Private market investors, including middle-market collateralized loan obligations (CLOs), have prioritized software and health care services companies as some of their top holdings.  Investments in these industries have attracted attention due to their high growth potential, their defensive nature and relative stability of revenue, generally low capital intensity, and a robust pipeline of add-on opportunities based on the presence of myriad smaller players--allowing sponsors to execute on their buy-and-build strategy. Together, software and health care providers and services companies represent over 20% of total exposure among our credit estimates (per our Private Credit And Middle-Market CLO Quarterly: The Times They Are A-Changin' (Q4 2024), Oct. 18, 2024, publication).

For many software companies, recurring revenue streams are expected to provide predictability as they become increasingly integrated with business operations, at which point the complexity and cost of switching platforms can become prohibitive for customers. Moreover, strong operating leverage and low capex requirements (which can be as low as 1%-5% of net revenues) translate to attractive cash flow conversion potential, and sellers benefit from premium valuations on software companies.

The health care services industry has its own growth story with a confluence of an aging population, inelastic demand for essential services, and limited price sensitivity since government programs and health plans cover the bulk of costs. Health care is also highly regulated, creating implicit barriers to entry for this countercyclical industry.

Considering these attributes, both these industries have long been staples for BSL and private market investors, who rely on cash flow consistency to service leveraged buyout (LBO) debt and business growth to drive returns. But the risks are evident alongside the opportunities. Credit-estimated borrowers--who are overwhelmingly sponsor-owned--are currently the most aggressively levered in these industries and the majority of borrowers are not producing free operating cash flow (FOCF). Both industries also feature the highest number of defaults across the credit estimates portfolio year-to-date, even though the overall default rate has been trending lower. Looking ahead, credit quality improvement for CEs and lower-rated speculative-grade issuers hinges on stronger operational execution and additional reductions to benchmark rates.

Industry Subsectors Present Diversification Opportunities, Alongside Different Risks, For Private Credit

Our analysis of nearly 500 credit estimates year-to-date highlights the plethora of subsectors within software and health care providers and services--with enterprise software and specialty clinics leading their respective industry groups. (S&P Global Ratings provides credit estimates [a point-in-time confidential indication of the likely credit rating] on unrated entities whose loans are held in middle-market CLOs.)

Within the software space, enterprise applications (used for such core organizational functions as finance, human resources, customer relationship management/sales, inventory and supply chain management) represented more than half (52%) of the credits reviewed, followed by IT consulting/managed services (21%), data analytics (10%), and a smaller number of cybersecurity (8%), educational software (6%), and consumer software developers (3%). While many of these companies provide purpose-built software for specific industry verticals, others serve a broader range of customers. Several are also quite niche, and include elements like payment processing for religious organizations, content management for academic institutions, and applications supporting government and emergency services functions.

Additionally, we have seen several companies engaged in the process of transitioning from traditional licensing models to software as a service (SaaS) delivery, which can help with revenue predictability, customer retention, and accessibility for smaller enterprises. However, a cluster of non-SaaS companies appears to remain in the middle-market, possibly catering to customers who prefer more customized solutions utilizing their own infrastructure.

Middle-market software companies are generally not as profitable and cash flow generative as their BSL counterparts.  Compared to lower speculative-grade rated software companies, credit-estimated borrowers we reviewed year-to-date had similar median leverage and interest coverage ratios, but they were also significantly smaller in terms of business scale. The share of credit-estimated borrowers producing positive FOCF was also much lower, though we note that the cash flow-generative rated entities' median forecasted FOCF-to-debt ratio was only 3%. While approximately 70%) of the software CEs were scored at 'b-' or above, year-to-date actions have skewed slightly negative with a downgrade-to-upgrade (D/UG) ratio of 1.2, which improved from 1.7 in the first half of 2024. However, it remains the most highly leveraged industry across our credit estimates universe with median debt to EBITDA and cash interest coverage ratios of 7.8x and 1.2x, respectively. Its median S&P Global Ratings-adjusted EBITDA margin was around 22%. This subset of CEs also included 27 companies generating more than $500 million of annual revenue--which is often viewed as a threshold for the upper middle-market. The most common sponsors for the industry were Vista Equity Partners, Thoma Bravo, and Insight Venture Partners.

Credit-estimated health care providers have been conservatively levered relative to rated syndicated peers, but trail on cash flow along with a very wide gap in scale.  Within the health care services and providers space, common subsectors included specialty clinics (24%), outsourcing/administrative (17%), dental practices (14%), and home care (13%). Smaller fractions of the subset included providers of medical support services, rehabilitation, veterinary, and long-term care providers.

Compared to health care services companies rated 'B' and below, the CEs companies had more conservative leverage, with median debt to EBITDA of 7.2x landing more than a full turn below the rated group. However, the proportion of cash-generative companies was significantly lower as was the typical size of the business. Otherwise, the CEs were similar to the syndicated credits based on profitability and interest coverage.

About 80% of the health care CEs reviewed year-to-date were scored at 'b-' or higher, although actions this year have been firmly negative with a downgrade to upgrade ratio of 2:1 due to operational issues and liquidity challenges. The median adjusted EBITDA margin was roughly 14%, and the subset included 29 companies generating more than $500 million of annual revenue. The most common sponsors for the industry were Windrose Health Investors, Varsity Healthcare Partners, and Audax Group.

Credit Quality Improvement Unlikely To Materialize Until The First Half Of 2025

Downgrades across the broader credit estimates universe may have peaked but will likely continue to outnumber upgrades in the near term.  The percentage of total CE reviews resulting in downgrades declined slightly to 13% in the third quarter (compared to 14% in first-half 2024). Aside from the overlapping dynamics of high leverage and weak cash flow for credit estimates and rated credit at the lower end of the speculative-grade spectrum, companies operating in the software and health care providers and services industries are also experiencing discrete headwinds that continue to inhibit credit quality.

We expect the U.S. Federal Reserve's recent interest rate cuts, along with the expectation of further reductions, will help alleviate some of the pressure on floating-rate debt issuers' cash flows and interest coverage ratios. Additionally, many borrowers have enacted cost-cutting measures, and some with stronger credit profiles have been able to re-price their loans at reduced spreads. Nevertheless, the cadence of future rate cuts remains uncertain, with many borrowers likely continuing to navigate a challenging all-in rate environment well into next year. Therefore, near-term relief may be limited to 'ccc+' CEs already on the cusp of a 'b-' score. Notwithstanding those select credits, it will take longer for credit estimates in the 'ccc' category to realize meaningful improvements to their cash flows, liquidity, and overall capital structure sustainability.

Table 1

Although middle-market revenue and earnings across both industries have increased at a median midteens percent clip over the last 12 months, this may become increasingly acquisition-driven rather than organic based on our forecasts for lower-rated syndicated credits and ratings' net negative outlook bias on both the broader technology and health care spheres. However, even though M&A opportunities have started to pick up on sustained economic strength and the prospect of lower rates, it's unclear when activity will return to more normalized levels.

Recent software earnings strength will be difficult to replicate as enterprise users tighten spending and consolidate platforms.  Credit-estimated borrowers in the software space have generally performed well, with median revenues and EBITDA increasing 12.9% and 13.4%, respectively, for credits reviewed over the last 12 months. We've observed that top-line growth has come from a combination of tuck-in acquisitions along with partial organic effects from increased product upselling and cross-selling, new customer bookings, and in some cases, a shift to higher-margin segments. The median change in adjusted EBITDA margin was an increase of approximately 110 basis points (bps) due to ongoing cost-reduction efforts including workforce optimization and lower marketing spend. However, profitability has been stagnant for some of the weaker credits against the backdrop of residual wage inflation, high customer acquisition expense, and anticipated deal synergies that have yet to materialize.

Furthermore, there are headwinds from enterprise software users who, since late 2022, have also reduced their workforces, narrowed budgets to focus on high-priority projects, and are looking to raise productivity by consolidating the number of applications they use. Some of the traditional IT spend is also being reallocated to artificial intelligence (AI) functions. Accordingly, companies with seat-based contracts could face pressure, along with makers of limited-use software that may be rendered obsolete or eventually get acquired and integrated into larger platforms. Moreover, weaker software companies with wide cash flow deficits will likely need to trim development expenditures to preserve liquidity. Even for borrowers who generate positive cash flow, the magnitude is usually quite modest and not enough to substantively reduce debt.

On the acquisition front, established software platforms are scaling up to provide more streamlined and comprehensive offerings. Software makers in the middle market are widening their offering within industry verticals, incorporating cybersecurity and data recovery products to mitigate risk of breaches, and building up cloud capabilities. We've also seen integration of AI in applications such as underwriting, editing, and general process automation.

Based on our projections for lower-rated software credits, organic top-line growth for CE borrowers could also slow next year due to enterprise customers' continued cost-consciousness and ongoing operational restructurings. For these rated issuers, we are forecasting median year-over-year revenue growth of around 5.2% for fiscal 2024, along with a 170 bps increase in adjusted EBITDA margin. In 2025, we expect revenue to continue growing at a mid-single-digit percent pace with a 90 bps uptick in margin.

Health care providers and services in the middle-market remain challenged by residual cost pressures and reimbursement issues as a negatively skewed outlook on low-rated credits lingers into the new year.  These companies also exhibited feverish growth, with both median revenue and EBITDA increasing by more than 16% for CEs reviewed over the last 12 months. Most of these companies are benefiting from organic growth along with a much smaller portion fueled by bolt-on acquisitions. Clinics are generally experiencing higher patient and case volumes, expanding virtual operations, and some have noted a better payor mix (likely due to Medicaid eligibility redeterminations). However, median adjusted EBITDA margin contraction was roughly 50 bps despite improved labor conditions and easing inflation.

Across specific subsectors, specialty clinics are benefiting from increased visitation, likely a result of patients catching up on care deferred in prior years along with subsequent follow-ups. Many clinics have also become more efficient by outsourcing non-core services. Providers continue to optimize staffing of doctors and nurses, though some clinics still struggle with voluntary turnover, and a shortage of physicians is not likely to abate anytime soon. Veterinarians are also benefiting from an increase in post-pandemic pet adoption and clinical trial firms have been scoring new business. Yet, margin compression has been attributed to a combination of residual wage inflation, still-costly food and beverage provision as well as contracted services and maintenance, and declining billing rates for nurse staffing firms. Certain health care facilities also remain underutilized.

More broadly, the industry faces headwinds from reduced government reimbursement rates, meager increases on rates negotiated with commercial insurers, and tighter regulation. Many borrowers have pointed to payor rates that have not kept up with rising costs. Physician reimbursement rates under Medicare have decreased by roughly 1.7% in 2024, with another 2.8% cut proposed for 2025; compared to a 4.6% increase expected this year in the Medicare Economic Index (MEI), which measures inflation in medical practice costs. Additionally, a long-term care pharmacy operator noted a significant reduction in pharmacy benefit manager (PBM) reimbursement for generic drugs early this year, resulting in a loss of several hundred basis points on gross margin. The introduction of the No Surprises Act in 2022 (which aims to limit patient payments for out-of-network services) has hurt a few providers dependent on the higher-margin business, though the impact on private debt-funded borrowers is likely minor since we believe most have little-to-no exposure to out-of-network billing.

More emphasis on value-based care, while it may ultimately improve patient outcomes, appears to expand near-term risks to providers as insurers look to predictive analytics to rein in costs; thereby raising the administrative burden for providers and delaying payments. Administrative hurdles are also being compounded by the ongoing implementation of CMS' Hierarchical Condition Category (HCC) risk adjustment model V28--which adjusts Medicare Advantage plan payments based on patient health status and is progressively phasing in through 2026. This will test providers' adaptability to new coding/documentation requirements and could negatively impact revenue cycles in the short term.

Notwithstanding the momentum in visitation so far this year, there have been signs that patient demand started to normalize in the back half, and we believe a lot of the low-hanging fruit has been picked in terms of operational efficiencies. Our projections for lower-spec grade rated health care services issuers call for median year-over-year revenue growth of 6.9% in 2024, along with a 90 bps increase in S&P Global Ratings-adjusted EBITDA margin. In 2025, we expect median revenue growth in the mid-single-digit percent range with margin expansion of around 50 bps.

Refinancing, Repricing, and Dividend Recaps Are Trends To Watch

New borrowings by software companies fuel a refinancing push as health care seeks liquidity support.  Based on year-to-date debt issuance by credit-estimated entities, we've seen noticeable differences in how companies across these sectors are utilizing new funding. Borrowers in both industries are primarily using proceeds to fund acquisition-related activity, along with several dividend recapitalizations. Software companies appear better positioned to opportunistically refinance, whereas more of the health care services transactions have bolstered liquidity by infusing cash or clearing up revolver availability.

Mirroring BSL trends, more middle-market companies have been refinancing existing debt and executing dividend recapitalizations. Borrowers are taking advantage of accommodative financing conditions to extend loan maturities and seeking to lower their cost of debt. Dividend recaps by credit-estimated borrowers have become more frequent as valuation disparities continue to hinder sponsor exit opportunities.

We've also seen an increasing number of stronger middle-market credits reprice their private debt with spreads of less than 5% over SOFR and in a few cases, negotiating a removal of maintenance covenants to become covenant-lite deals. With sponsors demanding lower spreads on portfolio company loans, direct lenders have sweetened terms on larger deals to keep capital deployed and remain competitive with the banks.

Chart 1

Chart 2

As the liquidity runway narrows, health care and software lead year-to-date CE defaults.  So far in 2024, the health care industry has experienced the highest count of defaults among credit estimates, followed by software, leading to respective total default rates of 3.8% and 2.8%. Between both industries, we've assigned selective defaults to 12 companies--split between 8 in health care and 4 in software. Additionally, we've been notified of five payment defaults (two in health care, three in software). Four of the businesses were unable to make timely interest payments, and one failed to negotiate an extension as its loans matured. The borrowers who defaulted on payments included an ophthalmology practice, a health care management services firm, and several software companies engaging in email marketing, media publishing, and online learning courses. We've also found that health care has accounted for the highest number of payment defaults since 2020, per our report, Private Credit Payment Defaults Rose In 2023 As Weaker Borrowers Struggled To Service Debt, published June 26, 2024.

Meanwhile, in the U.S. rated universe, corporate defaults have subsided year-over-year through October. Yet similar to what we've seen in private credit, health care has had one of the highest default counts with 14 so far in 2024, mostly because of distressed debt exchanges along with a few bankruptcies and missed payments. There have also been five defaults by rated entities in the software sector, all of which were selective defaults tied to distressed exchanges.

As we previously noted, a substantial portion of 'ccc' category credit estimates across software (approximately 30%) and health care providers and services (21%) suggests higher default risk for this patch of private debt borrowers with over-levered and unsustainable capital structures. These credits will be most dependent on anticipated interest rate cuts to materialize and alleviate pressure on cash flows and liquidity (we note S&P Global's baseline assumption for SOFR in 2025 is 3.6%). Liquidity is already tight for the 'ccc' category CEs in both industries based on median 12-month sources to uses ratios of around 1.5x in software and just below 1x for the health care sector--implying a year to a year and a half of runway in the riskier score category. When including the 'b-' and higher CEs, the median liquidity ratios are much better at around 3x for software and around 2.3x for health care--though the latter has fallen by roughly 0.4x on an last-12-months (LTM) basis.

Table 2

Looking Ahead, Lower Rates And Operating Efficiency Will be Key

Credit-estimated software and health care services companies are dependent on lower benchmark rates and operational transformation to improve credit quality in 2025.  Middle-market companies in both industries are growing their top-line and earnings at a rapid pace, granted there are challenges to maintaining that momentum. They are also currently the most highly leveraged borrowers and the majority are struggling to generate free cash flow in a high-interest rate environment.

For more context on our outlooks for lower-rated spec-grade companies in the technology and health care services areas, readers can reference our articles: More Cautious Than Optimistic: Lower-Rated U.S. Tech Issuers Continue To Face Ratings Pressure, Aug. 15, 2024, and Despite Some Improvement, Weaker Health Care Services Companies Continue To Struggle, May 2, 2024.

Related Research

• Private Credit And Middle-Market CLO Quarterly: The Times They Are A-Changin' (Q4 2024), Oct. 18, 2024
• More Cautious Than Optimistic: Lower-Rated U.S. Tech Issuers Continue To Face Ratings Pressure, Aug. 15, 2024
• Private Credit Payment Defaults Rose In 2023 As Weaker Borrowers Struggled To Service Debt, June 26, 2024
• Despite Some Improvement, Weaker Health Care Services Companies Continue To Struggle, May 2, 2024