Rising inflation may spare smaller middle-market lenders

PennantPark bets that picking the right entrepreneur can protect private credit from rising prices

Art Penn

Marlow Hernandez keeps a picture of the day he stood in the beige conference room of InTandem’s Manhattan office to pitch his business to a group of mid-market lenders. The private equity firm that had taken a controlling share in his Miami-based medical centres needed money to help him expand. So it had invited some private credit firms to hear Hernandez plead his case. Their questions lacked imagination, recalls the doctor.

“We felt we were making history,” says Hernandez, the boss of Cano Health, now a listed company valued at more than $4 billion. Back in the 2016 meeting, the lenders were sceptical that a preventative-care business serving the elderly and the poor, founded by a former Cuban immigrant, would make money. Except for one. José Briones, a partner at PennantPark, asked how Cano’s healthcare strategies aligned with patient outcomes.

“He just got it. Plus, we were both from el barrio,” says Hernandez, using the Spanish word for neighbourhood. PennantPark lent the money. Cano Health has since paid off its initial financing, gone public and expanded across Florida and into Nevada, Texas and Puerto Rico. The lender kept an $8 million equity stake, which has increased in value to $107 million as of the end of September.

Cano Health
Cano Health
Marlow Hernandez (second from left) on the day Cano Health received its financing

Total lending by private credit firms, such as PennantPark and its larger rivals, reached its highest level in 20 years this week, according to data provider Preqin. More than 190 funds lent $189.9 billion to US companies. Loans to fast-growing businesses used to fall within the purview of the banks, but post-crisis regulations have squeezed balance sheets, enabling debt specialists such as PennantPark to take their place.

Although the stock market continues its upward tear, regulators have begun to warn that the economic conditions that underpinned the explosive growth of private credit will soon change. The Federal Reserve said in a recent meeting that inflation was here to stay. The largest European asset manager, Amundi, said in its 2022 outlook that inflation would bring tighter liquidity conditions and might trigger defaults – particularly in private credit.

Art Penn, the founder and chief of PennantPark, argues that smaller, more personal lenders, including his business, will prevail in a weakening market. “The game plan is to take an entrepreneur who might have 10 million or 15 million of Ebita today and institutionalise the company – bring in the audited financial statements, processes and procedures, controls and take their talent and grow that business,” he says.

The threat of stagflation – the risk of simultaneous inflation and recession, not seen for the last 40 years – however, “would be bad,” he admits.

Penn, the former co-head of Apollo’s credit business, founded his business in 2007. Today it oversees $5.2 billion of assets mostly in the business services, consumer goods, government services, healthcare and technology sectors. Almost 60% of that money is first lien loans held by joint ventures between PennantPark and private equity firms. Penn’s company works with 195 different partners who invest junior loans that take the first losses if the company goes bust. In the last 10 years, 14 out of 492 of these transactions defaulted. The loans yield between 6% and 8%.

PennantPark’s terms and conditions may help shield it during a recession, Penn says. A firm needs to hold cash of at least three times the interest payments, while net debt to Ebitda ratios must be met – measuring the debt owed against earnings before interest, taxes, depreciation and amortisation. All firms are tested each quarter. And sometimes PennantPark limits a firm’s capital expenditure.

Our key question is ‘Does anyone care if this company goes away?’
Art Penn, PennantPark

Inflation disadvantages borrowers before lenders, says Penn. His loans are floating rate. If prices increase, so will yields. He looks for inflation-proof firms. If the company can hike prices without losing customers, Penn knows he has a good bet. “Our key question is ‘Does anyone care if this company goes away?’,” he says.

PennantPark also creates bespoke packages of loans, depending on the risk appetite of the end investor. These can include senior loans with higher yields, mezzanine debt, distressed debt and collateralised loan obligations. PennantPark will provide any combination of these securities together in managed accounts for pension funds, insurance companies and ultra-high-net-worth customers.

Retail investors can invest in PennantPark’s loans through two business development companies listed on the Nasdaq. PennantPark Investment Corporation (PNNT) and PennantPark Floating Rate Capital (PFLT) work like closed-end funds and are regulated by the US Securities and Exchange Commission.

Regulators mount up

Penn baulks at the suggestion that he is not as closely regulated as a bank. The business development companies trade as public stocks. They file quarterly financial reports and proxy statements and must comply with a host of rules, according to the law firm Morrison & Foerster.

The SEC has warned retail investors to be wary of the kind of products Penn offers. “There are risks in owning shares or loaning money to the small- and medium-sized companies that are different from, and in some ways more significant than, investments in larger public companies,” the markets regulator said in a recent investor bulletin. “These smaller companies may be more likely to go out of business or default on their debts. Also, it can be difficult to find information about the companies BDCs invest in and to know for sure what they are worth.”

Most of PennantPark’s business, however, comes from institutional investors. “Our business is mostly for larger institutions and most regulators’ stance is that these larger institutions may not need as tight a regulatory overlay, because they’re sophisticated investors,” says Penn.

Other international regulators remain cautious on private credit at this point. The Financial Stability Board suggested in a November report that the growth of shadow banking “implies that risks are increasingly being intermediated and held outside the banking sector with implications for global financial system resilience”.

The public portion of PennantPark has enjoyed success so far. PNNT has no loans with overdue payments of more than 90 days, while PFLT has seen only a few defaults. The business development companies together lend to 97 companies in 29 different industries. Penn believes his business model should be compared with the broader syndicated loan market. “The leverage there is high, the yields are low, equity cushion is low, your opportunity to do real due diligence is short, you have to make quick decisions and it’s covenant-lite,” he says.

Penn prefers middle-market lending because he can keep in touch with the entrepreneurs of the firms that borrow his money, saying middle-market lending is like his hometown of Baltimore. “Everyone knew you,” he says. “You had these long, embedded relationships and had to act right. Like, you better be telling the truth, because if you’re not, you’re gonna be found out. You better be kind because if you’re not, it gets around quickly.”

Editing by Will Hadfield

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