BREAKINGVIEWS-How a software meltdown will shake private markets

The author is a Reuters Breakingviews columnist. The opinions expressed are his own. Refiles to remove extraneous word in second paragraph.

By Neil Unmack

LONDON, Feb 5 (Reuters Breakingviews) - Public market investors are freaking out about artificial intelligence. Yet the pain may be even more dramatic in the worlds of private equity and credit. Buyout barons and direct lenders — think of Vista Equity Partners, EQT EQTAB.ST, Thoma Bravo, Blackstone BX.N, KKR KKR.N, Ares Management ARES.N and Blue Owl Capital OWL.N — have spent years stuffing software companies and loans into their funds. An AI reckoning could get very messy very quickly.

Shares in listed software groups are reeling over fears that new AI tools, from developers like Anthropic, may eat incumbent products that handle enterprise tasks including expense management. The BVP Nasdaq Emerging Cloud Index .EMCLOUD, which includes names like Workday WDAY.O and Salesforce CRM.N, is down 14% since last Monday. Its constituents, excluding positive outlier Palantir Technologies PLTR.O, now trade with a median forward EBITDA multiple of about 16, according to a Breakingviews analysis of LSEG Datastream figures. That compares with a multiple of 22 at the start of this year, and roughly 30 just before OpenAI released ChatGPT in late 2022.

Debt prices tell a roughly similar story, at least in the widely traded syndicated loan market, which is distinct from the more opaque private credit world. PitchBook reckons that the volume of loans trading below 80% of face value, a sign of deep financial stress, has more than doubled since the end of December, to $25 billion. Software loans account for nearly a third of all so-called distressed credit in these liquid markets, PitchBook reckons.

All of this implies steep losses in private markets. Software companies were a popular choice for buyout barons after the pandemic, egged on by seemingly sticky customer relationships and cheap debt. Data from Bain & Co. shows that in 2021 alone, software buyouts amounted to $256 billion, or more than a fifth of the total. Marquee transactions included Thoma Bravo's $6 billion take-private of Medallia, or Vista's $3.9 billion acquisition of education group Pluralsight, which has already been taken over by creditors. In many cases, the debt funding came from direct lenders, who are likely still exposed. A Kroll StepStone benchmark covering $835 billion of U.S. private credit contains some $180 billion worth of IT sector debt, or 22%.

Dealmaking certainly got toppy in the post-pandemic boom. On average, software buyouts were struck at enterprise value to EBITDA multiple of over 20 in 2021, and carried debt equivalent to around 10 times EBITDA, per PitchBook figures. Leverage moderated slightly after that heady peak, with borrowing for new deals averaging 7 times EBITDA between 2022 and 2025.

Imagine a hypothetical company with EBITDA of $100 million in 2021. If acquired at 20 times EBITDA, with 7 times leverage, the initial equity would have been $1.3 billion, against $700 million of debt. Next assume that EBITDA is on track to grow to $150 million by the end of 2026, equivalent to a healthy 9% annual rate, and that the debt still remains. If the valuation multiple had halved, in line with public markets, the theoretical equity value would be down 40% to $800 million. If a fair multiple is more like 5 times, in line with some of the more distressed public software names, then the equity would be nearly wiped out and lenders close to facing losses. UBS analysts estimate that the default rate for private credit could jump by up to 8.5 percentage points in a scenario of rapid AI disruption.

One risk is that investors, fearing this scenario, pull money from semi-liquid private credit funds. Some vehicles, including those known as business development companies $(BDC)$, allow backers to withdraw a portion of their funds every three months. They've been sold to individual investors, who may arguably be less sophisticated and more prone to panic. Blue Owl Technology Income, one such BDC, had redemption requests equivalent to 15% of its shares in the fourth quarter of last year, despite a strong track record. While Blue Owl was able to honour the redemptions, a wider run on those vehicles could force funds to gate investors or even sell assets, which would depress prices further.

That would have a knock-on effect to other vehicles like collateralised loan obligations (CLOs), which slice and dice debt into different tranches for buyers like insurers. When a certain percentage of CLO assets are downgraded below B-minus, which in the credit-rating world signals a higher risk of failure, the vehicles can be forced to shut off cash payments to some investors. The net effect may be to drive up borrowing costs, and choke off funding for future buyouts.

That fallout is not yet apparent. U.S. companies rated single-B, the second sub-investment grade rung, on average have to pay some 310 basis points more than risk-free rates to borrow in bond markets, per ICE Bank of America indexes. That’s up some 30 basis points since the last week of January. But it’s still roughly in line with the two-year average. That narrow extra return, however, means there’s plenty of scope for financing conditions to worsen as the AI fallout spreads.

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(Editing by Liam Proud; Production by Streisand Neto)

((For previous columns by the author, Reuters customers can click on UNMACK/neil.unmack@thomsonreuters.com))