Yield-starved investors have fuelled the private debt market to a market cap of more than $1tn in recent years according to data from EY, amid traditional banks stepping away from the sector in the wake of the global financial crash. The junior debt subsegment remains a highly risky proposition, however, despite wider acceptance among investors. Penfund senior partner Richard Bradlow explained to AltAssets reporter Emily Lai how the firm is succeeding in the sector while avoiding its many pitfalls.
“In the lending business one has limited upside. If everything goes to plan you earn your interest rate. But you have unlimited downside, you could lose all your money. It is a fundamentally asymmetric return profile.”
Richard Bradlow’s stark warning about the dangers of junior debt investing highlight just how focused a firm needs to be to profit from the asset class. But profit Penfund has – the firm, which was founded in 1979, has grown to C$1.5bn of capital under management targeted at financing upper-mid market companies throughout North America.
“What’s very important is that you know what you are looking for before deals come in the door,” he says. “And we have a very sharply defined sense of the types of borrowers we seek.”
The firm focuses on companies selling inexpensive consumables goods which are non-deferrable and non-discretionary. A can of vegetables or a litre of motor oil are good examples. Service business tend to provide essential or contracted services.
“We look for stable primary demand drivers. Our borrowers provide products or services that people buy in boom times and in recessions,” Bradlow said.
Business model, too, is key when choosing which companies can prudently sustain high levels of financial leverge. The firm specifically focuses on asset-light businesses which can convert 80% to 90% of EBIDA to free cashflow. This minimizes risks and provides a higher level of flexibility for the businesses, Bradlow said.
Penfund’s final criterion is the business structure of the companies – and like the firm itself, focus is key. According to Bradlow, the simpler the better.
“We target businesses that are very simple. They tend to do one thing, but they have done it very well for many years. We are betting that an in-place management team will continue to execute repeatable tasks well, no more no less,” Bradlow told me.
Avoidance of risks over maximizing returns
Junior debt’s asymmetric risk profile means dangers are ever present for the incautious investor. But despite the ever-present possibility of failure, Penfund has only encountered one realized credit loss in 21 years of investing. Bradlow attributed that record to its conservatism – namely its focused, narrow and disciplined investment strategies.
One common mistake Bradlow identified is the temptation to take on equity risk in the hope of boosting investment gains.
“Most firms are looking to maximize the returns,” he said. “Many try to edge their return into the equity realm by assuming some substantive equity risk within an investment structured as credit. They underwrite and lend against operational uncertainty including M&A integration, aggressive growth or new product introductions, which belong to equity holders.”
Funding equity risks with debt might provide a higher return more akin to equity investments, but it also incurs substantial risks which Bradlow says makes it unsustainable in the long term.
“We always trade away upside for downside protection,” he added. “Our primary job is the avoidance of risks, not maximizing returns.”
It follows that Penfund views itself as a price taker with returns set by the market. Bradlow said the firm’s value is to analyse and minimise risks, taking the market return and identifying credit opportunities where risks are lowest in the market.
“Can we not factor in the risks in the pricing structure?” I asked.
“We don’t believe that modest adjustments to interest rates and leverage ratios can adequately compensate for elevated inherent business risk. We identify businesses that have inherently low business risk, otherwise we walk away,” he explained.
For Bradlow, covenants are not a protective measure against business risks either. Most covenants nowadays are “loose and meaningless”, he said, and are not generally included in larger junior debt deals.
Covid as a stress test
Thorough due diligence and deep industry knowledge are not only good business practice, but act as the anchors amid unexpected storms. And in as big a crisis as the global pandemic, Penfund’s anchors have not only held fast, but allowed the firm’s portfolio businesses to emerge from the disaster at an advantage.
Bradlow said many businesses raised additional liquidity during the initial period of the pandemic, given rampant uncertainty across the world’s markets. And if it turned out not to be needed for protection, companies were able to put the new capital to use for expansion.
“Many of our portfolio companies have come out stronger. They might be slightly more highly leveraged, but their competitors have been weakened. Market leaders that were strong before Covid probably hold stronger competitive positions in the market today,” he explained.
The same applies to the fund management industry itself, Bradlow said, adding that Covid was the first macro stress test for an industry in which half of the capital and managers in private debt only came into play in the last decade.
“Everyone looked smart pre-Covid when the economy was humming and there was no stress in the market,” he said. But LPs will now be able to better differentiate amongst managers when returns are revealed post-Covid, to see who most competently managed risk.
LP appetite for junior debt remained constant through the pandemic according to Bradlow because most LPs recognise that it is not a market easily timed. They did demand more frequent reporting, however, and more information on portfolio company performance.
Market returns for junior debt remained relatively stable compared to the equity market through the pandemic. Changes in public policy drove LIBOR to historical low levels which affects floating rate loans, but spreads have remained fairly stable over the long run.
Bradlow said that over the past 10-15 years, junior debt typically enjoyed a 325bps to 425bps spread over first lien loans. As an upper mid-market player the first lien loans in Penfund deals are a combination of true private debt and broadly syndicated loans.
Having successfully navigated the Covid crisis, Penfund is now looking to the future. Just two years after closing its sixth flagship fund on C$1.15bn, the firm is planning a summer launch for Fund VII, this time eyeing C$1.5bn. The asymmetric risks remain, but the smart money seems to be on Penfund continuing to succeed.
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