For most of the past decade, software was private equity’s favorite asset because of its high growth prospects, and private credit was its preferred way to fund deals. Lenders built a sector-specific product, the recurring-revenue loan, based on subscription revenue rather than earnings. The reason was not that software companies generated enough cash to carry heavy debt, but that sponsors and lenders assumed subscription customers would never leave. However, when rates rose and AI began threatening entire software categories, that assumption became the weakest point in private credit’s capital structure. Still, lenders avoided taking losses, using payment-in-kind interest and gradual markdowns to delay the losses and payments.
This past August, a lender group led by Blackstone, Apollo, and KKR finalized a recapitalization of Medallia, taking ownership from Thoma Bravo. The deal was one of the largest private credit restructurings to date. Thoma Bravo lost all of the $5 billion it invested.
Medallia is not a typical distressed borrower. It sells customer-experience software to large companies; it is profitable and has a long list of great clients. Thoma Bravo took it private at the height of the software landscape for $6.4 billion. The buyout was funded by a $1.8 billion recurring-revenue loan from a group that included Blackstone, Apollo, KKR, and Antares. By this year, about $2.8 billion of debt was outstanding. When the loan’s interest switched from PIK to all cash, Medallia’s annual debt service costs rose by about $100 million, to nearly $300 million, significantly above the company’s $200 million in annual earnings. With $2.8 billion of debt against $200 million in earnings, the company had about a 14x leverage ratio and could not cover its interest. The lenders had seen this coming. Blackstone’s market rate on the loan fell from 98 cents on the dollar to 69, and in March, Thoma Bravo admitted it had overestimated Medallia’s growth prospects and paid too much for the company.
To complete the recapitalization, the lenders swapped their debt for ownership, which greatly reduced the company’s debt; meanwhile, the lenders also put in $150 million of new capital. That money is meant to go toward their existing $500 million investment in innovation and the AI industry. Because the lenders switched their debt for equity and are now equity holders, their recovery depends on running the business, not collecting interest. That is a much harder position for firms that lend credit, but the lenders likely saw value in taking control and risking operating the company rather than selling the loan at distressed prices. The business still earns money, and the product can be rebuilt around AI instead of being replaced by it.
