The Rise of Recurring Revenue Loans in Europe

As growth stage companies rapidly expand there is frequently a need for additional funding to support continued growth notwithstanding that the business is not yet generating (or is only just generating) positive EBITDA. Increasingly such companies are looking to debt as well as equity raises to meet their funding needs. This alert considers the nature and distinctive features of recurring revenue term loans, a product that has emerged to provide funding to such businesses.

There are also a number of recurring revenue loans that have been made available in the market to later stage or public companies. These will tend to be working capital revolving facilities and the debt quantum made available may be based on a borrowing base concept. These revolving facilities are not the focus of this alert, although clearly they share certain features with recurring revenue term loans.     

What is a recurring revenue loan?

A recurring revenue loan is a loan that is made available and sized on the basis of the revenue stream of a company and the recurring nature of that revenue stream. The borrower of a recurring revenue loan is expected to show a book of expected revenues usually arising from contracts with customers. This has made the product popular in the context of expanding software businesses and other businesses which can show strong committed revenue streams from customer contracts.

For lower debt amounts lenders may consider the nature of the recurring revenue stream and its resilience as part of their credit analysis, and will then make a loan available based on their assessment of the ability of the borrower to service the loan from such revenue stream. In these loans the terms of the documentation varies, but in some cases may not include a specific recurring revenue covenant or a liquidity covenant while others incorporate a borrowing base concept. These loans will often be relatively short term (up to around 3 years), made available in relatively small principal amounts and are made available on the expectation that they will be refinanced in the short term as the underlying business grows. 

In relation to higher debt amounts the terms have become more sophisticated. The first sizeable recurring revenue loans originated in the US markets and, more recently, a number of specialist lenders have been willing to make such loans available on these terms to borrowers in the European market. 

Why can’t these borrowers just borrow a unitranche loan on usual leverage finance terms from one of many direct fund lenders?

The target market for recurring revenue loans is companies who have not yet reached the stage at which they have achieved positive EBITDA (or if they have, the EBITDA is insufficient to support a leveraged based facility). Frequently the companies have been in existence for a limited number of years, have been reliant on rounds of shareholder funding to date and show a high rate of cash burn as they are going through a period of rapid growth and development. These characteristics mean that the traditional leveraged unitranche loan metrics cannot be satisfied, at least in the early years of a recurring revenue loan.

What are the key features of a larger recurring revenue loan?

As noted above, the terms of recurring revenue loans in the market varies depending both on the quantum of debt being made available and on the stage of development of the borrower; also whether the loan is intended to be a bridge to an EBITDA based facility or a bridge to an IPO or another refinancing or exit.   

The terms of the smaller recurring revenue loans vary widely and will not be considered further in this alert. In relation to higher debt amounts, there are a number of features that have been included which differentiate them from leveraged EBITDA based lending. The summary of terms below is based on those features commonly seen and is not intended to provide a comprehensive checklist but is rather intended to flag a number of the features seen in the market. The relative importance of these features in any particular loan agreement will of course depend on the nature of the borrower and the specific business being funded as this is not yet a standardized product.        

Purpose:

Recurring revenue loans have been made available for various purposes, including capital expenditure and, on a number of recent deals, the funding of specific acquisitions and refinancing of existing indebtedness.

Conversion Date:

Recurring revenue loans are frequently provided on the expectation that the business will, at a certain point in the future (commonly up to 3 years after entry into the loan agreement – although there is some variation depending on the specific business plan), start generating EBITDA and, accordingly, be able to borrow on EBITDA based terms. The loan agreements for these recurring revenue loans will be drafted on the basis that the early stage liquidity and recurring revenue covenants will fall away at such point and be replaced by a unitranche-style leverage covenant. Certain loan agreements provide that this flip is at the option of the company (subject to a specified leverage level having been met). This ensures that the company does not have to deal with a forced refinancing at that point in the event it has not yet started generating sufficient EBITDA and equally has the ability to flip earlier if it outperforms the expected business plan. 

Provided that the company can comply with the leverage EBITDA based financial covenant, there are a number of key benefits to the company in the flip occurring. In particular:

• Margin: Prior to the flip the margin will commonly be a fixed percentage rate. Following the flip the company is likely to benefit from a leverage style margin grid. 
• Baskets: Where the loan agreement includes debt baskets these may be relaxed on the occurrence of the flip.  These may move from fixed figure based baskets or baskets accommodating a limited amount of growth based on recurring revenue to include baskets based on the greater of a fixed amount and a percentage of EBITDA. The ability to carry-forward and carry-back basket amounts may also become available after the flip.
• Distributions: Usually an objective of a recurring revenue loan is to provide the business with amounts required for growth (or as noted above, in certain cases acquisitions), at a time where it is not generating material or any EBITDA. Consequently until the occurrence of the flip there will usually be limited ability to pay dividends of distributions to shareholders, although these are likely to be permitted in limited amounts for the maintenance of holding companies of the borrower. Following the flip, the full range of unitranche leverage facility based permissions, including a basket and EBITDA leverage based distributions usually become available.
• Prepayment Fees: Recurring revenue loans will commonly include prepayment fees in relation to prepayments made up to the end of the third anniversary of the date of the loan. Any exclusions will tend to be discussed on the same basis as on unitranche facilities but there is a general expectation that the loan is unlikely to be refinanced in short order.  
• PIK Interest: The company will often be provided with the right to choose to PIK a portion of the margin payable on the term loan. This option may be limited to a certain period (e.g. up to two years) after the date of the term loan and prior to the flip and will generally be accompanied by an increase in the percentage margin payable during any PIK period. There may be a limit imposed on the number of times and the duration for which the group is permitted to exercise this right and the right to elect to PIK may also cease following an event of default.
• Financial Covenants: Prior to the flip the company will often be expected to comply with both a minimum liquidity covenant and a recurring revenue (or a variation which approximates to recurring revenue) covenant. The definitions used for these covenants will often be considered to ensure that they provide an accurate assessment of the financial position of the group based on its specific attributes. In particular funders are often keen to ensure that any cash counted for the purpose of liquidity is actually available, is not subject to security in favour of third parties and, to the extent that any cash equivalent investments are included in the liquidity amount, such amounts are genuinely able to be converted to cash on relatively short notice. The definitions used for purpose of the calculation of recurring revenue (and, accordingly, any recurring revenue ratio, usually being a recurring revenue based leverage covenant) are a matter for negotiation and vary between agreements, but fundamentally are usually looking to determine genuine recurring revenues arising under, e.g. software licences, and may exclude any other revenue and also adjust for any customer churn. Following the flip, any leverage ratio will normally follow a unitranche facility agreement position, based on total net leverage with step downs over the remaining term of the facility.
• Equity Cures:  While there is variation between deals on the treatment of equity cures prior to the flip, these amounts may be required to be applied in whole or in part in prepayment of the recurring revenue loan in contrast to the average European unitranche loan. Following the flip these are unlikely to be required to be applied in prepayment. Traditionally there was no ability to cure a breach of the liquidity covenant, although this is now a point of discussion depending on the level at which the liquidity covenant is set.   

Security:

Funders of recurring revenue loans tend to expect a high level of security coverage, both in terms of the members of the group providing security and in terms of the actual security being provided. In particular there is a focus on the assets of business with value, which for software businesses will usually specifically include the intellectual property assets. Funders may also look to be provided with actual diligence on the intellectual property to determine the scope of security to be taken, rather than relying solely on generic leverage style agreed security principles and a post-acquisition style assessment of the security to be provided.

Financial Diligence:

Given the growth trajectory of the borrowers of recurring revenue loans, funders will tend to require the provision of up-to-date management accounts as part of their credit decision to lend – audited annual accounts which may reflect the position of the group over a year prior to any lending decision are of more limited relevance in the context of these businesses. This enhanced level of diligence also tends to be reflected in the ongoing financial information provision requirements, which are negotiated and may include monthly management accounts, the provision of commentary on performance, comparisons to previous periods and updates on any material developments and key contracts of the group on a quarterly basis.   

Warrants / Co-Invest:

Funders may be provided with an equity upside as part of their return on lending. This may take the form of a right to co-invest with any equity or the provision of warrants, exercisable on certain events, commonly including a listing, exit, refinancing or at the end of a specified period following the date of the loan. Consideration should be given to whether any warrants are to be stand-alone or are to be tagged to the underlying recurring revenue loan to deal with any potential future transfers. For certain funders it will be important that any warrants include a cash exercise option depending on the terms and requirements of the fund making the financing available and their ability to hold any equity which may be issued.

Conclusion:

The debt quantum lent under recurring revenue loans has increased significantly in the past year. Given the continued trajectory of growth stage companies, their relative delay in going public compared to a decade ago and their ongoing need for funding, the availability of debt funding on non-EBITDA based metrics provides significant additional flexibility to enable these companies to continue to grow while limiting the need to raise additional equity. The increasing number of funders able and willing to provide this funding should ensure that this flexibility will continue to be available going forward while, of course, the specific terms of recurring revenue facilities will continue to evolve.