Few industries have been spared the heavy financial toll of the past two years. But for technology mid-market lenders, the pandemic proved to be a blessing in disguise. Cashflow boomed, company valuations skyrocketed and M&A activity reached record levels as the world embraced all things digital and technology proved itself to be a godsend.

Bankruptcies swept through many industries, but default rates in the technology space largely weathered the storm. Levels rose to 3.2 percent of deals by the first quarter of last year before falling to just 0.7 percent by the fourth quarter, according to research from law firm Proskauer. In comparison, default rates for the food and beverage sector were still at 6 percent by close of 2021.

Dealflow also continued to go from strength to strength. Data researcher Kroll estimates that software M&A achieved almost $500 billion last year, a massive 260 percent increase over 2020 and $247.7 billion more than the previous high of 2018.

“Over the last two years, we have seen a large uptick in the number of new transactions taking place in the software tech space,” says Chris Lund, managing director and co-portfolio manager, institutional vehicles, at US mid-market lender Monroe Capital. “These companies still have the opportunity to grow 20 percent to 30 percent-plus per year for the foreseeable future. And there is a growing understanding in the investor community that software tech lending is a very safe, steady port in a storm.”

The global shift to digital also played a key role in the clamour for new deals. US consultancy Gartner says that worldwide IT spending annually grew almost 10 percent in 2021, at $4.2 billion, and expects another 5.5 percent growth this year. Enterprise software is projected to see the biggest jump in 2022, with 11.5 percent growth, followed by IT services at 8.6 percent.

And while the economic impact of covid may be starting to recede, digitalisation is only projected to increase post-pandemic. In 2020, KPMG conducted one of the world’s largest IT leadership surveys. Almost half of CIO and technology executives agreed that covid had permanently accelerated digital transformation and the adoption of emergent technologies.

In the KPMG survey, software-as-a-service marketplace platforms experienced the greatest popularity swing in the first year of the pandemic, with 23 percent of respondents stating that they had embraced large-scale implementation. One in six organisations had begun using a SaaS platform for the first time.

Testing times

Deploying new technology and software solutions has helped countless businesses offset some of the operational challenges over the past two years, particularly for remote working. Squeezed margins, labour shortages and supply chain complications are also increasing the world’s reliance on automation and other predictive technologies. These economic headwinds will only intensify appetite for digital spending.

“The tech sector’s general resiliency versus other industries during the pandemic meant that a large part of the 2021 recovery in the mid-market was led by sectors such as tech,” says Viral Patel, managing director at Prime Lead Partners. “There are now quite a few lenders that solely favour the new economy and use this as an important filter to screen deals.”

On the flipside, he points out that many lenders have had to be more aggressive in terms of leverage multiples and commercial terms to secure deals in a market with plenty of dry powder.

The mid-market tech sector has also experienced shorter holding periods by equity investors due to exit valuations rising rapidly, but this probably suggests that the biggest shock to portfolio companies has been limited to the pandemic rather than a long economic recession or down cycle.

Flashing the cash

Regionally, there has been little to separate the boom in technology lending. In the US, mid-market private earnings continue to swell into 2022. Credit asset manager Golub Capital estimates that revenues for technology firms were up 19.3 percent in Q4 2021, while earnings increased by 9.6 percent year-on-year, more than healthcare and only eclipsed by the consumer sector.

Data researcher Pitchbook adds that 2021 was a record-breaking year for US private equity software deal activity. Buoyed by the frothy market conditions and unprecedented liquidity, 947 deals were closed across the 12 months at an aggregate of $167.1 billion, easily surpassing the previous year’s record of $94.8 billion and attracting the attention of lenders.

In Europe, technology accounted for 24 percent of all mid-market debt deals completed in the first half of 2021, the highest of any individual sector and up 2 percent over the second half of 2020, according to Kroll. Transaction deal size was also very stable.

However, the macroeconomic picture is not all positive. Inflationary pressures are starting to ramp up, which could disrupt the global economic post-covid recovery. In November, Fitch Ratings sought to reassure investors that European leveraged finance issuers have the headroom to absorb rising interest rates. Lenders are only likely to become significantly exposed to refinancing risks if there is a sharp hike. European focused asset manager Prime Capital says that technology firms made up just 2.8 percent of European high-yield bond issuances by Q3 last year.

“Rising interest rates will clearly affect investments but many lenders have already started implementing floating rate structures and other methods to counteract the impact,” says Olya Klueppel, partner and head of credit at technology advisory and investment firm GP Bullhound. “The impact of the invasion of Ukraine by Russia, however, is still not clear and is likely to be negative near term given the large number of IT professionals located in Ukraine, supporting many European tech companies.”

Patel argues that the initial impact of inflationary pressures is already being seen in the listed technology space. Some of this is sentiment driven and increasing interest charges on debt and cost inflation on operating models will reduce company earnings and ultimately dividend paying capacity.

But he stresses that software and broader technology has a big role in offsetting some of the economic headwinds. “Technology in some ways is seen as the panacea to these forces as it can increase automation and reduce labour costs,” he says. “High operating margins within tech companies somewhat reduces the sensitivity to any increase in cost of finance, coupled with widely available non-amortising loan structures, which eliminates covenant pressure in these deals.”

Lund agrees that the technology sector is better positioned than most to weather rising interest rates and inflationary pressures. “The gross margins are so high that technology companies are much less affected by rising costs. If you are a business looking to improve margins, one of the only places where you can invest and get efficiencies is software and digitalisation.”

Mid-market credit provider Northleaf Capital Partners increased its portfolio exposure to technology in the second half of 2020 after strong risk-adjusted returns in the first half of that year. “In 2021, we continued to see strong dealflow in this segment, although we have also seen some spread compression and higher leverage on tech deals,” says David Ross, managing director and head of Northleaf’s private credit programme.

Obstacles ahead

But new regulations in Europe and China could also take some of the heat out of technology dealmaking. In Europe, two new bills have been drafted to help protect users from accessing illegal content on social media platforms and prevent technology firms from abusing their market position. If passed, failure to meet obligations could result in heavy fines.

Over the past year, the Chinese government has also stepped-up its technology crackdown, triggering many exits from PE firms. E-commerce multinational Alibaba was forced to pay a record $2.8 billion fine for anticompetitive behaviour and food delivery app Meituan paid out $530 million for breaching the new regulations. Foreign lenders will particularly be worried about the long-term impact on the sector. Dealmaking could slow or shift to other industries that are less exposed to these regulatory risks.

The changing lending model could also impact dealflow in the mid-market. “Many technology companies are increasingly focused on growth versus profitability, as valuations are based on revenue instead of EBITDA,” says Ross.

He explains that the share of recurring revenue deals in the market continues to increase. “This introduces a new element of risk for lenders, as the loans are no longer underpinned by cashflows. The underwriter must now also focus on the ability for the borrower to grow versus just remain stable.”

Europe’s 5G bonanza

Appetite for private debt deals in the technology, media and telecommunications (TMT) sector showed no sign of flagging last year, despite the pandemic hitting other sectors hard.

Over the first six months of 2021, research from Deloitte’s Alternative Lender Deal Tracker estimated European TMT at 25 percent of total dealflow, larger than any other industry. Seventy-one percent of all European transactions were used to fund buyouts, highlighting the role of M&A activity, while the UK is still the main source of deal volume for direct lenders in Europe.

For telecoms debt lenders, European private debt manager Pemberton expects strong performance into 2023. The rollout of 5G across the continent has a strong investment pipeline over at least the next few years and digital infrastructure still lags the US and Asia. By 2025, the EU has set itself the target of reaching download speeds of 1Gbit/s for all households and uninterrupted 5G broadband coverage for all urban areas. Strong cashflow generation in the telecoms sector will also likely support further M&A, bolt-on acquisitions and consolidation.