drive a better deal and leverage multiples have crept up. I’m interested to see whether this enthusiasm for the tech sector gets tempered at all by what’s happening with the larger tech companies.”
Jo Robinson, a partner in the banking and finance department at Hogan Lovells and a colleague of Booth’s, says that some types of technology business may be more vulnerable than others. “I think it’s especially relevant to businesses that are consumer facing, where the contractual revenues are consumer based. That’s where you might expect to see the biggest impact from the general economic issues of the moment,” she says.
However, Monroe’s Lund makes the point that the kind of companies preferred by ARR lenders tend to be in stronger shape in the here and now than some of their larger (arguably more hyped) peers at the larger end. “If valuations come down a lot in public markets, there will be some impact on private middle market companies,” he says.
“But a lot of the froth is around situations where cashflows are 10 years into the future and the business is very nascent. Rises in rates have a big impact on the valuations of those companies. But with the kind of companies we target, the cashflows are coming in today. They could generate a lot of profit today if that’s what they chose to do, rather than investing significantly in growth.”
Sarri says that even if there are adjustments to be made, they’re unlikely to have a material effect on financings that are in any case done on a conservative basis. “In the European mid-market, these assets typically trade between six and eight times ARR and they get levered at two to three times ARR. Lenders have an equity cushion of typically over 65 percent, and we haven’t seen that cushion being compressed yet despite valuations softening somewhat recently.”
Some will take risk
As with any other type of lending, the best way of providing insulation from headwinds at a macro level is to get the underwriting right. “A lot of it comes down to the credit decisions taken by the lenders as to which types of businesses they’re prepared to finance,” says Robinson.
But assuming not too many bad credit decisions are made, ARR financing looks well set to continue growing in Europe, after having become reasonably well established in the US over the past few years.
As mentioned, software and technology accounted for a large proportion of private equity deals during the pandemic and lenders spotted the opportunity to support borrowers with strong potential to ramp up and grow. In addition, the EBITDA-backed leveraged finance space has become increasingly crowded, meaning that some debt funds are looking to add an ARR capability as a means of differentiating themselves from the crowd.
Sarri says she sees plenty of signs of the market continuing to grow. “Through our continuous dialogue with alternative lenders, we keep hearing that even lenders that haven’t done an ARR deal yet, have been investing a lot of time getting their investment committees and investors comfortable with the idea and are now ready to do their first deal. The pool of lenders is growing every time we go to market with a new ARR deal.”
Booth says: “We did our first ARR deal at the back end of 2018 and I’d say the volume of these has definitely picked up in the last 18 months.” There may be concerns about tech bubbles, but ARR lenders believe there is considerably more mileage left in their part of the financing universe.
‘Not all revenues are equal’
Some companies are not suited to ARR finance, but there may be opportunity in the non-sponsored market
Associated primarily with the software and technology sectors, there is in theory no reason why ARR financing could not be applied to any company with a subscription-type model.
In reality, as Chris Lund of Monroe Capital says, “not every recurring revenue stream is created equal”. He adds: “Enterprise software tends to be the main business model in which we get comfortable lending on ARR. Health insurance and insurance brokers, for example, generate ‘recurring revenue’, but the underlying revenues and cost structures are very different than enterprise software. Software’s marginal cost for new customers is very low. Other types of company don’t have the same gross margins and the ongoing costs of retaining customers are higher.” However, Lund does think there is a growth opportunity for ARR finance in the non-sponsored market where companies “might want to take on debt rather than dilutive equity”.
For smaller companies, there is the option of venture debt. Lund explains the difference: “The companies we target for ARR financing are bigger, more mature and have a proven history of retaining customers over time. Venture debt-backed companies are typically burning through cash and their exit would tend to depend on the capital markets.”
The ARR premium
It’s shrinking, but there is still extra money to be made on ARR deals
Lenders we spoke to for this article said that, in the early days of ARR, it was possible to obtain a premium of around 100 basis points over a comparable EBITDA-based loan. However, as the market has become more competitive, this premium has typically come down to around 50-75 basis points.
Could it shrink even more as the market continues to mature? “There will never be enough specialisation for there to be a lot more competition,” says Chris Lund of Monroe Capital. “But ARR deals could represent a third of all private equity deals in the relatively near future, so of course we expect there will be some more competition over time.”