Lenders (and investors) take a step into the unknown

Annual recurring revenue finance, which supports some of private debt’s most favoured businesses these days, was a talking point on the sidelines of our recent PDI Germany Forum. This is not least because providing that finance involves the possibility of lenders stepping into unfamiliar territory, while also needing to gain the approval of their investors.

To take a step back, the favoured businesses referred to are essentially technology businesses, such as those found in the software and healthcare sectors. Such firms were certainly on lenders’ radars before the covid pandemic, but during it they started to dominate dealflow. Many of these firms have a strong story to tell, but it’s one of future rather than present revenues – jam tomorrow rather than jam today.

This is not necessarily comfortable for limited partners that may only be familiar with cashflow-based lending, as we heard from one direct lender keen to incorporate ARR financing into its mainstream activities but still in the process of trying to win approval from LPs. In most cases, according to sources we have spoken with, this approval tends to be given but it’s not necessarily a quick or straightforward process.

ARR finance has only been gaining strong traction in Europe over the past few years (longer in the US) and many funds around now didn’t include it as part of investment mandates for the simple reason that it didn’t exist to any significant degree at the time. Managers today may need to go back to their LPs for waivers to make investments through their funds – or, alternatively, set up a separate dedicated ARR strategy or perhaps appeal for deal-by-deal support on an ad hoc basis.

One of the considerations for investors is the back-ended repayment of interest, with typically a payment-in-kind element in the early years. This is unlikely to be too much of a problem for LPs since committing to an illiquid asset class implies that they’re not necessarily keen to get their cash back in a hurry in any case. Also, there’s a perk, which may help assuage any concerns in the form of a premium of typically between 50 and 75 basis points versus a more plain vanilla loan.

Perhaps more unsettling for investors may be the negative sentiment around some of the larger, publicly listed technology stocks. “Big technology stocks are in the midst of their biggest rout in a decade,” as The Wall Street Journal put it this week.

Some of our sources familiar with ARR financing concede that this may indeed be an issue, particularly for consumer-facing technology businesses, but for the time being little impact on valuations was being seen in the mid-market. Furthermore, they point to typically low leverage and large equity cushions as significant safety nets in ARR deals. There is no sense yet of a bubble bursting in this part of the market.

Watch out for the July/August issue of Private Debt Investor, where we take a Deep Dive into this topic.

Write to the author at andy.t@peimedia.com