INTRODUCTION

Just as the IIIQ 2024 BDC earnings season approaches, the BDC Reporter – and our sister publication, the BDC Credit Reporter – are completing the BDC Credit Table for the IIQ. This involves dissecting every public BDC’s portfolio to identify all the companies on non-accrual, as well as compiling a host of datapoints about recent and long term credit performance. In the Credit Table we’ve also identified which companies have been removed from non-accrual status and why. (This typically involves the booking of realized losses from sort of terminal realization event – a company sale; a debt-for equity restructuring; a debt-for-debt arrangement or a liquidation). We hope to publish the Credit Table in both publications shortly.

However, most of the data in the Credit Table is backward looking while investors famously are said to look forward. As a result, we’ve added another feature to our analysis: we’ve looked through the several hundreds of non-performing companies and sought to identify which ones might figure prominently in the coming quarter. These are the “trending” companies which have the biggest potential to sway a BDC’s income and net book value – and – presumably – its stock price. We’ll be writing about several companies that might have a big impact in the days ahead. All are known to investors but to what degree has the market properly assessed the latest developments?

We’re going to begin with the largest setback of the IIQ 2024 in dollar terms.

Pluralsight, Inc.

It’s Everywhere

If you’ve not heard about the troubles of Pluralsight you’ve been living under a rock. The financial press – which usually ignores much of what happens in BDC-land – has had a great deal to say because of the huge amounts of debt involved and the very large loss involved for the company’s equity sponsor – Vista Equity. (This number includes the losses of the PE group’s other partners).

First Time

Anyway, in the IIQ 2024, $803mn of debt owed to multiple BDCs was placed on non-accrual for the first time. (One might ask – but nobody else seems to – is how the debt was valued almost at par as late as the end of 2023. At the beginning of that year, the company – we now learn – was already asking its lenders for concessions as performance was not meeting plan). The BDCs discounted the loans by about (50%).

Too Much?

So much capital was involved and the unrealized losses were so high, that ratings group KBRA felt compelled to reassure everyone in June that the ultimate losses expected would not materially impact the many BDCs caught up in what amounts to close to a collapse in the value of the business:

KBRA analyzed the exposure to Pluralsight across our rated private credit portfolio. As of Q1 2024, Pluralsight’s first lien loans appear in seven KBRA-rated BDCs with an FMV of approximately $375 million. While these KBRA-rated BDCs represent more than 50% of the approximately $700 million total exposure identified across all BDCs, individual investment exposures are low, with five of the KBRA-rated BDCs maintaining modest senior secured first lien Pluralsight loans at less than 1% of total investments while the remaining two BDCs had less than 2.5%

Roster

The public BDCs caught in the cross fire includes Ares Capital (ARCC), BlackRock TCP Capital (TCPC); Goldman Sachs BDC (GSBD); Oaktree Specialty Lending (OCSL); Blue Owl Capital (GBDC) and Golub Capital (GBDC). Listed in there are some of the canniest credit underwriters in the private credit game but all have been impacted to varying degrees.

Coming Up

In the IIIQ 2024, we are likely to see all that debt either written off or converted to equity. Given that the enterprise value of Pluralsight has dropped substantially, there should be a great deal of the former as the lenders take control of the business. Apparently, $1.3bn of the $1.5bn of debt previously on the books of Pluralsight will be forgiven. (Moreover, the new lender-owners have advanced, or committed to, $250mn new monies as well). This suggests that over ($90mn) of annual interest income being collected before the default will be permanently forgone. That’s a chunk of change even if spread out over many BDCs, both public and private.

Known Unknown

A key question is how much will the BDCs write off and how much will go into equity. Looking at the matter with an objective eye we’d say a further write down beyond the 50% already booked would be appropriate, but the BDCs involved – and their armies of “independent” valuation groups – may be more generous to themselves.

Hard Truth

Longer term, there’s no guarantee – even after this wide ranging restructuring – that Pluralsight will succeed as a company. The original CEO and the President have been replaced and measures are obviously being taken to steady the ship. However, the company – with any amount of debt and under any ownership – might not be able to survive. However, the bulk of the damage to the company is likely to have occurred in the IIQ 2024 and in whatever the IIIQ valuation brings.

Damaged

All the famous public BDCs involved will be materially – although not fatally – impacted by the Pluralsight mis-step. We don’t have space to go into each BDC in turn but click here for the BDC Credit Reporter’s Company File which lists for each BDC the amount invested at cost, the IIQ 2024 FMV, as well as our sister publication’s estimate of the ultimate further loss and realized loss. There are some big realized losses likely to seen. The only positive for the BDCs involved is that Pluralsight is LIKELY to be removed from the BDC’s non-accrual lists. We are hedging ourselves because sometimes – even after restructurings – debt is maintained as non-performing, and that could happen here. In any case, this will not make much difference to the income forgone from this ill-advised venture.

Wrong Emphasis

Way too much ink was spilled by the like of Bloomberg and the FT in the run-up to the failure of Pluralsight about how Vista Equity raised new capital to service its interest on its huge debt load. The PE group transferred certain intellectual property into a new subsidiary and used those assets as collateral to raise debt to service the $1.5bn debt. This was mistakenly treated as proof positive that Vista Equity was engaged in aberrant behavior by “stripping” away valuable collateral from its lenders.

Move Along

However, both the BDCs involved and the ratings groups have repeatedly denied anything untoward was occurring but the story took on a life of its own and was the subject of much discussion. Fitch, in an attempt to quash the subject, even published a press release in September , which began with the following:

The recent liability management transaction (LMT) executed by Vista Equity Partners’ portfolio company, PluralSight, does not portend deterioration in sponsor-lender relations and is neutral for Fitch’s privately monitored ratings, Fitch Ratings says. 

The Real Story

In our minds, Fitch hit the nail on the head when warning that the real issue was not sponsor on lender “violence” but :

…about the ability of ARR loan issuers to manage a high rate environment. Ratings pressure within the portfolio due to negative FCF and dwindling liquidity have persisted this year. In addition to the PluralSight default, Fitch has seen one other company default on its ARR loan.

The PluralSight default also raises concerns about potential recoveries in the segment. Despite being capitalized at the time of its LBO with over 50% equity, lenders have reportedly marked the loans down to as low as 46 cents on the dollar, highlighting the potential downside for the segment when underwriting assumptions regarding revenue growth and stickiness prove optimistic.

Iceberg Tip

Or, in other words, Fitch is warning that the Pluralsight fiasco might not be a one-off and that similar loans to similar companies might pop up. If and when they do, the likely recovery might be very modest, even if the debt was structured to be in a first lien position. For a market looking forward that may be the most disconcerting lesson. We could be in for a series of bad Annual Recurring Revenue (ARR) loans in the Pluralsight mode.

Plenty

There is no doubt that Pluralsight is not an idiosyncratic situation. Many of the BDCs involved with the benighted company have been involved in ARR lending for some time, as we’ve turned up in our research. Here are a few examples:

Head On

GSBD – in answer to an analyst’s question on its IIIQ 2024 conference call – sought to allay any investor concerns about their underwriting of ARR loans, like the one for Pluralsight:

Alex Chi Goldman Sachs BDC, Inc. – Co-President & Co-CEO

Yes. So in terms of how we approach recurring revenue loans, that has not changed since we’ve started managing the platform more than a couple of years ago. So we continue to look at because I mentioned companies that have best-in-class technology, mission-critical to their customers. But we also look at margins, we want to make sure that these companies are highly profitable and also have sustainable growth.

So if you look at the loans that we’ve made more recently in the recurring revenue space, and again, we are very selective about where we choose to do it. It fits all those different profiles. If you look at Pluralsight, at the time of investment, the company was at negative margins and also the product is a good product. But at the same time, what we’ve seen is that as their customers have pulled back on spending, this company has seen some underperformance as a result.

Unconvinced

ARCC also addressed their own exposure to ARR loans:

In addition, we remain highly selective when extending credit to companies based on annual recurring revenue as our total exposure to these loans is currently less than 3% of the portfolio at fair value.

ARCC – IIQ 2024 Conference Call – July 30, 2024

We’re not fully reassured as 3% of ARCC’s portfolio still amounts to $750mn…

A Tenth

OCSL has not addressed its ARR business on its conference calls since 2021 when booking the Pluralsight initially. However, what they said back then was not wholly encouraging:

Look, I mean our recurring revenue software deals is — it’s under 10% of our portfolio. We’re not looking to meaningfully add to it, but we’ll take a look at the deals that are appropriately structured from a covenant standpoint, appropriately structured from a capital structure standpoint. I wouldn’t expect for us to be chasing a whole bunch of these deals going forward. But we also don’t have this macro overlay saying that we will no longer be doing these deals or that we are topped out either. We’re a bottoms-up credit investment shop, and there will be deals that come through that might be recurring revenue, might be life sciences otherwise. So we’ll take a look at all of it.

OCSL – Conference Call – August 5, 2021

That would imply that – at least in 2021 – OCSL had about $250mn invested in ARR loans.

Defending

GBDC has claimed – back in 2022 – that were a first mover in ARR lending:

“We were arguably the inventor of the — this segment in the 2014, ’15 time period. We’ve done very well with it over time”.

More recently – as the field became more crowded, GBDC has found the segment less attractive but their earlier enthusiasm may mean there are companies in their portfolio that could get into trouble.

CONCLUSION

Not Yet

With the debt-for-equity swap for Pluralsight now in the history books and no longer getting much attention, BDC watchers may believe this chapter is closed. However – as we’ve said – the company itself has a long way to go, even with little leverage, before the BDCs involved can relax. The amount of capital likely to be written off, and income forgone, seems likely to be one of the highest in BDC history. Yet, further losses could still occur amongst the existing debt retained; the new advances made and the equity the lenders are receiving.

At Risk

More importantly, and something we’ll be keeping on the agenda, there could be many more Pluralsight-like shoes to drop. The number of BDCs involved is relatively small but the players involved are amongst the largest, best known out there. We hope the managers involved will provide a full reckoning of what total exposure looks like and how those loans are faring in a still high interest rate environment.