Need to Know: Leveraged Finance Market Update

Over the last 12 months, there has been an uptick in recurring revenue-based financings in the European leverage finance market. This has been fuelled, in part, by the increased popularity of subscription-based business models (primarily in software as a service). These financing structures have evolved to service a variety of companies generating high levels of "sticky" subscription revenues and on a high-growth trajectory – but not necessarily yet turning a profit.

Why lend based on recurring revenue?

Tech assets continue to be hot property for private equity investors having demonstrated resilience during the pandemic and strong future prospects in an ever-growing tech-centric world. Some of the most promising tech assets are EBITDA (earnings before interest, tax, depreciation and amortisation) negative or only just generating EBITDA. Their targets are set on revenue growth, scale and investment (a by-product often being high levels of cash burn) with a view to becoming highly profitable in the short to medium term. Therefore, EBITDA may not be an appropriate metric as part of the maintenance covenant package until the business is more mature and is turning a sufficient profit. Recurring revenue-based financing may be an attractive option for a borrower fitting this profile if the business can demonstrate identifiable, proven and sticky recurring customer revenue.

A recurring revenue facility is made available and is sized on the basis of the recurring nature of a particular revenue stream of a business – typically, revenue generated through customer contracts (often subscription revenue). The metric used by lenders will be an annualised recurring revenue (ARR) figure, based either on a last twelve-months figure or by annualising a figure for a shorter period, depending on a number of factors including seasonality of the business. The facility will typically be provided on the premise that, with the aid of the debt facility, the business will be generating sufficient EBITDA to sustain a traditional EBITDA based leverage facility within the next two to three years.

With its origins in the US, American banks and credit funds have lead the charge on ARR financing in Europe, though there is increasing interest from European lenders, particularly credit funds, viewing recurring revenue financings as an opportunity to deploy capital in a competitive lending environment and as a means of gaining access to attractive credits earlier in their life cycle. Borrowers tend to be US sponsor-backed businesses, but we expect this to evolve as European sponsors and debt advisors become more familiar with the product. 
ARR-based financing products in the European venture and growth space are also evolving at pace with a huge growth in market participants, ranging from US banks offering ARR borrowing-base products to digital disrupters that rely on data analytics and artificial intelligence tools to offer innovative, user-friendly lending products promising speedy deal execution and light-touch legal documentation.

Key features of ARR financing products

Based on transactions and term sheets over the past 12 months, some of the typical features of ARR facilities are as follows, though terms are evolving given the relatively novel nature of recurring revenue financing in European leveraged finance:

• Flip from ARR to EBITDA. Given ARR facilities are provided on the premise that the borrower will be generating sufficient EBITDA to support a traditional EBITDA leverage financing after two to three years, the facility itself will typically flip from being ARR based to being EBITDA based during the tenor of the agreement. We have seen this flip occur as early as  one year post closing, but this is more commonly two to three years now, with some direct lenders entertaining full-term ARR (though this is not considered market standard). There may also be an option for the borrower to elect to "flip" the facility sooner if they can comply with the traditional leverage covenant package as this often gives the company access to additional flexibility and more beneficial pricing, in the latter case with margin ratchets tending not to kick in until post-flip.
• Multiples of ARR. We are seeing multiples of ARR of 2-3x depending on the credit but this is being pushed upwards by direct lenders entering the market.
• Financial covenants: pre-flip. Lenders will also typically expect to have the protection of a minimum liquidity covenant to monitor cash and potentially a minimum EBITDA covenant to monitor the company's likelihood of having sufficient EBITDA come the time of the flip, though the latter will have larger than usual headroom given its purpose. In terms of ARR, debt covenants tend to have tighter headroom than traditional leverage covenants as deterioration in ARR is more impactful. 
• Financial covenants: post-flip. Covenants tend to revert to the more traditional leverage covenants with some transactions retaining the liquidity covenant depending on the credit. 
• Equity cures. Lenders will typically push for no cure to apply to the pre-flip covenants, though we are seeing cures applying pre-flip to reduce debt with a percentage of the cure being applied in prepayment. This contrasts with the generally accepted market position of no prepayment in mainstream leverage lending. Cures revert to traditional terms post-flip.
• Cash sweep. Cash sweeps pre-flip are uncommon given the focus on growth of the business, though they are not unheard of and lenders may still look to push for a cash sweep to apply pre-flip depending on the credit.
•  Controls. Lenders will typically look for tighter controls on financial indebtedness and cash leakage including payments out to shareholders pre-flip and may, in some cases, link relaxation of certain of these controls to the flip to the traditional leverage covenant package.

Facilities tend to be documented on Loan Market Association leveraged-finance template documents, adapted to reflect the specific terms of the ARR facility pre-flip.

Osborne Clarke Commentary

Despite a relatively slow initial uptake in Europe, we are expecting to see recurring revenue financing become a more regular feature of the European leverage finance market as attractive high-growth credits look to secure debt at earlier stages in their life cycle on more innovative and flexible metrics and lenders look to deploy capital in an increasingly competitive lending environment.

While terms are still evolving, lenders and sponsors continue to take their cue from the US market, though some of the more traditional European leverage finance terms still remain.  

Osborne Clarke has expertise in both leveraged finance and venture and growth finance, and a particular focus on the technology, media and communications sector, and on this and other emerging trends and typical terms in the market.