While the majority of private credit firms say they take an industry-agnostic approach to investing, they have a clear penchant for these two sectors. Tech and healthcare rank among the biggest exposures for nearly every top BDC vehicle, according to a 9fin analysis of public filings.

This doesn’t provide a comprehensive picture of the entire private credit market, of course, but the investment profiles of these BDCs are generally considered to be indicative of broader trends in the space.

Neither healthcare nor software individually make up 30% of any of the top BDC portfolios, and each of these firms has a differing ratio between the two sectors.

For obvious reasons, fund managers maintain diversified exposures. KKR, for example, told 9fin that it wouldn’t let their concentration in any one sector go above 20%-25%; the firm also invests in business services, insurance, real estate and media, among other industries.

Still, the concentration in healthcare and tech is no accident. These two sectors are popular with managers because they are traditionally perceived as ‘recession-resilient’, and have sticky business models, high margins, healthy free cash flow, and low fixed costs.

“Our job is to avoid defaults,” said Dan Pietrzak, co-head of private credit at KKR. “That is why we focus on allocating to companies in sectors that benefit from long-term structural tailwinds.”

Then again, resilience does not necessarily equal immunity. And while this taste for healthcare and tech has been a winning strategy for private credit over the past decade, it could could pose risks in an inflationary and recessionary economy.

Healthcare hiccups

Some of the biggest private credit opportunities have come from the healthcare sector. While talks over the potential $5.5bn financing for healthcare company Cotiviti’s buyout have ended, the proposed loan generated substantial interest from lenders.

While healthcare does have a history of outperformance during downturns, this economic cycle involves much higher wage inflation than any in recent decades. This is squeezing margins in the healthcare industry.

“The labor cost pressure, combined with the scarcity of labor, has created challenges in sectors that were historically recession resistant, specifically healthcare,” said Walter Owens, CEO of direct lending firm Varagon Capital Partners.

Reassuringly for lenders, demand for healthcare is relatively inelastic; everyone needs to take care of their bodies when they break down. And the sector has higher margins than many others, giving it defensive qualities that may help mitigate the most pernicious effects of a credit cycle.

Recent indications suggest healthcare remains in robust shape. Earnings of private middle-market healthcare companies increased 13.5% year-over-year in the first two months of 2023, according to Golub Capital’s Middle Market report, which covers deals Golub has backed.

“Is there some pressure on labor costs? Of course, right. You read it in the newspapers every day,” said one private credit fund manager. “But have we continued to see revenue growth and EBITDA growth across the portfolio? Yes. So there's a lot of downside protection happening.”

Loan ARR-ears

The increasing digitization of the US economy means tech has provided ample opportunities for private equity sponsors and lenders.

However, the sector has faced highly-publicized headwinds over the past year, with higher interest rates adding extra pressure to cash flows amid a slowdown in sales after the pandemic-driven tech boom.

The risk in this sector was ramped up by the debt-fueled growth spree that occurred in the low-rate environment of the past decade. But not all tech companies are in bad shape: those analyzed in Golub’s report saw 19% year-over-year earnings growth in the first two months of 2023.

Many tech deals have been structured as annual recurring revenue loans. These ARR loans became especially popular for growth-oriented tech companies in 2020 and 2021, noted Chelsea Richardson, a senior director at Fitch Ratings covering the BDC space.

“We saw a lot of BDCs increase their originations there,” she said. “Those recurring revenue loans are something that we’re monitoring.”

Some of the biggest transactions in private credit have been ARR loans to tech companies. The take-private of Zendesk was funded with a $5bn loan package funded by private credit firms and more recently private lenders provided a $2.6bn loan to fund the LBO of Coupa Software, as reported by Bloomberg — both were ARR loans.

The ARR model differs from traditional EBITDA-based underwriting, with lenders providing credit to as-yet unprofitable companies. Typically, these companies are spending heavily on marketing and research, with a view to rapidly scaling the business and then pivoting towards positive cash flow at a later date.

Loan-to-value ratios for ARR loans are lower than traditional unitranches, and revenues generally come from recurring sources like multi-year subscriptions, sources noted.

But with higher rates increasing debt service costs, the journey to generating positive earnings is likely to be a lot bumpier than it has been in the past.

“Over the last several years, many lenders gravitated to financing emerging software businesses that were still negative cash flow,” said Owens at Varagon. “It will be interesting to see how these companies perform through the next cycle.”