Zia Uddin, managing director and portfolio manager for private credit at Monroe Capital in Chicago, is enthusiastic about lending to the tech sector – but he backs this zeal up with hard data.
Monroe has financed more than 70 technology businesses in the US and Canada over its 15-year history. Uddin says that, along with healthcare, technology is the largest sector on its loan book. He particularly likes lending to software companies that serve businesses, a category known as enterprise software.
Advisory firm Gartner estimates that global IT spending will rise to $3.79 trillion in 2019, an increase of 1.1 percent on last year. Much of this growth will come from enterprise software, a market set to reach $427 billion this year, up 7.1 percent from $399 billion in 2018. Loan default rates among tech firms have historically been low: 2.2 percent since 1995, and under 0.5 percent for software, according to S&P LCD. “The default rate for enterprise software is low if you understand the space and the products,” adds Uddin.
If anything, software’s attractiveness to lenders has strengthened in recent years. This is partly because of the huge amount of private equity software deals, which present a wide range of direct lending opportunities.
Observers detect a useful shift from around 2010, when paying for software started to morph from the on-premise licence system of large upfront payments and lower maintenance payments, to the software-as-a-service model of regular payments every month, quarter or year, with software upgrades included. Finding good credits is not easy. One consideration is that the health of software companies depends, at least in part, on the health of the sectors they serve.
Suhail Shaikh, head of US direct lending at Alcentra in New York, illustrates the point with a real-life example. In December 2018, Alcentra lent to a business that had created an online wedding services platform. “Weddings are generally recession-proof,” he says. “Regardless of whether the economy is good or bad, people are going to spend money on them” – though some economists have attributed a decline in marriage among America’s white working-class to a long-term dwindling of economic opportunities.
Shaikh adds that if Alcentra were asked to lend to a similar type of company that served real estate investors, “we would take a harder look at that, because the underlying market would be a lot more volatile”.
On the other hand, lenders say technology companies are better protected and more attractive, even if they are serving cyclical industries or if their product is – as Monroe’s Uddin puts it – “mission-critical”. “You and I use Word, Excel and Outlook every day,” says Uddin. “If our business dropped 50, 60 or 70 percent, we would still need that online storage software offering.”
There is also a danger in being too positive about lending to technology companies. Matthew Linett, managing director and head of underwriting at Churchill Asset Management in New York, says a good software business could support leverage as high as 7x EBITDA, but it would have to be a “significant company” with the highest market share in its niche. For smaller software businesses “with otherwise attractive attributes”, he suggests leverage of 5x or 6x.
Jeff Davis, co-head of private credit at Eaton Partners, a placement agent and advisory firm based in Rowayton, Connecticut, thinks the many funds dedicated to technology lending are not being sufficiently cautious: “These types of dedicated lender need to be careful to avoid becoming too comfortable with ‘owning’ their space, to the point where they issue too many covenant-lite leveraged loans, with too much flexibility in call protection, restricted payments and the definition of EBITDA.”