For fast-growth companies in particular, recurring revenue (or annualised recurring revenue, "ARR") loans are increasingly common in the European loan market, as lenders and borrowers become more familiar with a new alternative to cashflow-based (i.e., multiple of EBITDA) lending for leveraged finance transactions. Below are the top five things you need to know about ARR financings.
What is it and what is it for?
Until recently, fast-growth businesses had limited options for raising third party debt, because banks and other lenders found it difficult to lend to those businesses based on conventional credit metrics. That left venture debt as the only realistic option for many borrowers. While venture debt is an extremely useful product for some borrowers, compared to conventional leveraged finance, it tends to be both expensive and restrictive while providing relatively limited amounts of debt, relative to the value of the borrower. In contrast, ARR lending is essentially a unitranche-style financing product for borrowers that are either pre-EBITDA or which have insufficient EBITDA to support a conventional cashflow-based, (i.e. multiple of EBITDA) leveraged financing. Instead, ARR (i.e., recurring revenue, being verifiable, ongoing revenues, often from subscription-type contracts) is used, with loans typically being sized in the 2x - to - 3x ARR range. The combination of a product which facilitates lending to companies with no or low EBITDA and the need for verifiable, recurring revenues means that ARR loans are particularly well-suited for companies in the growth sector with a subscription-based income profile–in particular for software–as service-type businesses.
What does it look like?
ARR loans are typically not syndicated, and are therefore mostly lent by credit funds. In that sense, these transactions are a subset of unitranche financings and their terms mostly reflect that. Certain financial covenants and definitions differ from typical unitranche deals, largely for functional reasons (see three and four, below), but an ARR loan document will, to a large extent, look familiar to anyone who is used to working on unitranche deals. A number of features designed to conserve the borrower's cash, including PIK interest options and no excess cashflow sweep, are more common than in most unitranche deals, but these are broadly isolated changes to documents that are otherwise familiar to most market participants. As with other types of financing, the style of covenants and degree of permissiveness will vary depending on a number of factors, including transaction size. It may be oversimplifying things to say that ARR documentation terms tend to be a little tighter than unitranche terms for deals of equivalent size, but as a rule of thumb, it is generally true.
Calculation of recurring revenue
Recurring revenue itself is relatively easily identifiable, which is a large part of its attraction as a financing metric. The precise definition will vary depending on the specific business being financed, but the principle is to describe revenues which come from subscription fees or similar, regular contractual payments. Language along the lines of "recurring revenue arising from arrangements or contracts that provide an initial service term of not less than twelve months" is typical. Revenues from maintenance or support services relating to the same contracts will often also be included (although lenders may resist this). The annualisation of these revenues is then typically calculated on a straight line basis, based on a relatively short period. Last quarter annualised (LQA) is the most common basis, although some deals now use a last month annualised calculation.
Most ARR deals include a recurring revenue net leverage covenant and a liquidity covenant. The recurring revenue net leverage covenant simply tests recurring revenue (as described in three above) against net debt (which is defined as it would be in any other leveraged finance transaction). In addition, there is usually a liquidity covenant, which is simply a requirement to maintain an agreed level of available liquidity, meaning cash and, in most cases, committed working capital facilities. There is somewhat less scope for difficult negotiations around financial testing for the recurring revenue net leverage covenant than for an EBITDA-based leverage covenant. While some pro forma adjustment or normalisation may be appropriate, adjustments for things like one-off items and synergies are considerably less relevant.
A key feature of most ARR transactions is that the deal will convert (or 'flip') into using more traditional EBITDA-based metrics at some point in the future. In most cases, this happens on the earlier of a borrower election (subject to meeting a leverage condition) and an agreed date. More recently, there is movement in the market towards some transactions (usually larger ones) not having a mandatory conversion, but the conversion feature remains relevant to most deals. After the deal 'flips', several things change. First, various ARR - related features will cease to apply–e.g., the liquidity covenant will cease to apply, an excess cashflow sweep will commence and the ability to make PIK interest elections may stop. Secondly, the leverage financial covenant will switch to a conventional net debt-to-EBITDA test. Thirdly, ratios previously tested by reference to an ARR ratio will be tested by reference to a leverage ratio, and baskets which were previously fixed may become EBITDA-linked grower baskets. In short, after the conversion date, the loan agreement will become, in almost all respects, a typical unitranche-leveraged financing. For larger financings, that may even be a fully covenant lite structure.
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