Private Equity Firms’ Secret Weapon for Big Software Buyouts
When Thoma Bravo was drawing up the financing of its $8 billion acquisition of Coupa Software last year, the private equity giant didn’t turn to a bank, and it didn’t get a traditional loan. Instead, it tapped a group of non-bank lenders including Sixth Street for a relatively obscure type of financing—one that has been making its way into more and more multibillion dollar deals.
That deal, the 10th-biggest buyout of last year, according to Dealogic, was financed not based on profits, but on annual recurring revenue. Recurring revenue loans have been used for smaller software buyouts for years, but are being used more and more to fund some of the biggest technology takeovers, several private equity dealmakers told The Information.
Private equity firms are increasingly tapping non-bank lenders like investment firms for loans, and ARR loans are more of an option with those firms since they’re less regulated and risk averse than traditional banks.
The option of using ARR loans to fund bigger technology buyouts is key for private equity firms, which have been mostly unable to get loans from traditional banks for months. The banking industry has all but stopped funding private equity buyouts because interest rates have risen and the banks have struggled to offload the existing debt on their balance sheets.
At least 10 notable private equity deals were financed with ARR loans last year, compared to six in 2021, none in 2020 and two in 2019, according to data from LCD, a division of Pitchbook that tracks notable-–but not all—of these deals because the data is elusive.
Among the deals done with ARR loans last year were Thoma Bravo’s $10.4 billion acquisition of Anaplan, Hellman & Friedman and Permira’s $10.2 billion acquisition of Zendesk, and Vista Equity’s $8.4 billion acquisition of Avalara.
“There’s more money pouring into software businesses from private equity and venture capital,” said Justin May, a managing director at investment bank Lincoln International who advises private equity firms about deal financing. He said investors are also looking for innovative ways to finance the deals as appetite for them grows.
In the back half of last year, the amount of bank-led leveraged buyout loans fell 80% year-over-year to $13.2 billion in the U.S., according to Pitchbook. Non-bank direct lenders—including investment firms and the credit arms of private equity firms—have picked up much of that slack.
To get a sense of how easily a company should be able to pay off its debt, lenders look at its leverage ratio, which is typically calculated by dividing a company’s net debt by its earnings before interest depreciation and amortization. If this debt-to-EBITDA ratio falls outside of a generally accepted range, warning bells go off.
With ARR loans, the leverage ratio is calculated by dividing net debt by annual recurring revenue rather than by EBITDA. Doing so enables lenders to fund buyouts of unprofitable companies, but because of their higher risk profiles, recurring revenue loans tend to have tighter documentation protections and covenants. They’re also more expensive. ARR loans typically carry slightly higher interest rates than traditional loans—for example, if a traditional loan had an interest rate of 7% over the secured overnight financing rate, an ARR loan might have a 7.5% rate, May said.
Many of the ARR loans also have a provision that requires the loan to flip to the more traditional debt-to-EBITDA ratio after a set number of years. If companies are unable to turn a profit by the agreed upon date, they might default on the loan.
This type of provision has become more common within the past six months to a year, according to Allison Liff, Head of U.S. Leveraged Finance at the law firm Freshfields Bruckhaus Deringer.
PE’s Eager Appetite for Software
The private capital industry is sitting on a record amount of dry powder, and both private equity firms and direct lenders have been directing much of it toward software deals. About 30% of private equity buyouts last year were within the technology sector, and 88% of those tech buyouts were in software, according to Bain.
“The predictable nature of [software] revenue and therefore the cash flow of those businesses make software a very exciting and stable industry to underwrite, particularly in uncertain economic times,” said Vista Credit Partners President David Flannery.
Several private equity dealmakers said depressed stock prices for unprofitable public companies have created an opportunity to scoop up growth-oriented firms with profitability potential at what they perceive as a discount.
“The valuation correction has been much more severe for these unprofitable companies versus profitable ones, which has attracted some more private equity buyers who have the expertise to help transition these companies to profitable growth,” said Thoma Bravo’s head of credit Oliver Thym.
Of course, not all recurring revenue loans are going toward multi-billion dollar buyouts of publicly traded companies. As fundraising becomes more difficult, founders of privately-owned software companies in Silicon Valley are increasingly interested in recurring revenue loans, too, as a way to put cash on their balance sheets, Vista’s Flannery said.
But in an environment of higher interest rates, earlier stage companies that aren’t able to turn a profit are more likely to default on recurring revenue loans starting later this year, said Bill Cox, Global Head of Corporate, Financial and Government Ratings at credit rating agency KBRA. Cox contrasted these companies with larger companies that might take out a recurring revenue loan to reinvest their earnings into sales and marketing initiatives. That second group of companies could more easily “turn off the marketing and sales spigot” and refocus that money elsewhere, Cox said.
“I don't think this is going to be a situation where folks say, “We shouldn't have done that,’” Cox said. “It’s more likely to be a case where economic conditions don't support as many of these companies being able to be invested in this way—at least for the time being.”