IVCA Feature: Highlights of Educational Luncheon ‘Trends in Debt: Providers, Terms & Structure’

November 12, 2014

The issue of debt structure in Venture Capital and Private Equity has become prevalent as the economy gets stronger. But what are the nuts and bolts regarding debt and the industries? The IVCA, along with sponsor William Blair, explored the subject at an Educational Luncheon on November 4th, entitled “Trends in Debt: Providers, Terms & Structure.” Five expert panelists provided insights on debt trends.

The moderator for the panel was Kelly Martin, Managing Director of William Blair, and the panelists were:

  • Jim Hickey, Principal at Vista Equity Partners
  • John Hoesley, Group Head of Technology Banking, The PrivateBank
  • Craig Nickerson, CFO of SAVO Group
  • Mark Solovy, Managing Director of Technology at Monroe Capital
  • Dave Tuttle, CFO of bswift (software and services for benefits administration)

The panel discussion was set up as a question-and-answer format, with Mr. Martin asking questions of the panel, and further questions from the attendees.

QUESTION: We’ve heard a lot about how hot the financing markets are, what are the surprising changes you’ve experienced as those markets have heated up?

Jim Hickey: We invest around a fairly broad range of company sizes. Financing markets for those range of businesses are very different. Probably the overwhelming trend we’ve see is how much appetite there is for software debt than there used to be. They are hard assets to secure against, as opposed to when assets walked in and out of the door previously and kept people away from it.

There is now more of an appreciation of the highly recurring revenue nature of software companies, whether they are a SAAS [Software as a Service] models or maintenance models with a big install base. There is also retention rates in the industry in the mid-to-high 90s. So those are assets that lure financing, and software also has remarkably high conversion of free cash flow, it can exceed 100% if you have a business that builds in a lot of deferred revenue, in which you’re getting cash in up front. It has attraction dynamics that can support debt. In the last decade, the outstanding software debt has increased by five times, as investors have appreciated those dynamics.

Recently, the Federal Government is trying to dial back the leverage approval terms that lenders are giving the software market. There has been a little bit of a short-term pullback in credit markets for software companies.

QUESTION: A question for the lenders on the panel. John and Mark, what are your views as you’re competing for investment opportunities today, as opposed to the last couple of years as you go back in terms of what is trending? Are you seeing more aggressiveness in the markets in terms of structure, leverage and pricing?

John Hoesley: I’ll take the Venture side. Now is a great time to be a borrower, that will be the one overriding comment I have. If you look back even a couple years ago, when the atmosphere started to loosen up after the Great Recession, the first thing to go was pricing, ultimately in 2009 you could get whatever you wanted if you were willing to loan money. Structure followed quickly thereafter, and in both of those right now we’re probably at the bottom from the lender’s perspective.

On the Venture side, as far as changes go, most Venture debt is within a ‘no covenant’ type of facility, which is incredibly borrower friendly. The rates are being pushed down, and in the hottest companies we’re not seeing any warrant coverage whatsoever. That’s a negative trend, as we’re not being paid for the risk.

Another trend I’ve noticed recently is that there often is an ‘interest only’ period at the front end of these facilities, before the debt starts to amortize. If you look back three years ago, if you got six months, that would be spectacular. Today, for the best companies you’ll see 18 to 24 months of interest only on the front end, in some cases, at much lower rates.

Mark Solovy: I agree. From a Private Equity perspective, the markets have become good if you’re looking for debt in your portfolio companies. There is a lot of capital out there, that is put into private debt firms like Monroe Capital. Hedge funds are getting into the marketplace as well, investors are looking for things that are not correlated to the market. So because there is all this capital out there, firms like ours has to put all of this debt to work. There is better pricing and better deals for portfolio companies, and Venture Capital and Private Equity firms that are using that debt.

So one of the ways we’ve been looking at things, what has been changing, is that traditionally, people had looked at multiples of EBITDA for debt. For example, a company has X dollars of EBITDA, with three or four times the leverage, whatever that number would be, so the justification would come from that perspective. Recently, we’re still thinking about that, but we also look at enterprise value. We’re looking at just those multiples of EBITDA, it gets to be very impressive. When you start to look at what is the value of these companies that we’re lending to, we think about how comfortable you are based on that. I don’t know if things have become that much more impressive, it’s just that valuations have gone up so much, that the multiples have increased also.

In terms of covenants, we are seeing pressure on pricing. We’ve started to do things that have attributes of Venture debt, even from a Private Equity perspective. So interest only, which I think was just a Venture Capital term, has now made its way a little bit into Private Equity, So we’re doing deals with those components as well. Bottom line, it’s a really good time to borrow money

QUESTION: As a follow-up question, Mark and John, when you think about structuring and financing for a Venture based company – whether it’s repayment or covenants, typical things lenders look for in protection – how do you think about the underwriting about those types of situations, as they might differ from a more conventional, developed later-stage growth situation or a more positive cash-flow generated business?

Solovy: We are looking at mostly positive cash flow businesses, it is about enterprise value, and we structure things to allow for that growth. In our tech practice at Monroe, we are at least cognizant of the many growth capital investors – whether in Private Equity or Venture Capital – are looking to grow the companies, which will bring down EBITDA multiples because they are investing in it. We tried to structure things as flexibly as we can, to allow for those situations, but we have to be cognizant of risk. It’s a tightrope on which we continue to tread along.

Hoesley: On the Venture side, it’s a little different, because typically you’re dealing with cash flow negative entities, and again the Venture debt product is actually moved to a covenant-free structure, in most cases. Once you write the check, you’re locked in, and there is not much you can do, to be honest. It’s a hybrid of underwriting, with aspects of conventional underwriting – loving the company, believing the business plan, respecting the management team.

But there are two things you’re falling back on, first what is the enterprise value in a fire sale scenario, and second is the syndicate. What is the track record of the Venture funds that have put money into the company? Are there deals through multiple rounds of financing? How tolerant are they with a miss in the plan? Those are the factors we would look at in underwriting Venture debt.

QUESTION: How long do we anticipate these conditions continuing? Does anybody see a change on the horizon or something that could upset the current environment that we find ourselves in, which is very favorable for borrowers?

Hoesley: From our perspective, we’ve been hearing about changes that have been coming, and the indication has caused some pressure in the marketplace. But we’ve been hearing about it for a long time, and I have to say at least for middle market and lower middle market type deals, but there hasn’t been much change. You can imagine that it can’t continue like this forever.

I think what we will see is that because there are many new lenders in the marketplace, they are being very aggressive on terms, and some of them are just trying to deploy capital for the sake of deploying, for multiple reasons. I think that when or if we have a pull back, some of those newer lenders will be challenged in figuring out how they are going to deal with their portfolio companies that may be missing things because there is a slight downturn. That will eventually happen, and it will impact things, but it hasn’t happened yet.

QUESTION: Let’s go to the operative’s perspective. In this market, where it seems like every borrower is attractive, as opposed to a more normal market. Dave and Craig, given the type of transactions you’ve had in the past, what are some of the tricks of the trade or lessons learned in makinh the financing process more successful?

Dave Tuttle: I think you have to approach a financing process the same as an equity process, that’s it’s part of a capital structure. So if you go into it as if you have a story to tell about the prospects of where you’re going, and what you’re doing with it, that builds the credibility – along with the management team.

Also you have to have the underlying data, and access to that information. Then you can go forward with it and have a reasonable conversation. But it has to be enticing as to how you will run the situation and how you will pay it back.

Craig Nickerson: Yes, I would agree with that. You’ve got to be ready-to-roll at a moment’s notice with that data. It’s good to have a virtual data ‘room’ update every month. I can internally attest to the fact that markets are amenable right now, solidly driven with a significant cash burn, and we’re growing above market rates. But at the end of the day, we do have a significant challenge in this atmosphere. In a SAAS company, it’s about having a strong and recurring revenue stream. It’s about being realistic and honest with your forecast – a bad forecast will get you in trouble.

QUESTION: Jim, from a sponsor’s perspective, as you look to get your portfolio companies, how you get those companies to prepare and have successful financing?

Hickey: Part of it is track record, obviously. Our firm brings some credibility to a company, because we have a good record. I think the comments you’ve heard about having good models and good data available, and being professional, is just part of any good investigation. You need to build confidence. Delivering on what you say you can do is probably most important.

QUESTION: How much is focused on making sure you’re talking to the ‘right type’ of lenders?

Hickey: Well, are you focused on lenders who have experience in the sector, or is it about the deal or the nature of the transaction? You have to think about determining the relevant audience for the deal.

Tuttle: It depends on size. We’ll do financings where we put a ‘club’ together of a couple of banks, for a better financing package. With that, we then have enough lenders who are comfortable with software types of businesses. We get a sense of their appetites, and we can tailor what we bring to them, with things that they’ve demonstrated that they’re already comfortable doing.

At the larger end of the market, we’re focusing on broadly syndicated loans, in which we have to pick up an agent and perhaps a bank with them. Again it’s about the track record. In that situation, it’s also do they deliver on what they tell you they’re going to do. We generally get underwriting commitments before we go to market, in those cases, with a flexibility in terms. With the syndicates, we’re telling the story, it’s up to them to find the investors.

Nickerson: When you’re first going to market you just need to honest about who you are, and what your business is. When I’m first calling on prospective lenders or partners, one of my first questions is their comfort level with loss, because there is no reason in wasting their time or our time. You need to have a good understanding of your business going forward, and from my experience when you get to a term sheet – and you pick a horse to run with – you’re doing it exclusively so you can make sure that you’re running with a partner that has a high success rate, and if the deal closes relative to the terms that were on that term sheet. Those are questions I would ask when going to a lender and checking references.

QUESTION: Since we have both the lender and the operating sides here, if you’re looking at a business that is sponsor-backed, versus a business that is family-run or angel-backed, how do you look at those different situations?

Hoesley: In almost all cases, it’s going to be preferable if it’s sponsor-backed. The reason being is that there is another pocket and potential backstop to the debt. In a closely held or family business, that is not there. The liquidity as a potential backstop is a positive. But we do a mix of sponsored and non-sponsored, and we’ll continue to do so.

Solovy: We’re about 50/50 for sponsored and non-sponsored. It’s about the personal backgrounds in evaluating an opportunity. With sponsored companies, it’s not only about the backstop, but also about an investment that can bring in capital, and they tend to have more disciplined CFOs and have gone through it before, and this is a better deal for a lender, because there are better sources of information.

On the other hand, we do spend half our time with non-sponsored companies, and it’s more challenging, but we look at that like Private Equity firms do, getting the CEO on board and teaching them our interaction. We can dig in, and those types of companies will hold debt longer than sponsored companies, because they don’t have flexibility or the connections to switch as much. We don’t prefer one over the other, they are just different types of opportunities.

Tuttle: Both of them have their challenges, and especially when you don’t have a sponsor in there, it can be a little more of a test to get to where you need to go, and you have to have the right partner. When you have a sponsor, you’re probably being sharper in pricing and terms, and it’s more of a competitive process.

QUESTION: Let’s talk about difference uses of financing. Where do you use debt versus equity, or is having a cash positive business a better financing methodology or strategy? As you have seen different levels in financing, is the reception different depending on what levels – such as acquisitions versus a recap distribution to shareholders?

Tuttle: With some of the larger companies, we did a couple of transactions that essentially funded a dividend payment back to shareholders as part of the business plan, and also used some debt to fund acquisitions. It was a pretty routine to go through in working with the lenders, as long as you had a good business plan and reasonable covenants. It’s a bit more challenging to do a dividend recap in today’s environment, certainly for smaller companies, because the smaller companies are focused on the debt that will fund the growth. There isn’t much tolerance for using debt as liquidity.

QUESTION: Mark, do you look at it differently if a company comes in to borrow for a liquidity distribution to shareholders, rather than some other purpose in growth?

Solovy: It depends. On dividend recaps, we do them all the time for Private Equity sponsored companies, or even non-sponsored companies. It depends on what they pulling out and how much skin they have left in the game. And ultimately, what is the value of the company?

If a Private Equity sponsor wants to take out a 100% of what they have put in, and we’re still sitting on a loan that’s half the value of the company, we’re still happy to do that. If you start to go beyond certain levels of debt to enterprise value, then it can get tricky.

Nickerson: From my perspective, it’s about getting lenders comfortable with your plan, and using a number of peer group metrics to look at the market. I think it’s important to understand when borrowing money what those metrics are, so you can position your request against those in the marketplace.

Hoesley: We probably look at it from a lender’s perspective, similar to what Mark [Solovy] just said. Ultimately we prefer debt being used to finance company growth, but with dividend recap it is highly dependent on enterprise value of coverage, and it depends on the size of the business. In a small business, if the top line declines, the operating leverage runs in the other direction. So the multiples you would lend on a recap would increase depending on the size of the business.

QUESTION: Jim, do you see lenders respond differently on big market transactions – away from the syndicates – when you’re going to them for a recap potentially rather than a deal financing?

Hickey: The comments have been right on, in all the size-of-the-company continuums. Lenders tend to be more aggressive on a new acquisition, because there is a thesis as to what is going to happen with the company. They are least aggressive when there is just borrowing to refinance the business. They’ll do it, but not in the same multiples of leverage that you have in acquisitions.

AUDIENCE QUESTION: Jim, since you’ve been in the industry for awhile, where do you see the asset values now in technology firms?

Hickey: They are high, they’re are also been bid up within the dynamics that we’ve been talking about here, with the government creating liquidity in capital at a record pace, and people looking for a place to put that liquidity, where they will get some kind of yield. This is a business fundamental, and people are trying to get a return on investment for their clients, so there are bid-ups in the stock market, the Private Equity market and the debt market. As long as we’re awash in liquidity, that will be sustained. And as long as we have a world of nearly no interest rates, people are going to search for entities that will give them a return or yield.

Some of these debt investments are maybe a better risk/reward trade off to some investors, because they can get some yield, but they don’t have the risk of the lower capital structuring in a world with high valuations. You have to parse different industries and trends, to see if it’s worth it. Values are high, because of the liquidity that is pumped in, and sometimes we’re seeing fits in the market when there is an indication that it might slow done. We will go through a correction, and as someone who just raised a large fund, a correction would be helpful. We’d like to see values become more consistent with long term fundamentals. But there are still good opportunities in the market, even at these valuation levels.

AUDIENCE QUESTION: For John and Mark, I do a lot of debt financing, and I see a lot of banks getting pressure from federal regulations, and a lot of non-banks taking advantage of that. Since we have both here, do you have any commentary on that topic?

Hoesley: From a regulatory standpoint, it’s pretty clear that the banks are under pressure, because of higher leverage multiples. It’s drawing more attention, and internally all banks are looking at it. What does that lead to? It manifests itself in a couple of ways when competing with non-banks. Typically the mode of competition comes down to do you want cheap money? If so, you go to a bank. Or do you want the maximum amount of debt possible? If for that, then go the non-bank route.

Within the leverage markets, you have some interesting cooperative competition going on, in the first-out, last-out structures. Most non-banks need a higher yield on the assets, and the banks will come in and take the least riskier portions of the deal. It’s a fluid environment right now, and competition is at every angle.

Solovy: Yes, we are having more conversations with banks for partnership. Before the banks would go out and take on the entire transaction, and get deep into leverage. And now they’re saying – because of regulation – that they can’t be that aggressive. So they partner with us. There are different elements of rates and terms, as a private debt firm we can provide amortization at a much lower rate than a bank. A typical bank may amortize an entire piece of debt over a period of several years. We as a private debt firm have more flexibility in that, so we may provide a small amount of amortization over the course of five years, rather than a whole payment at the end, so you can have more use and more flexibility with your capital.

QUESTION: As we wrap it up here, let’s talk about financing Venture Capital oriented businesses. What are you seeing in the Chicago market today, is that type of Venture debt financing that we’ve been talking about available here, or are we still lagging behind the West Coast?

Hoesley: I think it’s more available here today than it ever has been, by a wide margin. If you look at it historically, there was an aversion to Venture debt financing in Chicago as opposed to the West Coast, but as word got out, and rates have gone down, use of that has stepped up over the last several years. As you are seeing companies raising more than five million in Venture capital here today, there will be some form of Venture debt as part of the capital structure.

Solovy: I would add, since I opened a Chicago office from a Palo Alto branch Venture firm before joining Monroe Capital, the appetite for using debt in Venture backed companies have grown here. The availability here is better, but it’s not half as what is going on in Silicon Valley. There it was a competition between up to ten firms for debt financing, in a range of company value levels. There are not as many players here, and it’s still a West Coast culture rather than here.

QUESTION: And what is the perspective from the borrowers?

Tuttle: I guess I would echo that the demand in the past wasn’t there in Chicago, but now there is a willingness to take on both equity and debt. With use of the debt, it’s pushing the market, and more players are emerging locally.


The 2014 IVCA Awards Dinner, presented by Kirkland and Ellis LLP, will take place on December 8th, 2014, at The Four Seasons, 120 E. Delaware Street, Chicago. Individual tickets and tables are still available, click here for information