After years of bumper valuations, top US tech stocks lost $3 trillion of market cap in the first six months of 2022, according to data from S&P Global, as investors fled the asset class. The big hits to consumer tech names like Apple, Microsoft, Alphabet and Amazon filtered through to the ability of growing tech and software companies to access capital, driving an opportunity for specialist lenders.
David Flannery, president of Vista Credit Partners, says: “What we are seeing is that equity markets are pretty frozen, the IPO market is all but closed, the growth equity market is certainly choppy, and valuations are at best pretty uncertain. And we have seen the level of inbound calls to us from great enterprise software companies at least double.
“Today, founders of those businesses might have an equity option on the table but it is almost certainly a lot less attractive than it was a year ago. Our solutions in this environment have become extraordinarily appealing to growth companies that want to continue to invest in their business.”
Some of the larger deals that were historically done in the syndicated lending market are also now being done by direct lenders taking market share.
Timothy Gravely, head of credit at Aquiline Capital Partners, says his firm is also seeing interesting opportunities: “On the one hand you have a lot of technology companies that have raised money at valuations that look quite different in today’s market, so when they come to raising additional capital – if they are still in growth mode and pre-profit – there is a lot more interest in more structured solutions. There is an opportunity to get a lot more downside structural protection in return for offering less dilution and additional equity upside through some form of warrant coverage.
“The other area where we see a lot of interest is non-sponsored buyout activity, where entrepreneurs don’t need to sell and they don’t have a closed-ended fund that they need to generate liquidity for in a set period of time. Those owners don’t like current valuations but still need capital, so there is a growing demand for more structured capital in lieu of a change of control transaction.”
The non-sponsored market for lending to high-growth tech businesses has long been less competitive than the sponsored space, allowing lenders more structural protection and facilitating double-digit returns. That compares to single digits in the sponsored space, which is more heavily populated by generalist lenders.
“There is a more cautious tone from the more generalist investors that have been wading into technology and software in recent years,” says Gravely. “Perhaps with incremental volatility there are more traditional opportunities for them to look at, or they are just more hesitant. It is a market where specialists and investors that have been involved in this sector for many cycles are going to be more comfortable than generalists.”
Zia Uddin, president of Monroe Capital, says non-sponsored deals should increase in a market environment like this one. “Historically, non-sponsored deals have been a good chunk of our businesses,” he says.
“If you believe we’re entering a slowdown, we would expect to see an increase in non-sponsor volume. Historically, companies that were founder-owned took venture capital money because the capital markets on the debt side were not as well developed. We expect to see more founder-owned companies seeking debt to fund growth, in order to avoid dilutive equity.
“Over time we are going to see more competition from lenders, but this market requires a specific set of skills across origination and underwriting. You have to be living in this space for a while – you can’t just show up and think you know what you’re doing.”
Uddin says the US tech market is in a state of flux, causing a shift in focus among private equity buyers: “In the syndicated market, spreads have widened in the first half of this year. We are starting to see that in the mid-market too, but it has not yet been as pronounced. Valuations have also come down on the private side, and leverage levels are also down a bit.
“When it comes to sentiment, buyers today are placing more emphasis on profitability over growth, when 12 months ago it was growth that was more highly valued. Companies that are losing cash – and I’m not talking about the venture side here – are the most impacted by the drop in valuations.”
Vista’s Flannery says there is an important distinction emerging between enterprise software and technologies that cater to medium-sized companies, and what is happening to consumer-facing internet businesses.
“Enterprise software involves a long sales process before a company buys or licenses a product, but once it is up and running that really doesn’t come out” he says. “Even if a company files for bankruptcy and has to reorganise, it keeps its software running. We are in a pretty tough, uncertain economic environment, but that stickiness is why these enterprise software deals hold up and why there will continue to be a market for lending to those deals.”
There is a question mark, he says, over whether growth rates might slow even in enterprise software, as companies delay buying decisions. “But as a lender, I’m not that concerned about growth rates – I care more about whether revenues, and therefore cashflows, are not in decline,” says Flannery.
Cybersecurity remains a highly active part of the US market, but the most attractive deals depend more on end markets than on types of technology.
“We are certainly staying as close as possible to the sub-segments that we feel are resilient economically or don’t face end market deterioration risk as we go into a potentially difficult economic period continuing into 2023,” says Gravely. “Areas like property technology have been a bit more difficult compared to areas with pretty interesting tailwinds like human capital management software technologies.
“Some of the markets we have found quite interesting actually have more to do with the end market, like energy technology, for example. What we have seen in energy enterprise software is a huge reluctance on the part of many software investors to get involved in a sector that remains susceptible to energy price swings. We believe there is a core embedded level of customer demand that is not vulnerable to commodity prices that makes investments in these types of situations less competitive.”
Flannery adds: “We don’t necessarily think about subsectors so much as we think about great enterprise software solutions for a diverse range of end markets. If the software is state of the art, then we consider how cyclical the end market that it is servicing is.
“You might have to be a bit careful with more cyclical end markets like retail or apparel, but even then, retail isn’t going away. If you’re a software company with one of the best technology solutions and a broad customer base in retail, then you are in a pretty good spot.”
Uddin says there is no shortage of dealflow for lenders to US tech. “We look at around 2,000 deals a year and try to do 50 or 60,” he says. “For us, it has always been a numbers game, and we work with these very sophisticated sponsors that know what they are doing. We are trying to align with the right folks in really specific verticals, so we continue to see good opportunities.”
The outlook also continues to look strong. “As a lender, we are not getting deep into these companies, with loan-to-value at about 15-20 percent of the enterprise value,” says Uddin. “Obviously if you’re doing the right underwriting and the right kind of conservative lending, this kind of market environment is less problematic given the significant equity cushion we have behind our position.”
Why tech remains a strong bet
Fund managers are confident that the tech space offers good long-term opportunities.
“We are still in the early innings of this digital transformation, and we are expecting one in three private equity deals to be technology or software related by 2025,” says Zia Uddin, president of Monroe Capital. “Covid has accelerated some adoption, but at the end of the day, if you believe we are facing a recessionary environment, then technology and software should continue to attract investment from customers because it is one of the only places where companies can create massive productivity gains and operating leverage.”
While there may be a shake out as generalist direct lenders step back from tech and software, David Flannery, president of Vista Credit Partners, is bullish on the outlook for specialists: “The lending world is really going to see some dispersion. There are some tourists in this space, but not all technology companies are created equal and you’re going to see us and others that are embedded in the market continuing to lend to great enterprise software companies.”