One of the major success stories of the pandemic and beyond is the growth of technology companies.
Bridging the debt funding gap from start-up funding to traditional leveraged finance, which is predicated on companies meeting an EBITDA-based leverage covenant, are annual recurring revenue (ARR) financings. These are innovative loan products which allow companies which are not yet generating significant profits but which have strong revenues and are growing quickly, to access debt funding which can develop with the company: in almost all cases, an ARR-based covenant will switch to an EBITDA-based test after a relatively short period.
1. Characteristics of ARR Financings
The principal difference between an ARR financing and a traditional EBITDA-based leveraged financing is how the leverage is tested in the short term (before the covenant switch).
What is ARR?
The main metric for monitoring performance in the first few years is annual recurring revenue: exactly what this includes will vary from deal to deal, but typically lenders will be more concerned with the granular detail of the source of the revenue that counts towards the leverage covenant than they would be in a typical leveraged financing. To date, ARR financings have been used most commonly by businesses which derive most of their income from regular payments such as subscription fees. Because it is the revenue figure which is monitored (and tested against the debt figure), investment in growing the business, through marketing or sales, does not affect the company's ability to meet its leverage covenant. The ARR is typically an annualised figure based on the most recent quarter and seasonal variations may need to be taken into account.
Typically, the controls around an equity cure for an anticipated breach of the leverage covenant are tighter. Any equity cure will be subject to customary limitations, but the equity cure amount will also almost always be required to reduce the debt side of the covenant (and typically must be used to pay down debt).
The importance of cash during the period the ARR is used to calculate leverage
During the ARR covenant period, it is particularly important to lenders to ensure there is an amount of cash in the business, so they may also require a liquidity covenant, alongside the leverage covenant, which may be evergreen or tested on particular dates.
Outside this, there is usually a recognition that cash will be used for investment, so interest is typically structured as a PIK toggle and amortisation may be reduced or absent. For the same reason, a cash sweep would be rare. There are often prepayment fees as voluntary prepayment of the facility is not typically expected.
In a similar vein, lenders will be very focused on cash leakage, and will usually block dividends and require smaller baskets, or additional controls over the use of baskets where they might otherwise result in cash leaking from the group.
2. Precursor to mainstream leveraged financing
Typically the ARR leverage covenant will switch to an EBITDA-based covenant within a relatively short period, perhaps 2-3 years. In some cases, companies will have the ability to activate the switch themselves once pre-agreed metrics have been met: this would loosen the fetters on dividends and other use of baskets, allow access to a margin ratchet and may mean the end of the requirement for a liquidity covenant (though not in all cases).
3. Potential for growth
ARR financings started in the US, but are increasing in popularity in Europe, as debt funds seek new opportunities. They do require familiarity with the tech sector as a credit, but may well be an attractive prospect as tech companies continue to grow.
ARR financings are also used in the ESG sector where impact investors lend to enterprises for which EBITDA is a less meaningful metric.