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LevFinLevFin Leveraged Loans

Recurring revenue lending must protect its brand

technology_adobe_575px_6Nov20

When hot new debt products are on the march, someone will always push the boundaries beyond what is tolerable. In the case of recurring revenue loans, that would be a mistake.

Debt markets have always struggled to get a piece of the action in the ecosystem of hot new venture capital-backed start-ups, and for good reason. For high growth companies with rich equity valuations but scant (if any) profits and non-existent free cash flow, traditional lending metrics tend to paint the business in an unflattering light.

Better to turn to venture capital funders who share in the ambitious growth visions of founders than face the glare of stony-faced lenders looking at years of brutal cash burn.

Venture debt in various forms has existed for years, but in the past few “recurring revenue loans” have grown in popularity among more mature tech firms too.

These are provided by the likes of Golub Capital, Owl Rock and Monroe Capital to companies in the “software as a service” (SaaS) sector, which may have little in the way of profits to support regular corporate Ebitda-based lending, but which do have large books of sticky subscriptions revenue from enterprise clients in a variety of sectors.

Structurally, these loans look identical to corporate lending. There is no attempt to pledge specific revenue streams to lenders, beyond the usual asset security in a loan, but they offer a way for lenders to get comfortable with a different business model which is ill-served by the mainstream capital markets.

After all, there’s nothing magical about existing methods of parsing creditworthiness. Ebitda gained popularity only in the 1980s — “cable cowboy” John Malone, chairman and owner of Liberty Global, is often credited with its invention — and has been much-abused since. Accounting profit can be wildly distorted by taxes and non-cash balancing lines. Loan-to-value measures work well for hard assets but are of limited use in looking at intellectual property, brands and growth potential. There’s nothing wrong with choosing another metric that fits better with emerging business models.

The problems could come, however, if the sector starts to look beyond the SaaS businesses at its heart today. All kinds of companies of wildly variable creditworthiness can claim some amount of recurring revenue — nearly any business-to-business company has a selection of regular contracts and customers it can point to. Long-established business-to-business publications such as GlobalCapital, for example, certainly have recurring subscriptions from highly creditworthy customers, though very different growth trajectories from the hottest enterprise software firms.

So, it’s easy enough to imagine that, as new capital flows into recurring revenue lending, boundaries will become blurred and more firms will seek borrowing on more comforting revenue metrics, rather than face the cruelties of having their Ebitda adjustments dismantled in front of them.

Boundary blurring is a natural process in any capital markets innovation. The AA’s debut as a securitization issuer comes to mind. It was the first “asset-light” whole business securitization done in the UK. It took a debt structure template pioneered in property-rich sectors such as the pub operator companies or holiday parks, and applied it to a business with virtually none — simply a bunch of mechanics and their vans.

Using this structure allowed the owners to crank up leverage by an extra turn or so — compared with existing Ebitda-based corporate lending — meaning that, in its latest private equity takeover, the new sponsors actually had to put in more cash, making it a rare “deleveraged buyout”.

The AA is still in good shape, recently accessing debt markets to fund said buyout, at a respectable 6.5% — not bad, given that the bond ranks behind the securization.

But there’s still a risk in pushing new debt products into new areas. The point of doing this, almost by definition, is for companies to gain access to more debt on better terms — after all, if existing products or credit metrics would work, why bother reinventing the wheel?

More debt always amplifies corporate busts when they come — as they always do — and that will leave a nasty taste in the mouths of lenders, sponsors and financiers. Packages of recurring revenue loans are already being bundled into asset-backed securities, allowing lenders to lever up and juice returns. If the product’s strong software focus is diluted, this could end up tainting the whole sector, and rippling outwards through the buyers of the ABS notes and the banks that finance them.

Right now, it’s an innovative product that deserves a chance — but it’s best not to push the boundaries.

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