Software LBOs: recurring revenue loans will be a recurrent problem

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In the bygone era of cheap debt, private equity groups loved software companies. Financial engineers even created a new type of leverage: loans based on annual recurring revenue (ARR) from software subscriptions. Multiples were seemingly tolerable. But conventionally defined leverage from ARR loans often approached or exceeded 10 times ebitda.

The fad for avant-garde capital structures is over. But according to data from website PitchBook LCD, five of the 10 largest, low-rated leveraged loans due in 2024 and 2025 come from software companies. These include KKR’s BMC Software and Thoma Bravo’s Hyland Software.

Higher interest rates and investor risk aversion will make straightforward refinancings extremely hard. 

One option is a restructuring that hands over some or all ownership to creditors. The alternative is to infuse more equity. Buyout group Vista recently put in $1bn of equity to clinch the refinancing of $5bn of existing debt at portfolio company Finastra.

PitchBook LCD noted that across all industries, the majority of the $75bn of US leveraged loans due in 2024 had been refinanced. But most were at the higher end of the ratings spectrum. 

Credit spreads have narrowed substantially this year. After peaking at more than 700 basis points in 2022 they have fallen to about 500 basis points. The problem for US companies is that rates such as the Secured Overnight Financing Rate have kept climbing. Banks are pricing new leveraged loans at a juicy average of 10.5 per cent, according to PitchBook LCD.

The lowest rated companies have business models that cannot support interest rates higher than this, in the 15 per cent range. They would struggle with floating interest rate exposure when their existing spreads are just at 300 or 400 basis points.

Debts can only be serviced using cash flow left after other expenses. Revenue, even if it comes from steady subscriptions, should never be the basis for borrowing heavily. It is a lesson buyout groups are set to learn the hard way.

Lex is the FT’s concise daily investment column. Expert writers in four global financial centres provide informed, timely opinions on capital trends and big businesses. Click to explore