In April, software investment firm Thoma Bravo announced the completion of fundraising for its second credit fund at $3.3 billion, more than three times its target when leverage is included and significantly up on the $970 million for its first fund in 2019.

This followed the $2.3 billion fundraising for Vista Credit Partners’ third fund in October last year, another pool of capital targeting borrowers in the enterprise software space.

“Software as a subsector of tech lending is so mission-critical,” says Oliver Thym, head of Thoma Bravo’s credit platform. “The companies we invest in across the firm are, we think, the best companies from a credit perspective and growth perspective. The pace of technology adoption and proliferation means software is becoming central to everything we do, and enterprise software especially.”

Parent firm Thoma Bravo has been investing exclusively in software for more than 20 years, giving the lending platform an edge from an underwriting and sourcing perspective in an increasingly competitive credit environment, he says. Thoma Bravo Credit Fund II is already approximately 70 percent invested, deploying a record $2 billion into 39 portfolio companies in 2021.

Competition is not just coming from specialist credit funds. Northleaf Capital Partners has a broader credit programme focusing on loans to mid-market companies in North America and Europe. Northleaf managing director Brett Lauber says: “Software has been an attractive sector for private credit investors for a long time and becomes even more so in periods of market volatility, as we saw during covid, as a result of the stickiness and recurring nature of the revenues.”

Northleaf focuses primarily on niche software providers with subscription revenue models, which are highly integrated into the workflows of the businesses they serve. “We seek to have a neutral or even overweight allocation to the sector,” says Lauber. “Over the last 18 months we have seen elevated valuations and increased competition, which has led to higher leverage multiples and tighter pricing. The relative value has just not been there. As a result, our software allocation has come down and we are currently underweight, but we continue to take the long view and anticipate that lower valuations could provide for increased opportunities for lenders.”

It is the sector’s attractive contractual recurring revenues, high profitability and strong free cashflow conversion that drive more lenders into the space.

Non-sponsored opportunity

At Vista Credit Partners, senior managing director and president David Flannery says more than half of the platform’s business is in non-sponsored lending to companies where the founder is the largest single shareholder. “The non-sponsored market is actually an area where we don’t see as much competition,” he says. “We think it is a really rich area because the market opportunity is enormous. There is a large number of software companies that aren’t ready to do a buyout deal.”

It is not easy to source those deals, but the ability to draw on the broader Vista platform helps origination. It also helps underwriting: “We use the Vista platform to help us do technology due diligence and actually look at the tech stack of those companies in a way that we don’t think other private debt shops can do, particularly the generalists,” says Flannery.

For many tech lenders the mandate can be very broad, even within software. At Arcmont, the European mid-market private debt firm, software is one of the biggest sectors. Partner and chief commercial officer Karthi Mowdhgalya says: “Although we can do early-stage software financings, generally we focus on mature software businesses with growth potential. We tend to favour businesses with high levels of recurring revenues, high customer retention levels and good cashflow conversion. We are able to provide loans of over €1 billion. We do skew towards the upper mid-market because, as credit investors, that is lower risk.”

He says a big challenge of tech investing is the pace of innovation. “One of the key issues is making sure that the underlying business has longevity and is not a flash in the pan. You need to be sure it is a technology that is going to survive and become embedded. If you’re not very familiar with the tech landscape and what is coming down the pipeline, it is quite hard to make those judgment calls.”

Thym his firm thinks of software as three subsectors: cybersecurity, infrastructure software and industry-specific use. “We are just a software investor, but that penetrates any and all industries. Cybersecurity is a great example, because what industry isn’t impacted by cybersecurity threats? And right now, we are seeing a lot of opportunity in healthcare software to tackle inefficiencies and introduce data technologies into arcane healthcare systems.”

Flannery says that Vista prefers enterprise software focused on specific verticals in order to benefit from growing market share. “It may not just be software that addresses healthcare, but software that specifically targets hospitals. It could even go further into that, with software companies out there targeting the emergency room, or the scheduling of doctors and nurses tied into electronic medical records. Targeting those specific work processes and niches can become very defendable.”

The acyclical nature of software businesses is fuelling lender appetite. “There is a subset of technology businesses that are very high-quality, resilient, with recurring revenues,” says Mowdhgalya.

“In this kind of market environment there is a flight to quality both among private equity sponsors and lenders, so for those businesses you are seeing very high multiples being paid and aggressive leverage packages. As we look through the medium term, with the macroeconomic uncertainty we have, those businesses will continue to gain a fair amount of interest given the expectation that they will be resilient through the cycle.”

While the challenge is for lenders to remain disciplined in that context, Lauber says the drop-off in tech valuations in the public markets could feed through to private companies.

“Competition will persist but when valuations drop off, tighter loan-to-value ratios could create an environment that provides a better balance in terms of risk and return for lenders,” he says.

“Returns have compressed over time but we are starting to see a bit of a reversion, more so in Europe than North America right now. It is important to have a flexible mandate and be able to invest across industries and geographies to find the best relative value.”

The scope of the software opportunity suggests plenty of value to come.

Growth lending to tech

Ed Testerman, who leads the growth lending platform at King Street Capital Management, sees a big opportunity to back pre-profitable growth businesses on the credit side.

“A lot of companies raised equity capital at high valuations in 2021, are still burning cash and are going to need capital. Their sources of equity are becoming more limited as the IPO market is effectively closed and they don’t want to raise down rounds. The venture debt space has not scaled to keep pace with the growth of the VC equity market so growth lending has a nice opportunity.”

There are three segments of the tech space that King Street particularly favours: proptech, fintech and consumer internet. Favouring market leaders, Testerman says that borrowers must be on track to generate EBITDA and cashflow during the life of the loan.