Software companies pay steep price to buy time against AI threat

Private-equity backed software firms are racing to roll over a glut of debt maturing in the next two years, offering higher yields and deal sweeteners to lenders nervous about AI disruption.

More than half a dozen software companies have closed so-called “amend-and-extend” deals so far this year to push back looming maturities by two to three years, rather than pursuing full refinancings, which typically carry up to seven-year debt terms.

The more cautious approach reflects investor scepticism towards software firms’ long-term competitiveness amid rapid advancement of AI models, particularly for private-equity-owned businesses laden with debt that need to refinance pandemic-era debt at much higher interest rates.

About $40bn of speculative-grade software debt is set to mature in 2028, according to Moody’s.

“There is a desire by the market to keep these firms’ feet to the fire,” said Jeremiah Lane, co-head of global leveraged credit at KKR, adding that short-term debt extension allowed lenders to renegotiate financing terms while monitoring borrowers’ resilience to AI threats.

Proofpoint, a cyber security firm backed by Thoma Bravo, last month extended some $4.3bn of debt by two years after agreeing to dozens of creditor-friendly enhancements, including mandatory quarterly lender calls and collateral protections, according to people familiar with the matter.

Yet, the additional time came at a steep cost. The new debt would yield about 9.3 per cent, or an extra 1.5 percentage points above the secured overnight financing rate compared with its existing debt, the people said. Proofpoint left more than $700mn of loans untouched because extending a larger portion of debt would incur even more interest expenses, the people added.

Sophos, another Thoma Bravo-backed software firm, is also expected to offer a bump in coupon and tighter covenants to win over investors when it refinances more than $2bn of loans in September.

Improved earnings and a relief rally from software groups including Salesforce could also help lift investors’ sentiment in the sector.

“These are the better houses in a bad neighbourhood,” one lender said of Proofpoint and Sophos.

He added that for companies that had struggled to grow their business or ones that faced a daunting AI challenge, the path was far rockier, with buyout groups staring at large losses and lenders preparing for painful restructurings.

Thoma Bravo and Goldman Sachs, which led both transactions, declined to comment. Proofpoint and Sophos did not respond to requests for comment.

“We’re taking a fine comb to all of the terms and figuring out where we can tighten them,” said Kearney Posner, portfolio manager at Lord Abbett, which prefers shorter-term exposure to software debt. “Investors are still very uncertain and don’t want to give as much leeway.”

“If it doesn’t play out the way that we expect, we’re in a much better position come the next maturity to ensure that our collateral is secure,” Posner said.

In a sign of shifting power dynamics, lenders have been securing major concessions such as “omni-blocker” provisions, which help prevent management liability exercises that strip important assets away from the existing creditors. Other sweeteners include restrictions on new debt and dividend payouts, as well as loan concentration limits by single investors.

“We’re seeing some of the best documentation that we’ve seen in the loan market for a long time,” Lane said.

While private equity groups often give less demanding lenders priority to participate in new deals, “that carrot is not as enticing as it has been in the past”, said a leveraged loan investor.

Melanie Hanlon, head of credit research at Napier Park Global Capital, said many software companies were voluntarily disclosing more performance metrics to placate investors.

“Lenders are getting more questions answered,” Hanlon said. “Companies are under pressure to provide information because that information loop directly translates into where their debt trades.”

Some software companies are tapping the junk bond market to expand their investor pool, even though bonds often come with more public disclosure and non-call provisions that bar borrowers from early redemption.

Earlier this month, Medicaid software firm Gainwell Technologies sold more than $1.7bn of junk bonds as part of its $5.8bn refinancing and debt-extension package.

Widening the lender base is especially important for software companies with debt mostly held by collateralised loan obligation funds — investment vehicles that buy pools of leveraged corporate loans — as many pandemic-era funds are also nearing maturity.

“A lot of those CLOs are older vintage CLOs, so the longer [the loan] extends out the less capacity these funds have,” said Cody Gunsch, head of North America leveraged finance capital markets at Morgan Stanley.

Still, software companies need to convince investors that they can adapt to a new business landscape with slower growth and more intense competition, all while managing creeping debt.

“Many of the businesses have too much leverage in light of the concerns investors have about enterprise value coverage,” said Michael Miller, head of Americas leveraged finance at Barclays.

“It’s less about a company’s financial position today and more about whether it will be solvent two years from now,” he said.

Additional reporting by Eric Platt