Loans to larger software companies that are yet to be profitable once yielded attractive returns, but pricing has fallen and leverage on these loans has doubled or tripled, said Luke Chan, head of private credit at HighVista.

There is a bifurcation in the ARR-based direct lending world where larger software and private equity-backed companies today can access capital relatively easily while companies on the smaller end struggle to find funding, Chan told Creditflux. Larger borrowers in the space have the option of public equity as the NASDAQ sits at an all-time high. Credit markets, both public and private, are also supportive. As a result, private ARR loan pricing has fallen for these large companies and lenders are offering more leverage than before.

Previously, direct lenders saw lending to software companies without traditional EBITDA as a kind of “sexy new area that was maybe a little dangerous,” Chan said. There were questions about whether one could lend against annual recurring revenue. Taking that risk usually resulted in higher returns compared to more straightforward EBITDA-based direct lending.

“People could get some spicy returns [back then.] Now, it has totally gotten away if you’re talking about lending to large software companies,” Chan said. Companies with an ARR of more than USD 25m or USD 50m will be able to find cheap financing and get a good amount of leverage relative to years past.

These days, direct lenders are happy to offer 2x-3x leverage on ARR loans even as the cost of capital comes down if the company fits their box, according to Chan. The amount of leverage seems to have doubled or tripled even though the ARR figure is still sort of a contractual top line rather than the actual top line of the company.

“You can borrow now at 500bps over SOFR, the same price that you might get if you had your traditional, sponsored EBITDA-based loan, “Chan said. “Then the amount of leverage you could get has been going up. It used to be 1x ARR was the limit.”

Competition among direct lenders and easy access to capital has given borrowers the upper hand.

There are more direct lenders this year than there were last year and there is competition to put money to work, Chan said. That competition means larger companies, often seen as more attractive, will continue to have access to relatively cheap ARR loans and with more leverage.

Interest in large ARR loans has remained high in part because the technology sector has performed remarkably well over the past few years compared to other areas like healthcare, chemicals, consumer retail and food. Defaults for ARR loans, often made to fast growing software-as-a-service businesses, have stayed relatively low.

However, the industry should remain cautious as it is unclear how high recovery rates will be if stress rises in the sector.

“The losses today [in ARR loans] are totally manageable,” Chan said. “But we also have not been through a cycle.” With ARR loans often being made to companies with relatively few tangible assets — such as software companies — recovery rates could be a concern in the future if defaults rise.

If a company that has tangible collateral like a factory or equipment goes into bankruptcy, a private credit firm can sell those assets and hopefully get a good recovery rate, Chan said.  If a software company goes under and the lenders take over, they may not have much to sell. One could argue that the collateral is the recurring contractual revenue, but if there is a lot of customer churn that value can be destroyed very quickly.

“I think we’re looking for areas that are either specialized so the competition is lower or dislocated,” Chan said. “When we think about ARR and tech-based lending, if we’re going to get involved, it’s going to be the smaller end.” High Vista is interested in finding companies that are not well served by banks or other direct lenders. Companies that have a much “heavier lift on a custom underwrite” to understand the borrower base and the company are also attractive opportunities.