‘SaaSpocalypse’ Risk From AI Reaches Beyond Private Equity

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2:09Well, it is the money issue from the Bloomberg Markets Magazine team. And one story we wanted to bring to all of you, it really kind of seems fitting with some of the bigger narratives that are going on. It's about how artificial intelligence looms over software companies and the investors, Tim, who piled into them. More specifically, the buyout funds and the lenders who were drawn to reliable revenue and low costs are now facing an entire business model that is at risk. Here to explain is Paula Seligson, Bloomberg News senior reporter. She covers private credit and leveraged finance. She joins us here in the Bloomberg Businessweek studio.

2:39Congratulations on this story. We talk a lot about the SaaSpocalypse, but this is really a deep dive into leveraged buyouts and what initially was so attractive to some of these private equity firms about software. That's where I want to start because there was this joke like, oh, that's software margins. The margins on these companies for so long was so high. And that was part of the attraction. Absolutely. Because the better the margins, the more debt you can load it up with, right? The whole basically private equity business model is to use debt to lever up a company when they buy it. The debt is not borrowed by the private equity firm.

3:14The debt is borrowed by the target company being acquired. Please repeat that last part, because that is a really crucial point when it comes to a leverage buyout. Wait, isn't that a classic private equity also move? Yeah, exactly. This is how private equity makes so much money. It's through leverage, but the key thing is that the private equity firm is not on the hook for that leverage. The target company is, and that's kind of what's at stake right now. Well, so let's talk about this because I think one of the things that we keep thinking, is it one shoe to drop? Is it two shoes to drop? Is it a lot of shoes to drop?

3:43Because so far it seems to be manageable. So tell us about kind of what we are, what we've seen, but why maybe the situation or environment is changing for some of these names. Yeah. And so that's an important distinction to make. The SaaS apocalypse has not happened yet, right? This is all about the fears that it could be coming. So at the heart of it, AI technology has a potential to disrupt existing software businesses that were considered pretty much fine. And the fear is that, you know, you'll have certain types of software companies, especially affected. You know, if you are providing software, that's like the infrastructure layer of a company, probably okay.

4:20If you're doing data visualization and that's your main product, you can just plug that into Gemini or chat GPT. And those business models could be especially at risk. Can you do that that easily? That's a fair point. And that's one of the defenses people have, which is that, you know, if you're a big corporation, you have all your, you know, employees using certain products you're not going to have them just go off on their own and use ai but you know cloud code has developed very rapidly and that's maybe taking the place of some products that would help softer developers is the concern specifically that with some of these site types of services you describe and you write about you would have internally uh people create some sort of program maybe vibe coding or use cloud code to do this that would replace paying for seats of certain paying, like on a per seat basis for certain companies.

5:07Exactly. And the fear is that even if this doesn't fully disrupt revenue, it could chip away at it. It can maybe even just chip away at revenue growth. And that's where the debt comes in. I don't know. I'm still, okay, we'll get, I'm just still, I'm still skeptical of the whole, the whole thing. That you believe that it's going to actually work and that companies are going to entrust doing data analysis. Part of it has to do with, part of it has to do with like the pipeline of innovation at some of these companies. Like they're constantly iterating on their products and making their products better and better for their customers.

5:35I mean, that's the way that it's worked. You can't just get, you know, one person within a company to create a, you know, to replicate something that they've been paying for for years. But then have the updates and make it better and better. I don't know. I'm not trying to be a defender of all these SaaS companies. No, I think this is the big question. And this exact discussion we're having right now is what investors are trying to figure out. Is this a real risk? Is this not a real risk? And then you get to this point where, okay, I'm an investor. How do I pick winners and losers? How do I anticipate winners and losers?

6:07And that's where a lot of the questions are right now. Yeah, but the thing is, the bets have been made. The deals have been made. The debt's been issued, right? So then who's at risk? Like, let's, Paul, carry it out. Let's say there is a SaaS-pocalypse. It's so hard to say. But let's say this does happen. What does that look like? Who gets hurt? What investors get hurt? What companies get hurt? Who's on the line for the debt that ultimately doesn't get paid back or pennies on the dollar? So there are a lot of people who could be affected by this in the investment community. So first, let's talk about how a leveraged buyout works.

6:45So when a private equity firm decides to do this kind of transaction, they typically have two types of debt markets. And I think we have a chart on this. I'm not sure. So, and we'll bring it up and forgive for everybody on radio, but Paul is going to walk you through it. Yeah. So basically, you You know, the way this works is that the private equity firm is buying a company and it can essentially finance some of that with its own equity commitment, which is just cash. And then it can finance part of that with debt. And when it decides to finance part of that with debt, it can tap one of two markets, the public syndicated debt markets that consist of high-eld bonds and leveraged loans, or the private credit market, which grew very rapidly starting in roughly 2020 to compete with the high-eld bond and leveraged loan markets.

7:24That private credit component is very interesting. We should never discount the leverage on high-hold bond markets. Those are still very big parts of this financing process. But private credit grew a lot, and they were also willing to do more aggressive deals than the syndicated counterparts. And so, you know, having debt on your balance sheet really creates two problems for a company. The first is you have to pay the interest expense. And the second is you have to refinance it. And both of those will have issues if revenue starts to come down at some of these companies. Right. And we just had a chart up, but it really shows what the buyer, the title on that graphic was, how a PE fund can buy a$6 billion software company for$3 billion because they just put up$3 billion and then they've got the lenders on the debt side putting up the rest.

8:07Exactly. And so what we're seeing now is basically questions over how this will unfold. Because when a private equity firm levers up a company in this way, they're doing it because they believe that they can rapidly increase revenue and rapidly slash costs so that the company can basically grow over time to adapt to its large debt load. That means revenue has to grow, right? So if revenue growth slows or even worse, reverses it all, that makes the debt potentially untenable. Who's at the top of the debt stack here? So that would be the senior secured lenders. It varies depending on the exact structure.

8:39But notably, the private equity firm is at the bottom of repayment, right? Because the way debt works is basically the debt investors get paid back first. And if there is restructuring or bankruptcy, typically the equity is wiped out. Medallia is a very interesting example of this. It's important to note Medallia is a software company. Its problems predate the current AI concerns. It had its own set of issues. But in that situation, Toma Bravo and his co-investors lost$5 billion, one of the largest wipeouts in private equity in years. Well, let's talk about Toma Bravo. I mean, people who listen to our program, we've spoken to Orlando Bravo in the past.

9:12We spoke to him at Milken years ago in a completely different environment than it is today. We weren't talking about a SaaSpocalypse. No, everybody was just chasing private credit and wanted exposure and put it anywhere. And this is a firm that for years has been all about software. So talk a little bit about the Medallia example, but also Toma Bravo's role in this. Yeah, so Toma Bravo took Medallia private. It seemed like a very smart investment at the time. they used a 1.8 billion private credit loan to finance it, and specifically a recurring revenue loan. So what is common in earlier stage companies is they're not generating a lot of like earnings or what's called EBITDA yet.

9:48And so an alternative is to base the loan off of recurring revenue. In old debt times, that would have been considered pretty extreme and lenders want to see a history of earnings. But for the newer software companies, that was considered more common. And so it also had a special feature, this is getting technical, called pick or payment in kind, where you could basically defer some of the interest by adding it to the principal payment of the debt later. And so basically this company tried to increase earnings. It couldn't, but because it was picking the debt, the actual total debt size kept increasing and it ended in a very unfortunate restructuring earlier this year.

10:24Right. So the target for success had to be even higher because the debt load kept hiring because they kept adding on the interest. Exactly. And again, And that's what is hard about debt is it amplifies risk. You know, it's so funny. It's not funny. We talk a lot about the software space. I mean, what do investors look for? Is it a case of a bunch of deals starting to have problems? Is it a case of a big deal? Or we just don't know. How do we know if this is going to become a bigger problem? Is it a higher rate environment that all of a sudden makes it trickier? What's the thing that maybe tips everything over?

11:00or all of a sudden AI is just doing everything that these companies do? Yeah, so it's kind of twofold. So first, can a company pay its interest expense? And that's where the rates question comes in, right? A lot of these leveraged buyouts were done in the 2020 to 2022 era, and they all use floating rate debt for the most part. So as the Fed increased interest rates, their borrowing costs also increased, which caused problems and squeezed their liquidity a bit. And to be fair, I think they thought, right, three to five years, they would be exiting. Exactly. And then that became problematic. And that's the other component.

11:29As interest rates increased, valuations fell, making it much harder to sell a company. Private equity firm doesn't want to sell it for less than it bought it for. That's a nightmare, right? And so a lot of companies are basically just stuck and they can't be sold or IPO'd right now. Then the other part of this and the real test is the refinancing, because a lot of the debt is roughly seven years of maturity. And so a lot of that debt's actually coming due. Between now and 2029, there's about$150 billion of it across syndicated public and also private markets. And so each of those is going to be a test case, basically.

12:01You said earlier in our conversation that it's unclear at this point if the SaaS apocalypse has actually happened. I think some public market investors would look at some shares of SaaS companies and the way they performed over the last 12 to 18 months and said, wait a second. It looks like public market investors have made a decision, at least as of now. When do you think we'll be able to definitively say whether or not there is or is not a SaaS apocalypse? I think it's just going to be something that unfolds slowly in the coming years. At least in the debt markets, it's going to be kind of on a case-by-case basis.

12:31Okay. Well, and the other thing, if we can bring up our last chart, we just have about 30 seconds here. You have seen basically investors or lenders growing wary, right? So we do have a chart that shows buyout funds binged on software deals. But if you look at 2026, you can see that has come down dramatically. Exactly. And lender confidence is key because if you lose access to debt capital markets, at the very least, your borrowing costs will go up even more. And in a worst case scenario, you might not be able to refinance at all. And either of those can cause a restructuring. Right. Can create the problems.

13:03So, all right. TBD, we're watching. This is a great explainer of why we're watching and kind of some of the maybe metrics to keep an eye on. A masterclass, too, in understanding the structure of these things. Thank you. Thank you. So appreciate it. Paula Seligson, she's Bloomberg News senior reporter. She covers private credit, also leveraged finance. This is in Bloomberg Markets Magazine. It is the money issue. There's a bunch of stories in there. They're just so smart. They're very deep dives. It's good stuff. Stay with us. More from Bloomberg Businessweek Daily coming up after this.

13:39What if data didn't sit still? What if intelligence moved with us? not buried in reports, but activated in real time, where lives are being shaped, where decisions are being made. It all starts with a question. Where is the potential? Cotality turns data into clarity, intelligence into insight, insight into action. Because when intelligence moves, we all move forward. Cotality, intelligence beyond bounds. Aging is real. And so are the benefits of adding Vital Proteins Collagen Peptides to your daily routine. Because around the age of 30, your body needs backup to keep your collagen up to help support healthy hair, skin, nails, bones, and joints.

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15:28Army struck deals with several companies to build critical minerals processing plants to do it on military bases around the country. It was a first-of-its-kind initiative by the Trump administration to boost domestic production of these key materials. Realloys, Titan Mining, Ioneer, Limited, Energy X, all had reached agreements with the Pentagon to build out some facilities to do just that. And just last week, President Trump, we talked about this all week. He touted that$3 billion in U.S. investments in critical minerals mining at a meeting with top industry executives. That was aimed and that is aimed at weaning the U.S.

16:02off supply chains that have been dominated by China. This week, Carol, we've been digging deep in critical and rare minerals. Those that are quite literally digging deep to get them. They are indeed. One such individual is Lippi Sternheim. He's president and CEO of Realloys. He joins us from Palm Beach, Florida. Lippi, it's great to have you here. Your stock's up almost 60 % year to date. I will point out 19 % of the float is short. It is way down from a high back in September of 2021. You do come out with earnings, so I know there's certain things that maybe you can't get into. Tomorrow earnings, right?

16:33Tomorrow, yes. tomorrow. Hey, you are always considerate to give us some time. Tell me a little bit about how things are going, because it feels like there's been time where the White House is spending a lot of time on this and it backs off. But give us an update. Thank you for having me. Nice to be back. I'll give you just on the Army side, which you just finished talking about. We're working very closely with them to get to the finish line. Obviously, there's a lot of things that go into it. Aside from just a lease and putting up a building. There's water needs, power needs, all the different things that go into a facility like this.

17:07There are significant demands, and we're making sure that all those are in place so that we can actually accelerate our process of being on the Army base with our process, whether it's separation, metallization, and things like that. So they're actively, very actively involved, and daily talks to get to the finish line on that. in general, you mentioned Trump's last week roundtable meeting or Washington meeting with the executives and the money that they're giving out. There seems to be no slowing down to the government's interest in making sure this happens. And since you mentioned you've been digging in, you probably know why.

17:46There's still a massive gap between us doing anything and China controlling the process. How big is that gap? Like when you say massive, how do you measure it? Has anything changed. It won't change overnight. I think I mentioned this to you last time, although everybody would want it to be. Yeah, we're impatient. That's the thing. We keep asking about this. Clearly, but it does take time. The reality of it is it goes back to that waiver to that no waivers executive order that Trump put out the other day. If you read it closely, there obviously always has to be an exception to the rule and things like that.

18:21But what it tells you is that there's a there's a very very significant need to get and wean yourselves over china and we're not playing games and you really need to be on top of this but something that took four decades to build up in china is not going to take four weeks to build up in america so realistically speaking you know you have the process as i mentioned to you last time very slowly the other the separation which is the biggest and that's really what we're focused on the separation of rocks to rare earth and you have the metallization which is another significant component and then you have the magnets at the end so if you open the magnet factory tomorrow you still need to have what to make go through there to make and that boils down to separation which for heavies as i always say there's lights in the heavies and we're mostly focused on defense needs which are the heavies you know for the higher temperatures and things that you need heavy rare in the mixed floor.

19:12So in a realistic world, I would say we're still a few years away. I mean, we're looking at that January 1st defarce cutoff and making sure that we're aligned next year to deliver, whether it's metals initially and then onwards later, obviously, we left the scale of magnets, but just metals and oxides that are North American made. And we're really trying hard to come to that deadline with actual material to the table. And I think we're there. But others, you know, in the space, myself included and all the other companies, we're all working really hard to get there, but it does take time to build up an entire industry.

19:46And these things are not simple, you know, turn on, turn off, you know, put up a switch. You keep saying it takes time. We know that, but it also takes resources. And that's where the U.S. government and that's where this administration has been. And that's something that we've talked a lot about, Lippy. And I'm just curious what else you need or what else you think the industry needs from the U.S. government? I think right now things are moving along. We, as a company ourselves, and we'll put that out, as you said, tomorrow. So we'll talk about that next time. But we're funded for our processing rollout and our metallization rollout.

20:18We haven't taken money from the government yet, and we're funded for phase one. We'll get to the finish line with making metals by 2027 and then scaling it up. For us, it's not a matter of actually making. It's about making more. Yeah, I'm getting to the finish. They're making more. But the other companies that are getting funded, they are working, you know, whether they're magnets or they're metals. We're the most focused on heavy rare earth. And we're on target for next year to start having production and obviously to keep scaling up year after year. But it still will take us to 28, 29 to get to a full, you know, where we can supply more than just, you know, little bits and pieces.

20:54You said you haven't taken. Yeah, I'm sorry. No, no, no. You finish, please. I was going to say, when I say it takes time, you know, you're looking at really magnets, you know, whether it's, I'm not going to, like I said, all the companies, look at the three, four companies that you're very familiar with that are in the news every day. They'll all tell you 28, 29, 30, 31. And it takes a few years. And that's if everything goes right. Our interest was to take what's existing now. So we had the SRC in Canada. They're nearing completion on their phase one plant. And our metallization plant is under construction.

21:23And again, our interests are to get to heavy rare earths to the metal form as soon as possible. And by next year, not promises about five years from now, but actually deliverables now with commitments to scale. Hey, just got a minute left here. You said you haven't taken government money yet. Is it because you don't need it? You don't want it? You're holding off? Like, what's the deal? At the moment, for what we've done, we don't need it. We're in talks, obviously, for further things. If the army expansion goes more than just a lease on their property, for example, or in other words, if we go bigger and faster on Scala.

21:54For the moment, privately, we raised $100 million from very significant institutions, which was publicly disclosed, and$50 million before that. We were leveraging off what the other companies that we bought out or partnered with had spent hundreds of millions of dollars doing. So we don't fall into the boat of give us a billion dollars and we'll go build everything for you in 10 years. We're building it as we put our money where our mouths. We're actually building it and showing results. And then we can go back with a stronger hand and say, you know, if we want to add this or add that. But so far, we've been doing fine with the industry funding.

22:24Obviously, we're in talks with many different various factions of the government. There's the administration. There's the army. We put out the EXIM loan and we want to get, obviously, something to do with that. But, you know, it takes time. These are commitments. You know, that takes time. And we'll get there as we scale up. We're not in a rush tomorrow to need money. All right. We'll really appreciate it. Like we said, we've been doing a deep dive this week. So, Lippy, thank you so much. Stay with us. More from Bloomberg Business Week Daily coming up after this.

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