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Private Credit 

David Bell

A cocktail of issues are putting pressure on software credits such as Citrix, Quest Software, RSA Security and GoTo. They exemplify the risks created by the sector’s heavy use of leveraged capital markets in recent years — with echoes of the 2015 energy crisis.

As new innovations and low interest rates fueled a boom in software LBOs during the late 2010s, which continued after the initial crash of the pandemic, sponsors and lenders alike delighted in the virtues of recurring revenue, low capex, and strong free cash flow.

But things are changing. Rising rates are pushing up interest costs, and while subscriptions are sticky for top-quality products, sales are coming down after the pandemic boom. Software companies have found it tough to retain key sales staff amid the “great resignation”.

It’s a particular concern for the leveraged loan and private credit markets, which software companies have leaned on heavily for capital. Some sources go so far as to compare the current state of software lending to the energy boom and bust in the early 2010s.

“It’s a little bit like energy in the high yield market in 2015-2016, which was by far the biggest industry weighting and you had a ton of capital raised in the four years leading up to that, then a major washout,” said Bill Zox, a high yield portfolio manager at Brandywine Global.

“We’re setting up for that with software credits in leveraged loans and private credit,” he added. “There are plenty of good businesses, but probably many more of them are pretenders, and probably are not in a position to flourish when they have today’s cost of capital.”

At 12%, software is by some margin the largest sector in the Morningstar LSTA US Leveraged Loan Index (healthcare is next at 6%).

This partly reflects a surge in LBOs in 2021 and early 2022 as PE firms cashed in on a boom in communications and remote access technology during the pandemic. Market participants may remember how energy similarly came to dominate the high yield market in the mid 2010s.

Their debt is overwhelmingly floating rate: software companies represent only 2.5% of the high yield bond market, according to the ICE BofA index. For some market participants, this is the biggest concern.

“Those larger LBOs where they piled on tons of floating-rate debt are going to have problems,” said another portfolio manager. “If companies are impacted by a pullback in corporate spending or delays in projects, coupled with higher interest expenses, that could be a toxic combination.”

Private equity sponsors have followed a similar playbook in the software sector for years — so similar that Vista Equity Partners founder Robert Smith once said software companies “all taste like chicken”.

Since we’re generalizing, we might point out another common characteristic of software LBOs: sponsors would target companies with high double-B or even investment-grade ratings, and then pile on debt until leverage reached 7x-8x and their ratings got cut to single-B.

In the late 2010s, banks were happy to underwrite such deals despite the leveraged lending guidelines. The theory was that leverage would come down quickly due to their rapid growth. Institutional investors were happy to back them for the same reason, reassured by their recurring revenue.

In many instances, that playbook worked out nicely. But now, many companies that went big on floating rate debt to fuel growth are being hit hard by rising interest rates (unless they are hedged, which some might be).

“We’re coming to a moment now where your interest costs have doubled if you’re a pure leveraged loan issuer with no hedging,” said a second portfolio manager. He pointed out that rising rates had obliterated market standards around the ratio of free cash flow to total debt.

It used to be that 5% was seen as an acceptable ratio, but for many issuers that has now deteriorated to breakeven due to rates alone: “That’s even before the FX issue and any softening demand. You’re into a scenario where a lot of these companies aren’t making free cash flow.”

This could be exacerbated by slowing demand as the US economy heads into a recession. Trends at the big tech giants such as Amazon suggest a slowdown in cloud spending, which could filter down to smaller players in the leveraged finance space.

Recurring revenue and strong customer retention may offset that, of course. Industry supporters with a taste for chicken also argue that the pandemic highlighted the importance of tech spending, which could actually bolster demand — but still, some companies are already suffering in what is an increasingly competitive and commoditized software sector.

Quest Software and RSA Security have reported declining sales after demand initially surged for remote-working capabilities during the pandemic.

“At a certain point, tech budgets are getting cut back and rationalized and I think we’ll find that the overspending on software in the pandemic was probably much higher than we had guessed a year ago,” said Zox.

Quest (rated B3/B-) provides cloud management and cyber security. The company was taken private in an LBO by Clearlake early last year, after being carved out of Dell in 2016. Recently, a sharp decline in sales has caused a sell-off in the company’s debt.

Its $2.81bn 4.25% TLB due 2029 has sunk to a dollar price around 74, from 91 in mid-September, while its $765m 7.5% second lien TLB due 2029 is trading at just 62, down from 87.5 over the same period.

Leverage was around 7x at the time of the buyout. But this is expected to climb: Quest reported a year-over-year revenue decline in the “high-teens” (in terms of percentage change) in the second quarter of its fiscal 2023, according to S&P.

That was substantially below the rating agency’s forecast of low to mid-single digit growth. As a result, S&P revised its outlook on the company’s B- rating to negative on October 14, saying the company is expected to report negative free cash flow for the year.

Explaining the downgrade, the agency cited a “significant, disruptive increase in turnover among the company's sales staff on top of a hard strategic pivot to subscription sales over traditional perpetual licenses.”

For some borrowers, this switch from licenses to subscriptions is coming at exactly the wrong time — exacerbating the cash flow pinch from rising base rates. “There is a big working capital mismatch when you switch to subscriptions,” said the second portfolio manager.

We approached Quest when writing this article, asking for comment. A spokesperson said that as a private company, Quest “neither discloses financial information nor comments on speculation.”

RSA Security (Caa1/B-) also enjoyed a spike in demand in 2020 and 2021, as clients scrambled to provide work-from-home solutions for their staff — but those solutions are far less in demand as workers return to the office.

The company was spun out by Dell in February 2020 and sold to a consortium of buyers including Symphony Technology Group, Ontario Teachers and AlpInvest Partners. A recapitalization in 2021 brought Clearlake on board as an equal partner with Symphony.

However, RSA’s revenue declined 14% in its 2022 fiscal year amid a decline in sales after the pandemic and disruption in the company’s sales force, according to Moody’s. Leverage is high, and “operational stumbles post closing have also exacerbated the original deleveraging plan”, said the agency when it downgraded RSA to Caa1 earlier this month.

Craig Nickerson, RSA’s chief financial officer, told 9fin that revenues had “normalized” in 2022 after the pandemic boom, but forecast higher sales in the 2023 fiscal year as the company transitions to a SaaS model.

“RSA remains extremely profitable, with growth driven by increasing software bookings, dedicated systems, processes, and teams supporting all our businesses, and a very loyal customer base,” he said via email after we approached the company for comment.

“While our debt leverage has remained relatively stable over the past two years, increasing interest rates are resulting in a higher cost of borrowing. Despite that, our business continues to deliver significant profits.”

Another troubled remote-access provider is GoTo, formerly known as LogMeIn. The B2/B/B rated borrower, which provides unified communications (UCaaS) services, was formed when LogMeIn merged with GoTo as part of a 2019 buyout led by Francisco Partners.

The company’s $950m 5.5% senior notes due 2027 have sold off to 61, for a yield-to-worst of around 18% (compared to 11.5% in mid-August). Its $2.25bn TLB due 2027 has slumped to a dollar price of 65, from around 80 in August.

It’s a bit early to make a call on Citrix, which only just went private. But during syndication of the debt backing its take-private and combination with Vista portfolio company TIBCO Software, buysiders and bankers alike noted the multiple challenges facing the deal.

Citrix, GoTo and their financial sponsors did not respond to requests for comment.

Other names in the software sector provide little reassurance. Larger peers such as Microsoft and Zoom are facing headwinds (the former is cutting staff and the latter recently slashed its free cash flow forecast), and then there’s the recent drama at Avaya.

Some credits in software may have few options other than cutting staff. Other blue-chip tech companies have already led the charge on this, with the likes of Twitter and Meta announcing widespread layoffs in recent days.

“They might have bulked up over the past two years at the peak of the cycle,” said Alen Lin, a senior director at Fitch. “The products they offer are still important, but they’ll need to have the right cost structures to be sustainable.”

Then again, many of these companies are also struggling to retain their sales staff, which is already making it harder for them to generate revenue. If staff are cut in the wrong areas, these problems could be exacerbated.

Staffing issues are a problem for many companies across the US economy these days, although there are signs that the labor market is beginning to cool off. But the problem is particularly acute for the software sector, which has long attracted workers with stock-based compensation.

This incentive is intended to help retain staff, but it can have the opposite effect when companies go private. Existing employees with deep institutional knowledge may cash out, and new hires may find equity options less attractive, because private stock is less liquid.

“Everyone gets cashed out of their equity,” said the second portfolio manager. “A lot of people start looking at moving on to the next place.”

Software has often been a place to hide out during market downturns. Indeed, some investors still see a path to growth for some of these credits if they can weather the headwinds they are facing.

“These are high margin, recurring revenue businesses,” said the portfolio manager. “Some of them have different stories, but there are attractive buys here at this pricing, at the first-lien level.”

The ones that thrive are likely to be those with strong retention rates, an ability to retain customers, and strong products — all of which require a good development team and an ability to attract solid engineering talent, he said.

Many of these companies were levered up in 2019-2021, so may not have maturities coming due until around 2026-2027. This, coupled with loose covenants, may provide companies with room for maneuver (although perhaps not always to the benefit of lenders).

If it becomes necessary, raising cash may be tough. The financing backdrop is completely different from when many of these credits were first underwritten: “The math is tough to work when your first-lien cost of capital is 9%-10%,” said the second portfolio manager.

Private credit may still be a solution for firms that do want to raise cash, according to Ted Smith, co-founder and partner at tech-focused investment bank Union Square Advisors. But he’s still telling his clients that the best option is to stay out of the markets entirely.

"We’re advising clients that, if you don’t have to do anything in the current environment, be comfortable waiting it out,” he said.

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