A Win for Borrowers and Investors
In recent years, there has been a boom in the relevance of technology and software companies around the world. We spoke with Recurring Capital Partners, is a growth investment firm that specializes in debt financing for Software as a Service (SaaS) and other recurring revenue model technology-driven companies, to highlight the opportunity set behind their niche private credit strategy.
The Software Evolution
In August of 2011, noted entrepreneur and investor, Marc Andreesen of eponymous venture capital firm Andreesen Horowitz, proclaimed that software is eating the world. At the time, global spending on enterprise software was about $270 billion. Today that number is $405 billion, a 6% compounded annual growth rate (“CAGR”) or 3X the growth rate of the U.S. economy over the same period. That software is eating the world, however, doesn’t capture the changing diet. In 2015, Software-as-a-Service (“SaaS”) accounted for only 27% of software deployments. By 2017, that number had grown to 35% and, according to Gartner, is expected to grow to 45% by 2021.
The industry’s evolution to SaaS has resulted in a highly scalable business model with greater revenue visibility, higher gross margins, lower capital expenditures, sticky customer bases, and a higher percentage of discretionary expenses. This new paradigm has captured the attention of equity investors, who are willing to pay high multiples of recurring revenue (the average publicly traded SaaS company is currently valued at over 13X recurring revenue).
The shift in business model, coupled with the aforementioned market growth, has resulted in greater resistance to macroeconomic forces as well. In fact, during the Great Recession, beginning in December 2007 and lasting until June 2009, the U.S. economy contracted 4.3% while SaaS companies continued to grow. Salesforce, for example, grew 36.9% quarter-over-quarter on average during this time.
Value Proposition to Borrowers: Preserve Optionality and the Cap Table
Despite fewer headlines, this evolution has also served as a catalyst to the creditworthiness of software companies. Until recently, a software business wanting to raise growth capital was limited to selling equity. Traditional banks, constrained by regulation, won’t lend money to a business that GAAP determines unprofitable without tangible assets. For the company, however, reinvesting what otherwise could be free cash flow to acquire new customers is the appropriate path to maximizing shareholder value. The venture debt industry (think Silicon Valley Bank) has been around since the 1970s, but these lenders essentially follow around venture capital firms, underwriting that equity investor’s willingness and ability to continue funding operating losses. Various capital sources have stepped in to fill the void. Structure can take many forms (Revenue Based Financing, Line of Credit, Term Loans, etc.), but the value proposition to borrowers is consistent: it’s cheaper.
We would argue the lower cost of capital is more commensurate with the risk taken by the investor. Consider a $7 million Annual Recurring Revenue (“ARR”), bootstrapped-to-date SaaS company raising $3.5 million of growth capital. They are hovering around break-even, experiencing moderate percentage-rate growth, and have customer acquisition metrics and an addressable market that warrant pouring fuel on the fire. This company understands the importance that growth rate and scale will have on the exit multiple. One option is a $3.5 million equity raise at a $28 million pre-money valuation (4X ARR). Another option is debt carrying an 11% interest rate and warrants representing 1% ownership in the company. How do the two options compare assuming the same $75 million outcome? The debt scenario allows the founder to put $7.5 million more in their pockets by lowering their cost of capital by 9.3%. And as the exit valuation grows (and/or pre-money valuation at raise lowers), the cost of capital spread between the two options increases. Furthermore, the relationship is not linear as you can see from the chart. A 33% valuation increase to $100 million leads to a 176% increase in spread.
While cost of capital is perhaps the more conspicuous benefit to a founder, maintaining optionality is equally important. To a founder, selling equity is equivalent to getting married. In addition to board seats, raising equity typically outsources approval of key decisions to the investor. Want to hire a new VP of Sales? Invest $250K in a growth initiative? Raise additional capital? And, of course, sell the company. In each case (and many others), the equity investor holds the key. With debt, all decision making remains with the founder. If that founder wants to get rid of a lender? Simple. Pay them off. Alignment of interest is far more important when raising equity and difficult, if not impossible, to accurately assess at the time of choosing a partner.
Why Investors Should Pay Attention: Equity Returns for Debt Risk
Over the past 25 years, the average nominal annual return for the S&P 500 was just shy of 10%. The Cambridge Associates Private Equity Index compounded 13.4% and Real Estate grew 7.4% per year over the same period. Meanwhile, private loans to SaaS companies are currently getting priced in the high teens with 12-14% current pay.
Senior-secured, fully-amortizing loans
12-14% interest rates plus warrant coverage
Low Loan-to-Value (“LTV”)
Senior to founder’s net worth and all equity investment
Floating interest rate with a floor
Prepayment penalties
The total return relative to other asset classes is attractive. However, risk adjusting the returns is what makes this niche private credit strategy so compelling. Consider a middle-market buyout financing in which an acquirer uses 50% leverage. In today’s market, you’ll find that paper priced in the high single digits. By definition, the LTV in such a transaction is 50%. In contrast, let’s assume SaaS Company X borrows 50% of ARR at the rates above. Further, let’s assume equity markets would value Company X at 4X ARR, making the LTV 12.5%. The LTV is roughly equal to the current yield (never mind the warrant value) while the LTV on the buyout financing is over 5X the yield. Yes, the analysis is unquestionably buoyed by frothy equity markets, but parity between IRRs and LTVs are difficult to find in any asset class. Investors with an appetite for high-yield, attractive risk-adjusted absolute returns and a cheap call option on continued software growth should consider this unique private credit strategy.
Special Thanks to Our Contributor
Brian Henley
Managing Partner
Recurring Capital Partners
P: +1 (512) 766-0676
E: Brian@recurring.capital
Recurring Capital Fund II specializes in debt financing for Software as a Service (SaaS) companies and other recurring revenue businesses. The firm focuses on high gross margin companies and provides senior secured, four-year term loans with warrant kickers, and all loans are floating. The cash on cash yield is in the low teens. Founded in 2016 in recognition that the migration from the license/maintenance to a subscription-based model enabled companies to service debt.