PennantPark’s pick and mix investment model

Arthur Penn is the founder and managing partner of PennantPark, a New York-based investment firm focused on providing debt capital to middle-market companies. PennantPark has AUM of approximately $2.1 billion, and lends across the capital structure via two publicly-listed Business Development Companies (BDCs), an institutional LP/GP fund, a joint venture with an insurance company, and various co-investments. Penn sat down with PDI to discuss trends and issues in private debt, BDCs, and middle-market lending.

What do you see as some of the key trends today in BDCs and private debt funds?

Arthur Penn

AP: Historically in private credit we saw different vehicle structures by audience. Retail and wealth managers were the main investors in classic BDCs. By contrast, pension funds, insurers and other non-taxable institutions typically invested via PE-style LP/GP funds or SMAs. Two notable trends have emerged recently: first, we’ve seen institutional investors begin to embrace the BDC structure and second, there has been a notable uptick in interest in US private debt funds by investors domiciled elsewhere.

These trends have led to the emergence of “hybrid” structures such as the private BDC which starts with the classic BDC structure and mixes in components of private vehicles.

Why are non-US investors interested in private BDCs today?

AP: The first reason is of course yield and current income. As compared to their home markets, the yield investors can earn in US direct lending is very attractive. And investors know they’ll get current income because BDCs are required by the 1940 Act to distribute a minimum of 90 percent of taxable earnings quarterly.

The second reason is the BDC structure itself. Foreign investors coming into US private debt for the first time take comfort in the superior transparency, governance and reporting of Registered Investment Companies (RICs). It’s a natural fit for European investors accustomed to UCITS funds which – like the BDC construct – set parameters on asset eligibility and feature strong compliance and regulatory oversight.

Lastly, a lot of the momentum we’ve seen in the past two years is due to passage of the PATH Act (Protecting Americans from Tax Hikes Act of 2015). PATH ended the uncertainty regarding withholding tax exemption on distributions from BDCs/RICs to non-US shareholders.

What features of traditional LP/GP funds are you seeing being adopted by private BDCs?

AP: Private BDCs are comparable to LP/GP funds in that assets are marked-to-market quarterly and do not trade in the secondary market. Also, the way they raise and deploy capital is similar to PE-style private funds; shares are offered via a private placement and committed capital is drawn over time as investment opportunities become actionable. Lastly, although the BDC structure itself is perpetual, today’s private BDCs include provisions to seek a liquidity event within a fixed time, resulting in an effective duration similar to private funds.

Can you expand on how life-cycles/exits compare between the two structures?

AP: Sure. A typical LP/GP private debt fund has a three-year investment period followed by a two-year harvest, so many LPs assume this results in five years total duration. In practice, the three-year investment clock doesn’t start until after the marketing period ends, which is 18-24 months these days. On the other end, harvest periods of private funds are often extended due to transactions not being fully exited. When you add it all up, that “five-year” fund starts to be closer to 7 to 7.5 years.

By contrast, a private BDC has both a tighter timeline and more exit options. The clock starts on the initial close. Following the private period (similar to the investment period in an LP/GP fund), the vehicle can be liquidated/harvested. Alternatively, it could pursue a (potentially shorter and more certain) capital markets exit: conduct an IPO, list on an exchange, or merge with an existing public BDC such as one of the two PennantPark already runs.

What are investors interested in when it comes to private debt?

AP: Most of the investors in private credit have long-term obligations as part of their core business model. Think of insurers which have future claims or pension funds which have long-term benefits to pay their retirees. Private debt managers with strong origination and a stable senior team which has underwritten and preserved capital through various cycles can provide those investors with safe current income that is hard to replicate elsewhere. We believe this is a long-term trend and has driven the secular shift toward private debt as an asset class.

Where in the capital structure are you focusing?

AP: We feel that now is a time to be careful, cautious and conservative, and to put primary focus on preserving capital, even if that means accepting a lower yield. We’re most active today in the top of the capital structure – senior secured first lien, stretch senior/unitranche, and second lien.

What are some of the competitive issues in middle-market lending?

AP: There is no doubt that the market has become more competitive as capital has flowed into the space. The key is to continue to invest and improve the platform, especially origination. Over the last three years, we have opened offices in Los Angeles, Chicago, Houston, and London, and beefed up our New York headquarters. That investment in the team has paid off in terms of seeing increased and interesting deal flow from both new and existing relationships. As our funnel widens, we can be even more selective about which transactions make the cut.

What are your views on middle-market sponsors and the opportunity set today?

AP: My sense is there is still tremendous opportunity. We have closed transactions with about 170 US middle-market sponsors in the past 10 years, but there are hundreds more out there and more emerging every day as teams spin out from established platforms. They all have one thing in common, which is a need for debt capital from reliable long-term partners.

What are some of the keys to executing and managing deals in this market?

AP: Many of our deals involve sponsors which have identified a fragmented industry and an opportunity for consolidation. In those transactions, we are observing a much higher level of execution intensity. Financial sponsors today bring deep industry knowledge, operational expertise, and strategic management focus to institutionalise the companies, manage them professionally, execute the roll-up strategy, and ultimately exit.

What are some of the strategic ideas at PennantPark for navigating the middle market?

AP: We started PennantPark more than 10 years ago and ramped our first vehicle right into the global financial crisis and economic downturn. Even though it owned mostly second lien and mezzanine securities at the time, the portfolio average EBITDA through the trough of the recession was down about 7 percent, at a time when EBITDA for high-yield companies more broadly was down over 40 percent.

In 2011, we launched PennantPark Floating Rate Capital because many of our private equity sponsor clients wanted us to be a bigger part of their first-lien capital structures. More recently we conducted the final close of our first institutional LP/GP fund and launched a joint venture with Kemper Insurance. Along the way, we have closed several co-investments with investor partners.

Moving forward, we intend to expand both our private offerings and the public BDCs. That said, the guiding principle has always been “measured growth” to ensure we never waver from our credit-intensive, highly selective underwriting process. Our core mission is not always easy to execute, but simple in its expression: partner with our middle-market sponsors to support transactions with attractive and appropriate risk/reward while relentlessly working to create long-term value for our investors.

This article is sponsored by PennantPark