Easy credit's latest twist: Loans to companies with no income

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No earnings? No problem. At least for some companies seeking loans now.

Private-equity firms are finding it easier than ever to get loans to finance their buyouts of corporations that are nowhere close to being profitable, even by lenient measures. The loans are mostly coming from investors outside the banking system, including asset managers like Ares Management Corp. and Owl Rock Capital Partners, that are looking for higher returns than what they’d earn from more conventional debt.

Vista Equity Partners used this financing, known as “recurring revenue loans,” for its leveraged buyouts of companies such as Mindbody Inc., a maker of payment and scheduling software for fitness studios, and Apptio Inc., which provides software that helps companies manage their information technology spending, according to people familiar with the matter.

Data on the loans is scarce, but other private-equity firms including Thoma Bravo, Warburg Pincus and Marlin Equity Partners have also relied on the market, the people said, asking not to be named because the transactions are private. Ares and the buyout firms declined to comment or did not respond to requests for comment.

Cycle’s Top?

The deals are a symptom of how far private-equity firms, and their lenders, are willing to go now to boost returns. Buyouts traditionally focused on companies that generated solid cash flow by at least some measures, but whose net income was depressed.

After years of exuberant stock markets and cheap debt prices, buyout firms are now snatching up younger and younger companies with fewer assets and less income, often in the technology industry. They are financing the deals with loans based on expected revenue from the companies’ service contracts, hence the name “recurring revenue.” The loans come as the Federal Reserve is cutting rates, expanding the money supply this week for the second time this year, spurring lenders to chase higher returns.

“The market is getting more aggressive as it often does towards the top of the cycle,” said Gustavo Schwed, a former partner at the private-equity firm Providence Equity Partners, who is now a professor at New York University Stern School of Business. “That’s when people get creative.”

‘Equity-Like Risk’

That creativity could turn into regret. Lenders to relatively new companies “aren’t getting equity-like returns but you’re taking equity-like risk,” said Ian Walker, a lawyer who has scrutinized some of these loan documents for the research firm Covenant Review.

Traditional banks and other investors in the syndicated loan market have largely been reluctant to lend to companies with a minimal history of generating the kind of earnings that pay interest costs. Exceptions have been confined to unicorns such as Uber Technologies Inc., usually in anticipation of their high-profile upcoming stock offerings.

Private-equity firms were the same, historically buying out companies with positive measures of such income that pays interest, known as earnings before interest, taxes, depreciation and amortization or Ebitda. Recently, they have have grown more willing to aggressively adjust Ebitda higher through moves like giving companies credit for expected future cost savings.

Low Leverage

And now buyout equity firms are going further, looking at companies with minimal or negative Ebitda even on an adjusted basis, but whose revenue is growing fast. Key safeguards for these loans allow lenders to take more control of the company if the borrowers’ finances deteriorate, and are initially calculated on a measure of recurring revenue — typically the most recent quarter annualized — instead of Ebitda.

The companies in question are often software firms that have clients locked into multiyear contracts. And buyout firms might finance as much as 80% of the acquisition with equity, meaning the loan would be 20% or less of the transaction. In a conventional private-equity acquisition, debt might account for about 70% of the purchase price.

Direct lenders including Golub Capital, Monroe Capital, and credit investing affiliates of buyout firms like TPG Capital and Vista are among those that have underwritten recurring revenue loans, according to the people familiar with the matter and data compiled by Bloomberg. Chunks of the loans have ended up in credit funds that invest money on behalf of large institutions as well as in business developments companies, which are vehicles that allow retail investors to get exposure to pools of corporate loans.

The firms declined to comment or did not return requests for comment.

Higher Yields

The loans have many similarities with those that banks arrange for their private-equity clients and syndicate to institutional investors: They generally mature in five to seven years, are secured against a company’s assets, and pay a variable interest rate.

Recurring revenue lenders have been so far willing to underwrite loans worth between one and three times a company’s annual recurring revenue, with some of the largest transactions stretching past $500 million. They typically pay a spread of between six and eight percentage points above the London interbank offered rate, the people said, about a percentage point more than a company with a more solid track record might pay.

Some traditional lenders like SVB Financial Group’s Silicon Valley Bank have made loans like these in the past, but typically on a smaller scale, and usually closer to around one time the company’s revenue.

2U Inc., the maker of an online learning platform, received a $250 million loan to finance its acquisition in May of Trilogy Education. The loan would have resulted in debt equal to more than 14 times 2U’s Ebitda based on its 2018 results, an eye-poppingly high level.

“These are deals that banks can’t do, that they don’t have appetite for, or wouldn’t do well if they wanted to,” said Craig Packer, co-founder of Owl Rock, which manages $13 billion of assets.

Bloomberg News
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