Private debt in focus

As the technology sector is continuously evolving, investors need to maintain a key focus for investment opportunities. The rise of Artificial Intelligence (A.I.) has driven global optimism for the potential societal impact leading public and private investors to search for investment opportunities. And even though the 3Q2024 global market selloff was short-lived, it caused anxiety for some technology investors. However, it is important to distinguish between the structural outlook versus the tactical outlook.

Since the pandemic, technology (along with other sectors) has passed through unique economic phases. Global government stimulus helped shorten the duration of the pandemic driven-recession. As businesses and consumers weighed the aftereffects of the pandemic, there was much expectation that remote work and an enhanced digital life would be brought forward as a result. Businesses made significant investments in technology to meet the expected demand.

However, this proved unrewarding as consumers cut back spending amid high inflation impacting the top and bottom line for businesses. Businesses reacted by consolidating technology vendors and/or declining to renew vendor subscriptions. Positively, we appear to have passed this near-term trough. According to Goldman Sachs, Information Technology spending is rising above or back to long run averages which suggest businesses recognize the structural necessity to invest for future growth (see chart below).

The gyrations in the public markets and the volatility in tech spending has muddied the structural outlook for the sector. However, we remain optimistic that the technology sector will remain a key focus for investors. We devote this Private Debt in Focus to highlighting why we maintain a favorable view on the sector, discuss how A.I. is influencing our underwriting, discuss an evolving approach to technology private credit investing, and present a recent investment case study.

An Evolving Approach

A major theme is the implementation of Annual Recurring Revenue (ARR) loans to finance deals in the private credit industry, but particularly in the Software-as-a-Service (SaaS) industry.

We apply two underwriting approaches: 1) EBITDA based and 2) Annual Recurring Revenue (ARR) based. In an EBITDA or traditional “cash-flow” underwriting approach, the debt quantum provided to borrowers is based on EBITDA. However, many middle market companies have yet to reach a mature phase in their business lifecycle. In this phase, operating costs are high as companies focus on driving growth. They are not producing significant and/or positive cash-flow or EBITDA.

Therefore, we cannot anchor to an EBITDA based underwriting approach to measure a business’ progress that is in the growth stage. As such, over the past few years, industry practitioners have employed an alternative approach – ARR based underwriting.

Many technology companies, specifically software companies, have recurring revenue through a subscription model with clients. As one measure, we look at the stickiness of client subscriptions year-over-year (i.e., how binding are these subscriptions). This ensures steady, predictable and consistent revenue over various reporting periods depending on the length of the contract with the end customer.

However, revenue doesn’t always predict long run profitability. As such, a key characteristic in ARR loans is a “covenant flip”. As lenders, we want to ensure that a business is ultimately driving towards profitability given profitability influences the valuation multiple that a business commands when it becomes an acquisition target. A “covenant flip” dictates that the debt will transform from being measured against recurring revenue (Debt/ARR) to being measured against EBITDA (Debt/EBITDA) after certain conditions have been met or by an established timeline (usually 2 to 3 years after loan closing).