Continued Boom In Aggressive Deal Activity

Fortunately for lower-quality, highly leveraged technology companies, the recent COVID-19 pandemic-driven economic downturn was brief. Credit markets shut down in March and April 2020, but quickly rebounded despite uncertainty around the recovery's sustainability and the pace of reopening of global economies.

It was not long before technology companies (e.g., Epicor Software Corp., Cardinal Parent Inc. (dba Zywave Inc.) leveraged up to pursue aggressive debt-funded shareholder returns, acquisitions, and leveraged buyouts (LBO). The V-shaped rebound in credit market activity catapulted high-yield and leveraged-loan issuance to record highs. New loans issued by private-equity-backed companies exceeded $300 billion so far in 2021, topping the record $295 billion in 2018. With the help of significant market liquidity, many lower-rated companies that otherwise would not have had favorable terms were able to opportunistically refinance debt to lower their debt service costs. This allowed them to prioritize their focus on operating their businesses in a still weak macroeconomic environment.

The side effect of this issuer-friendly environment is that resilient investor demand allowed both established companies and first-time issuers to secure low debt-funding costs that facilitate more aggressive transactions and debt-refinancing opportunities. All the aggressive issuance meaningfully increased the 'B-' rated universe, which now accounts for approximately 40% of rated U.S. technology issuers. Nearly half of our speculative-grade portfolio is rated 'B-' and below, and approximately 55% of rated U.S. tech companies in this category are financial sponsor-owned and reflect greater risk of default. They are heavily indebted, typically with S&P Global Ratings-adjusted leverage in the high-single-digit area and weaker free operating cash flow (FOCF) to debt less than 3% on average. Some even reached low-double-digit leverage and near break-even free cash flow (FCF). Sponsor-owned companies tend to tie their debt capacity to debt service ability rather than absolute leverage, exacerbating the already high leverage in the low-interest-rate environment. Weak credit metrics and reduced cushion should be worrisome for investors as some tech companies continue to face ever-increasing industry challenges. Additionally, in reviewing the capital structures of these low-rated technology companies, we find many with leveraged-loan-only structures that are covenant-lite, which provides less lender protection and often prevents lenders from intervention before it's too late. Furthermore, the weak covenants allow financial sponsors to layer on additional debt if desired.

Since 2019, 'B-' rated issuers are consistently about 30% of the entire U.S. tech portfolio. Of all U.S. speculative-grade firms, about half have been rated 'B-' and below. Of the 22 new issuers thus far in 2021, we rate about a third 'B-'. We rate only two, Synnex Corp. and Fortinet Inc., investment-grade.

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Among the most highly leveraged issuers are Gator Holdco (UK) Ltd. (dba Aptean), Zywave, and QBS Parent Inc. (dba Quorum Software). For Aptean and Quorum, both with leverage exceeding 15x as of Sept. 30, 2021, this was primarily the result of the financial sponsors' aggressive acquisitive strategies. However, we expect both to maintain steady growth and successfully integrate acquisitions, as reflected in their stable outlooks. Zywave, on the other hand, went through an LBO at the end of 2020, and has also made an acquisition in November resulting in our expected leverage of nearly 18x through 2021. We expect the company to support its high leverage through highly recurring revenues and growth based on secular trends in the personal and casualty and employee benefits industry. The three companies, although they have higher leverage than their 'B-' rated peers, are like most 'B-' rated issuers within our tech coverage: software companies with steady growth prospects and adequate FOCF generation to meet debt service requirements.

Deleveraging Prospects And Credit Improvements

Over the past 18 months, financial sponsor exits through strategic take-outs, traditional public offerings, and special-purpose acquisition company transactions drove upgrades from 'B-'. These catalysts provided liquidity and opportunities for significant debt reduction and improved credit metrics. While some rated issuers could still pursue these paths to improve their credit profiles, we do not expect many to shift their financial policies that would allow for significant and sustained improvements in their credit profiles.

Of the 42 positive rating actions among companies rated 'B-' and below from March 2020 to September 2021, nearly half were reversals of negative actions related to risks from the macroeconomic impact of the COVID-19 pandemic that turned out better than feared. While business activity was certainly slower during the pandemic, many low-rated issuers performed broadly in line with our expectations, achieving forecasts that supported our credit ratings. We expect the improving macroeconomic growth over the near term will help earnings and cash flow and improve overall credit metrics.

The technology sector continues to benefit from secular growth trends, including strong demand for information technology (IT) products and 5G technology transition. As the economy reopens with continued COVID-19 vaccine roll-out, we expect the gradual return-to-the-office trend will further boost enterprise spending, spanning from investments in servers and networking equipment to increased broadband usage. The software industry, specifically, dominated positive rating actions and the reversal of negative actions. Many of these companies either are cloud native or have transitioned to software-as-a-service offerings from license and maintenance business models, blunting the impact from customers' initial response from the COVID-19 pandemic to delay capital spending and prioritize liquidity.

The pandemic provided another data point that supports our view that many lower rated software companies benefit from products with high renewal rates that allow for strong recurring revenue and cash flows even in times of stress. Looking ahead, software companies continue to benefit from secular growth trends in acceleration of digital transformation driven by COVID-19, continued cloud adoption, and increasing need for automation. Despite these positive attributes, many of these lower-rated software companies are sponsor-owned, therefore operating at high leverage under more aggressive financial policies, constraining the rating and limiting potential upside. Since the beginning of 2020 to September 2021, we raised our credit rating on only one software company within the 'B-' and below cohort, VS Holding I Inc. (dba Veeam Software Corp.). which was upgraded to 'B' on maintained robust growth while generating strong cash flow. We note that while Veeam's data protection products are competitively positioned against competitors, the company may face headwinds to further growth unless it can displace legacy vendors from their position protecting the most sensitive workloads at the largest enterprise customers.

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We view the overall U.S. tech sector as having fared relatively well while other sectors were battered during the pandemic. Few downgrades reflect our expectation that many companies have high recurring revenue sources that are resilient during downturns and their offerings do not face significant technology transition risk. Their softer business performance was temporary due to pandemic-related disruption rather than poor management execution or unviable business models longer term. While we believe resumption of business and social activity will support healthy revenue and cash flow improvements, we downgraded companies facing greater business challenges because of uncompetitive products and technology transition (e.g., SkillSoft Corp., SunGard AS, Riverbed Parent Inc.) or those operating a cyclical business while saddled with high leverage that pressures its ability to meet financial obligations (e.g., Natel Engineering Co. LLC) to 'CCC+' or below.

If Industry Prospects Are Good, Why Are We Raising Flags?

The strong availability of capital, seen in private equity firms raising new technology focused funds, will continue to spur competition for LBO targets. As valuations of tech companies continue to increase, leverage continues to rise in LBO transactions, despite financial sponsors being willing to increase their equity contribution. When evaluating M&A transactions in the tech sector, we acknowledge companies can boost revenue and expand core offerings to better serve customers via acquisitions. However, some of these bolt-on acquisitions involve complex business roll-ups and aggressive cross-selling strategies that are not guaranteed to succeed. Additionally, while high leverage in and of itself is not detrimental if managed aptly, we expect some companies will invariably not meet their and our financial forecasts due to business uncertainties such as competitive threats. We believe the low cost of debt stretches tech company valuations, extends payback periods for owners, and forces financial sponsors and their portfolio companies to take greater operational risk to achieve their revenue growth and cash flow targets.

We anticipate the absence of financial sponsors' incentives to lower their financial risk tolerance, good growth trajectory in tech sector that favors M&A transaction, as well as opportunistic debt-financed dividends to limit the number of issuers upgraded from 'B-' over the next few years. Additionally, as financial sponsors look to monetize their investments, sponsor-to-sponsor sales or dividends could further worsen already high valuation and debt to EBITDA multiples.

The Triple-C Threat

Despite rising leverage, we expect the U.S. technology sector to have low 'CCC' downgrade risk for now. Many tech issuers have benefitted from the favorable debt market conditions over the past 12 months, extended maturities, and lowered cost of debt. Improved capital structures allowed many tech companies to maintain adequate liquidity and generate modest FCF to meet commitments over the next 1-2 years. Therefore, none of our U.S. 'B-' rated technology issuers have negative outlooks.

While we view 'CCC' downgrade risk to be low, the 'B-' group warrants close monitoring. Idiosyncratic business factors will be the main driver of downgrades, rather than a broad-based theme that affects all 'B-' firms. In evaluating U.S. tech companies rated in the 'CCC' category, some are burdened by tight loan covenant cushions in addition to high debt loads, slow business recovery from pandemic-related disruptions, and associated supply chain challenges. Some companies, such as SunGard (unrated) and Riverbed secured debt relief through distressed exchanges, though their fundamental business challenges remain and growth prospects are still questionable. Riverbed subsequently filed for Chapter 11 bankruptcy on Nov. 17, 2021, and we lowered the rating to 'D'.

While we view software companies more favorably, incumbent companies, such as Blackboard Inc. (acquired by Astra Acquisition Corp.) and SkillSoft Corp., endured years of slow product development and uncompetitive offerings, ultimately ceding market share to emerging cloud native competitors. This contrast is particularly stark in the cloud versus on-premises products. We expect digital transformation trends to strongly favor cloud vendors as customers demand more flexible and faster deployments. Certain on-premises-focused tech vendors or service providers have track records of revenue growth challenges and face strategy shifts or business restructurings to effectively compete against new entrants unburdened by legacy offerings.

Downgrades To 'CCC' Category Since 2020

From the beginning of 2020 through September 2021, there were six downgrades to 'CCC+'. Most rating actions were due to our view that a prolonged macroeconomic slump could further weaken an already deteriorating business, materially affecting their abilities to meet financial obligations. We also downgraded companies that operated in areas hit hardest by the pandemic, such as Cvent Inc. (event planning) and Priority Holdings LLC (payment processing).

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Generally, hardware companies' business performance is inherently volatile given their transactional nature and require greater liquidity cushions. Therefore, we believe hardware companies have lower leverage and better liquidity than software and IT services companies. Additionally, we find business risk is rising for certain hardware vendors as software can be increasingly decoupled from hardware systems, which are becoming more commoditized, allowing customers to combine best-of-breed software to run on a broad array of hardware systems. This shift requires legacy hardware vendors to prove their integrated approach is superior, which may require pursuit of strategic software acquisitions.

Over the past few years, a spree of LBOs, debt-funded acquisitions, and sponsor dividends pushed leverage higher. While software companies are more resilient, we believe those reliant on acquisition integration and synergy realization for deleveraging have greater risk of rating downside. Also, some low-growth software companies in mature industries pursued debt-funded acquisitions to bolster revenues, adding downside risk over the next few years. Not all companies will meet forecasts and elevated debt will reduce their abilities to manage weaker demand.

Recovery Implications Longer Term

The number of 'B-' rated leveraged loans in first-lien-only capital structures rose as investor risk tolerance allowed. This is important because we expect recovery rates could remain at historical lows in the low- to mid-60% range or even continue to erode as higher acquisition multiples drive up leverage. Moreover, asset value can deteriorate longer because of covenant-lite credit agreements that have become a predominant theme over the past several years even for smaller-scale issuers.

We believe some capital structures are becoming stretched as some companies fund bolt-on M&A using preferred equity, as was the case with Gator Holdco and BY Crown Parent LLC (rating discontinued upon its acquisition by Panasonic Corp.). This indicates diminishing debt incurrence capacity or operational flexibility. We also view increased risk for reduced cushion or subordination in the capital structure that might lower recoveries for first-lien loans despite their senior ranking. High company equity valuations imply substantial cushion to absorb losses, though it might be fleeting. Prevailing multiples come with higher leverage through all first-lien capital structures. Rapidly eroding equity cushions could wipe out significant value, leaving no debt subordination for senior lenders.

Alarm Bells Ringing Yet?

Even as the market expresses concerns about eroding credit quality deal activity continues unabated. While we expect good technology industry growth prospects to support EBITDA expansion, improved credit metrics, and manageable refinancing needs, we are carefully monitoring credit issues that might emerge over the next couple of years. We acknowledge leverage ratios can continue to rise without significant downgrade risk. Strong capital market conditions have allowed companies with strong or weak growth prospects to pile on low-interest-rate debt and still generate adequate FCF to meet debt service costs.

Nevertheless, deleveraging plans are predicated on continuing favorable economic conditions that support business growth and access to capital markets that enable flexibility to build and expand their offerings through acquisitions to remain competitive. Market conditions will eventually turn, and we are closely monitoring highly leveraged 'B-' rated companies based on patterns of companies we downgraded to 'CCC+' or below. Below (Table 2) is a list of 'B-' companies with challenged industry growth prospects. They are mature hardware and software vendors that face high technology transition risk and/or have high concentration, are exposed to meaningful business cyclicality, operate with high leverage that impedes product innovation to remain competitive, and have limited operating track records.

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