Out of a crisis, it seems, comes innovation. One of the distinctive features of the pandemic from a business point of view has been a sharp bifurcation between sectors that flourished and those that struggled badly. Businesses in the healthcare, software and technology sectors have found themselves favoured perhaps more than any others.
Private debt managers wanting to support these types of firms, however, have faced a challenge. Many lenders, especially those of a more generalist persuasion, have become used to financing businesses with long track records and strong profits. But many of the best-performing firms today may well lack both. Their main priority has been growth, and many have flat or negative earnings before interest, taxes, depreciation and amortisation. No one should assume, however, that this makes them a bad credit risk.
We hear that, in recognition of this, many more lenders are now considering lending against recurring revenues rather than EBITDA. This is not exactly a new phenomenon, having been an option in the US for around a decade, but what is striking is how much more popular it has become. One investment bank told us that they had typically been involved in four to five recurring revenue financings in the software sector per year but, over the past 12 months, this had risen to 20. A greater proportion of deals are now happening in Europe, where they have only taken root over the past few years, and estimates put the number of lenders in the region prepared to do such financings at around 75, compared with approximately 40 a year ago.
One of the misconceptions around this type of financing is that, by eschewing traditional metrics, it must be inherently riskier. But the investment banking source told us that the recurring revenue deals they have seen have typically involved loan-to-values of around 20 percent rather than 50 percent in the wider acquisition market and leverage multiples of around 2 percent (compared with 5 percent). While senior loan defaults have been in the range of 4 to 10 percent for the wider market over the past six quarters, in the software sector the range was 0.4 to 3.5 percent. Recoveries in default also tend to be stronger, due to the likely presence of valuable intellectual property.
Given these attractive characteristics, it is not surprising that many lenders are taking a closer look. In the fast-changing environment of the past 18 months, “sticking to the knitting” has seemed a less viable approach. The dislocation opportunity in the early months of last year was an example of fund managers needing to be adaptable and quick off the mark. Those qualities are still required to take advantage of today’s opportunities.
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