The technology sector has proved to be one of the most popular and resilient for private credit lenders ever since the covid-19 pandemic, and the trend shows little sign of letting up. According to deal data from Deloitte, private debt fund investments in technology, media and telecoms businesses accounted for 22.8 percent of all European deal activity in 2022. This was the third year running that the sector has been the most popular in Deloitte’s analysis.
For private debt lenders, the opportunity set in credit is likely to grow in the wake of the collapse of Silicon Valley Bank, and several investment and private equity firms are now thought to be looking at how they can fill a funding gap in the technology market.
On 22 May, Bloomberg reported that Japan’s SoftBank is considering launching a private credit strategy focused on late-stage tech startups. According to the newswire, the fund would look to provide debt and debt-like structured financing to provide liquidity for technology startups, with a returns target in the mid-teens.
The move is thought to be driven by the gap in financing that has opened as a result of the failure of Silicon Valley Bank, which often backed innovative technology companies. SoftBank already specialises in investing in the technology sector but has suffered losses on its equity investments through underperformance in firms such as office sharing company WeWork and ride-hailing business Didi Global. Private credit could be a way for SoftBank to continue backing the technology sector but at a lower risk level than with equity exposure.
Claire Trachet, chief executive officer of startup advisory firm Trachet, says tech firms are currently experiencing tough conditions in equity markets that could further drive the need for alternative financing solutions.
“The uncertainty of the economic climate has had a drastic impact on the sector,” she says. “We have seen the collapse of SVB, Tech Nation, and Britishvolt – to name a few – which has caused anxiety amongst not only startup founders, but investors who have become much more risk-averse during these times.”
A further major development came on 8 June when global investment manager BlackRock announced it had entered an agreement to acquire European growth lending specialist Kreos Capital. London-headquartered Kreos has been providing venture lending to companies in the technology and healthcare sectors for more than 20 years and is currently raising its seventh-generation fund, which is thought to have already secured more than €1 billion.
Stephan Caron, managing director and head of European mid-market private debt at BlackRock, tells PDI that the deal allows it to bring in an experienced team in this area of investing.
“This acquisition is the best way for us to accelerate getting to scale in this part of the market and offer a wider range of products to our clients. What happened with SVB really reinforces our conviction of venture debt that there will be opportunities linked to ongoing disruption in the banking system,” he says.
Expertise in underwriting technology businesses is essential to grasp the opportunities it presents, according to tech lending specialist Vista Credit Partners.
“We lend exclusively to enterprise software and technology-enabled companies, which by nature is a highly specialised field,” says Vista’s senior managing director David Flannery. “We underwrite against a different set of financial metrics and assess a company’s balance sheet and growth prospects through a selection filter of characteristics we believe are required to be a successful software company.”
One crucial area where tech-specific expertise can be useful is in differentiating between firms that develop software and those that manufacture hardware, which can be very different from an underwriting perspective.
“Hardware manufacturers tend to be asset-intensive businesses that are more sensitive to cyclical fluctuations in consumer or business spending habits and have considerable capex requirements,” explains Flannery.
“Enterprise software companies, on the other hand, have mostly adopted a ‘software-as-a-service’ model, meaning they have far more consistent, predictable recurring revenue streams. They are asset light in the traditional sense but have intrinsic collateral value through intellectual property.”
The underwriting challenge
In order to underwrite loans for firms that don’t typically have the type of assets lenders would normally look for as security, other metrics are used to evaluate the creditworthiness of potential investments. These can include customer acquisition costs versus life-time value, the company’s cash position, runway vs burn rate, gross margins, recurring revenues and customer churn. These can help a lender to understand if the underlying business model of a technology firm is profitable.
While the collapse of SVB has undoubtedly hit the tech sector hard, it is not the only factor facing firms in a market which Flannery believes has long been inefficient.
“We still view the credit financing markets for enterprise software companies as inefficient and largely underserved,” he says. “Historically, only a select group of banks and lenders catered to this market and focused almost entirely on sponsor-backed opportunities. This inefficiency in the sponsor market and lack of attention paid to non-sponsored businesses is the ‘white space’ our FounderDirect platform was launched to address, and the contours of this opportunity set have continued to widen in recent months with the growth equity markets in upheaval and the IPO markets still frozen.”
Tougher times in equity markets are also likely to drive more tech firms to seek out alternative ways to fund their business. Valuations are down in many sectors, and while tech has been more resilient than most, it is not completely insulated from macro-economic conditions. All this means that equity sponsors are either offering less cash or looking to take a larger stake than they would have in the past. By offering an alternative that won’t dilute the equity of tech entrepreneurs, private credit is likely to see demand continue to increase within the tech sector.
Vista is banking on an increasing number of sponsorless deals in its approach and believes this will also offer an attractive proposition for LPs, as it offers “the ability to access a historically underserved constituency, which drives the ability to structure equity-like returns with strong downside protection characteristics.”
Private credit lenders have long favoured technology, and recent market conditions are likely to further drive demand for assets. They are also likely to drive demand for financial solutions within the industry beyond the more familiar venture capital and private equity routes. But the out-of-the-ordinary underwriting and structuring demands of these businesses will require specialist knowledge and skills, which increases barriers to entry for firms looking to break into this market segment.