The rise of direct lending funds continues to be scrutinized from all sides of the market, especially as they now compete fiercely with broadly syndicated loans and bonds, as well as bank-based credit in general.
Indeed, direct lenders have shown a willingness to provide jumbo unitranche deals of £1 billion-plus, putting them in direct competition with underwriting banks. A combination of macro events has further forced banks to retrench from lending, thereby creating a fertile environment for direct lending funds to proliferate.
However, it is in the lower end of the European mid-market where competition between funds is really playing out. This dynamic is bringing innovations, with lenders looking at new metrics of company performance such as annual recurring revenue (ARR) rather than a standard EBITDA measure, with deals done on this basis adding to a growing cohort of “ARR financings.”
“While it’s true that direct lenders generally are seeking to deploy via bigger tickets, some lenders that are newer to the ARR space are willing to look at smaller deals as a way of dipping their toe into the ARR market,” said Steve Green, senior director at Alvarez & Marsal. “Undoubtedly, as these lenders become more comfortable with ARR over time, they will revert to seeking the larger tickets. However, for now the smaller deals are a neat way for these lenders to gain experience and better understand the market dynamics.”
Most direct lending funds are looking into deploying ARR financing, market sources agree. “I am looking at ARR at the moment—we all are,” confirmed one direct lender.
“We are getting more and more queries from our mainstream clients who want to know how these ARR deals work,” said Francis Booth, partner at Hogan and Lovells.
Origins of ARR
ARR financing was spawned in the US, and more particularly in Silicon Valley—where technology companies are legion. Technology firms tend to be resilient and have withstood the COVID-19 pandemic well, and are also the companies that will more likely have the kind of clearly identifiable, recurring revenue based on subscriptions which is the corner stone of ARR financings. “A gross profit or pre-EBITDA business whose revenue doesn’t truly ‘recur’ could be seen as weaker credit,” explains Aymen Mahmoud, partner at MWE.
“Tech has been a fantastically resilient sector over the course of the pandemic and that’s what’s bringing people to have a look at ARR and try and understand the businesses and the credit thesis, whereas before, they might have left them,” Booth says. “Over the last few years, it’s been a less crowded marketplace in Europe—but that looks set to change,” he added.
Furthermore, ARR financing makes it possible to tailor a package that is not based on EBITDA—such in cases where companies would have no EBITDA or a negative figure, for example—on the premise that such a company is on route to generate a lot of revenue, and soon enough EBITDA.
“Assuming there is mandatory flip to an EBITDA-based leverage test, there is generally also a window in which the borrower can elect to flip,” says Booth. “That may unlock the margin ratchet, grower baskets and dividend permissions, but there may also come a point where the business is finally turning a profit and it’s actually easier for the CFO to meet the EBITDA test than it is to keep growing revenue to meet the ARR test. That all depends of course on the profile of the ARR test.”
Multiplication tables
Meanwhile, competition for financings is driving up ARR leverage multiples. These generally began in Europe around 1/1.5x, but the market is already seeing deals going up to 3x ARR. “Whilst ARR leverage multiples started off relatively modest in Europe, they now often start with a 2 and are also getting done at 3x ARR. Some borrowers are also able to negotiate ARR for life, and not just in the VC space, Booth said.
“The market has moved from requiring a flip to EBITDA-based covenants after two or three years to more ARR-for-life structures as sponsors seek to drive value via top-line growth—particularly given most of these assets are valued based on ARR multiples,” said Alvarez & Marsal’s Green.
As for covenants on such deals, these are a bit different from plain vanilla unitranche financings, but otherwise work in the same way, market sources agree.
Space exploration
Lenders such as Sixth Street, Blackrock and Silicon Valley Bank have been active in the ARR financing space for several years, however there are an increasing number of direct lenders beginning to look at the space, sources say. “Some lenders that are keen to do more in the ARR financing space are somewhat restricted by the mandate of their funds, which don’t cover such structures,” explains Green. “But it is likely that as part of new fundraising processes lenders will increasingly look to include the ability to invest in ARR financings.”
In terms of pricing for ARR financings, the market seems to agree that this is roughly lining up with conventional unitranche packages, or perhaps coming a little higher. “There is some 25-50 bps on top for ARR,” another direct lender said.
Among recent examples of ARR financings, Marlin Equity Partners has this week raised debt financing to support the future growth and recapitalization of its portfolio company Heimdal Security, a provider of cloud-based cybersecurity. And in January, Marlin acquired a majority stake in Silobreaker, a risk and threat intelligence SaaS provider, to support its continued growth strategy, with an ARR financing used.
Elsewhere, there was also an ARR financing supporting Corten Capital’s acquisition of Matrix42, one source said.
The level of interest that ARR financing is generating from all parts of the private lending market means it is already evolving quickly, and will be an area to watch closely as the year progresses.
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