CJ DOHERTY: Welcome to the Lending Lowdown. I'm CJ Doherty, Director of Analysis at LSEG LPC. And today, we're going to be quite focused and talk about ARR loans. Annual recovering revenue loans, widely referred to by the acronym ARR, have developed over time to allow lenders to facilitate the financing of growth stage companies with low or negative EBITDA. And we see the increased frequency and larger size of ARR loans over time, particularly in the sponsor-driven space. And so, in order to explore this type of lending, I'm delighted to be joined today by Ben Radinsky, who is a partner at HighVista Strategies. Ben, thanks for joining me.
BEN RADINSKY: Thanks so much for having me, CJ.
CJ DOHERTY: So, let's start with our usual first questions and get you to tell us a bit about yourself and your firm, just to set the stage for our listeners.
BEN RADINSKY: So HighVista has been around for almost 20 years. We're Boston-based. We manage about $11 billion of assets, and we pride ourselves on being a firm that focuses on alternatives, with a real emphasis on specialty alternatives that require knowledge governance, ability to understand where inefficiencies lie in markets. And really, how we can capitalize on market outperformance, where we separate the difference between what I would call market risk and outperformance of market risk.
CJ DOHERTY: OK, great. And now to kick off the key part of this conversation, can you give us an overview of what is ARR lending, including what are the unique features of these transactions and how they differ from more traditional EBITDA-based financings?
BEN RADINSKY: So over the last three decades, private credit has really grown dramatically. It's now almost $2 trillion. It is as large as the high-yield markets and the leveraged loan markets. And I think before we get into what ARR lending is, it's important to define what has happened in private credit generally. So private credit, historically, has grown from the growth of private equity and what that means is a typical private equity transaction, when they go to the market, they are not just looking for the equity piece, which is what they themselves are providing, but they're also looking for the broader capital structure, meaning the debt that is required in order to finance the transaction. So a typical transaction in private equity may look something like $100 million of EBITDA or annual cash flow and we're going to buy it for some amount, let's say, we're going to buy it for six times that cash flow. So we'll buy it for $600 million. How do we pay for that? Historically, what has happened is the private equity firm would come in with $100 or $200 million of that, and then the remaining amount, in this example, if it was a $600 million purchase price, that $400 million would come in the form of debt. That debt is the private credit market today. So typically, the advantages that folks have in dealing with private credit funds is that you're dealing with a single counterparty, you have flexibility and you could really match all of the terms of your debt to what you're trying to accomplish as an equity owner and private credit. But fundamentally, what that looks like is, it is a leveraged loan transaction where the debt is five times the yearly cash flow. Now all of these credit instruments are very correlated, not just to each other, but they're also correlated to the broader markets. So if there were ever an issue in, let's say, the broader equity market or in the S&P 500, it would be likely that these loans would be strongly correlated to that performance. So that's generally what's happened in private credit today. So I will now as a shorthand refer to that as just simply LBO-type loans, leveraged buyout type loans. Now what ARR does is we're trying to actually isolate different aspects of that credit profile so that we can actually create loans that have a better risk profile. So if you have a software company, and that software company has revenue that's reoccurring. And because it's reoccurring, you have a strong basis to say, I know with very high certainty what my cash flow might look like over the next few years. And on top of that, you may have a further understanding of what the cost structure of the company is. And if you could then create very tight covenants, what you can do is you can have a loan that is very, very secure. Why is it secure? Because in the first example, when you're just an LBO lender, you're just basically assuming that the company will continue as a going concern. That going concern will generate cash flow and I'm now lending against that cash flow. But often times what happens is that cash flow is unpredictable, it's broad based, so it's dependent upon lots of different variables, and even more than that, specifically as it relates to the most recent years of these types of loans, that cash flow has lots of adjustments. So you don't even know if it's real. ARR loans, what you're doing is you're trying to isolate cash flows that you actually know with high certainty will exist overtime. You can predict what that cash flow looks like in terms of ultimate profitability and because of that, you can have very tight covenants as a lender where you can come in and you can say, OK, I want to lend against this very specific asset.
CJ DOHERTY: Great. And so what types of deals lend themselves to being structured as an ARR financing and what are the steps you go through in evaluating whether to provide an ARR loan?
BEN RADINSKY: So when looking at ARR loans, what you're really trying to understand is what is the nature of the contractual obligations that customers have to accompany? So, let's take the simplest example that many of us are probably all familiar with. We all in small businesses, we use accounting software. That accounting software that we may use, we pay a monthly subscription service for. And not only that, it's the type of software that it's very sticky. Once a customer begins using it, it's something that is very hard to change. So, if we were looking at a company like that, it would actually be a fantastic credit in certain regards because you know the customers are sticky, you know that there's a monthly subscription rate, you could predict with a high level of certainty what the company will look like over the next two years, assuming no growth. And I can now say, OK, what is my cost in order to sustain that software so that you the customers will not immediately leave if the services that are provided are not nearly as good as what you expected. If I take all of that in totality, I actually have a very clear understanding of what my cash looks like over the next several years. Once I can understand what my cash looks like over the next several years, I can now say, OK, I'm willing to lend you two times that annual cash flow where my covenants are very tight. They may say something like, OK, I expect you to have certain growth. Or if your churn, so the way churn is defined is it means that if a customer actually leaves. So, I have been subscribing to your service for some time, but I leave. So how many of those customers leave on an annual basis? So, if I could look at the churn rate and I could then put a covenant in my credit instrument that says if the churn rate gets too significant, so then we're going to have to change something. So, the idea is because I have very real predictability over the next several years of what cash flow looks like, and then I could tweak the credit instrument so that I can say, OK, I'm looking at what the growth will look like and what the churn will look like. So now as a credit lender, I actually have very high confidence that I'm going to be repaid. And that's what allows you to do things that other firms wouldn't. So again, to be very simple about it, what we're doing is we're looking at what the recurring revenue is as opposed to, in the world of LBO financing, what they're looking at what the ultimate cash flow is. But I would argue that in the ARR world, you're almost more protected because you really have a clear definition as to how that cash flow will transpire and what ultimately it will relate to in terms of profitability.
CJ DOHERTY: And so, following on from that, Ben, what are the key areas of negotiation between lenders and borrowers when it comes to these ARR deals?
BEN RADINSKY: So given the fact that what you're trying to do as a lender is you're trying to create a very, very tight covenant structure. So, some of the negotiations are on really specific things like, what do I think a realistic growth plan will be? How much recurring revenue will I have over the next two years? In the documents, it will actually say, if you don't achieve those growth plans, that could be an event of default. Or what do I think that the customer churn rate will be? That could be an event of default. Or what do I think that marketing spend will be? Because the real reason why it's so beneficial for these companies is every dollar they spend on marketing has a tremendous return on investment. Why? Because every new customer that they're getting is a recurring customer. They're providing subscription services, and if they have great software. Think about again that accounting software. You might be a customer for 10/15/20 years. So that's very valuable. So, what are they using my money for? I'm lending them money. They're taking that money and they're investing it in all of the sales and marketing to get new customers onto their platform. So, one of the things that we make covenant is we may say, OK, you have to use that money in a productive way. And if you're not actually converting customers at the rate that you expected, perhaps that would be an event of default. So, I've now named three very specific areas. So, the first is what revenue growth looks like. The second is possibly what your cost structure looks like. And the third is what is your customer churn. Each of those are very highly negotiated and the reason is because both the lender and the borrower have a very strong incentive to make sure that it's right. Because if it's right, it means that the loan is going to be successful and that the company is successful. And if it's not, we're going to have to figure things out.
CJ DOHERTY: OK, so you've given us good insight into ARR loans and how they work, but what are the pros and cons of these loans? Can you elaborate there?
BEN RADINSKY: So I think that the hard part for investors is if you're so used to some framework of LBO lending and again, that's the context that this is all coming from where there's a very wide body of work across many different asset management firms and many funds over time where they've done LBO loans, it is very important to understand that these are not the same. And that's a pro and a con. LBO loans have very clear metrics. What is my EBITDA coverage ratio? Or, in English, what is the ratio between the total debt that I have versus the annual cash flow. Or what is the interest coverage ratio? Or in in English, what that means would be, what is the percentage of your annual cash flow that is being paid as interest payments on your debt every year? Those ratios are standard and if you look over time you have a lot of data that you could point to that you could say, OK, what do I think default metrics will be? In ARR loans, it's a little bit of a younger, newer type of product and because of that, there's just not so much data. And so, what lenders do to offset that data is they say, OK, we're going to have incredibly tight covenants. But if you were to look at the industry in general, and I think that this is very important, if you were to look at, as an example, credit rating agencies. There's been a lot of talk as to concern among the credit agencies as to how ARR loans will perform. What credit are they equivalent to? Are they equivalent to high-yield credit? Or are they slightly better? Slightly worse? And the problem is all of the analysis is predicated on these old metrics and what they don't capture, and this is the pro and the con, is if you're an investor that really understands the space, you actually could make the covenants so strict and you could have such control over the company that it mitigates the risk in a way that is not captured in the historical data.
CJ DOHERTY: OK. And let's talk a little bit, you kind of touched on performance there, if we could talk about that a little bit more, you know we've been through a period of higher rates. So, you know how have ARR deals performed in recent times, you know, has this performance differed from the traditional EBITDA-based financings?
BEN RADINSKY: So, in our experience these loans have actually performed quite well and what I mean by that is both on a risk basis and on a return-basis. So, because we are focused in a space that is inefficient, there are not so many lenders that are doing this, it means that the market is in favor of the capital. So, the lenders are able to define not just the covenants, but also what the return thresholds are. And often times they're not just able to get a pure interest rate, but there also may be some small equity warrants or things like that that could enhance returns. So overall, you're seeing returns that are better than what you would see in traditional private credit funds, but then the risk side of the equation is we're not seeing any degradation any more than we've seen more than we've seen broadly across all of LBO lending. So, the net result of that is you're getting a better return than private credit, but you're not actually taking any more incremental risk.
CJ DOHERTY: Right. And now before we wrap up, let's look ahead. What's your outlook for ARR lending going forward, you know, will this area of the market evolve?
BEN RADINSKY: So, I think that it's a great opportunity, but as all things that we do, as things develop, as companies grow, it means that there's just going to be more competition, more capital coming into the space, more sophistication and what that can do is that could sometimes degrade returns over time. We haven’t seen that yet because it's still at the early stages, where there's just way more opportunity than there is capital. And so, as time evolves, I think that what you'll see is you'll see more funds that are interested in these types of loans, you'll see some sort of consolidation where the traditional private credit lenders are actually going to enter into this market, at least for a piece of their portfolio, and that could create some competition. But there's always going to be the opportunity for the mid-market traditional ARR loan where I think that you can get strong covenants as lender.
CJ DOHERTY: Great. And that's all we have time for today, Ben. Thanks very much for that insightful overview.
BEN RADINSKY: Thank you so much for having me. I really appreciate the time.
CJ DOHERTY: Thank you all for tuning in. I invite you to check out our direct lending and syndicated loan market news data and analysis at loanconnector.com. Follow us on X at LPC loans. I'm CJ Doherty, subscribe to the Lending Lowdown on your favorite podcast platform.
