Description

PennantPark is a recently formed business development company (BDC), founded by Arthur Pen, the former President and COO of Apollo Investment Corporation (AINV), arguably the most successful of the publicly traded BDC’s that IPO’d in the last several years.  PNNT’s book value per share is $13.97, versus its current price of $13.33.  It IPO’d on 4/19/07 at $15.00.

The bullish thesis is relatively straightforward.  Over the last several years, many BDC’s have IPO’d and fallen below NAV for a brief time before they began trading on dividend yield and a corresponding premium to book value.  Even for those BDC’s that didn’t break NAV, there have been relative trough periods early on in their trading from which they rallied impressively.  Many of these have been posted on VIC—ARCC, NGPC, PSEC, AINV, GAIN, and GNV, plus a few that haven’t, for example, KFN, although that BDC did merit a mention in the most recent Value Investors Insight.  The risk/reward and margin-of-safety becomes very compelling at or below NAV for these early stage BDC’s, especially the better run businesses that have significant potential for gains from savvy selection (via their warrant participations) and accretive secondary offerings (which seems to be dependent on a mix of both performance and reputational status).

The bearish thesis is also relatively straightforward—why purchase a BDC when one can buy a high yield bond fund that is purchasing similar instruments, or if not similar instruments, bonds whose yield is determined by an efficient market that incorporates the relative risk difference between the BDC’s portfolio and the selections of the bond fund?  Some of these bond funds have 30% leverage, but run at significantly lower fees than the 2 and 20 typical of externally managed BDC’s.  The bearish case is also augmented by the fact that these BDC’s have all repriced to reflect the current repricing of high yield loans in the entire credit market, and therefore don’t represent a unique opportunity to own higher yielding assets.

While I understand both arguments, the impressive historical performance of BDC’s as they recover from near or below NAV valuations makes PNNT a compelling investment with a highly favorable risk/reward.

As a quick mention, in light of the impressive rally in the space, and given PNNT’s current non-participation, I’ve decided to submit these notes today.  PNNT reports earnings tomorrow, and I’d prefer to have the updated information from that presentation, but instead, I’ll update following their earnings call.

Company background:

PNNT was founded this year by Arthur Penn, co-founder of AINV and former head of UBS Leveraged Finance.  It began with four investment partners, plus a CFO hired from Blackrock.  PNNT began with a fully formed portfolio, although this isn’t reflected in the dividend yield, given that the first dividend only reflected a partial quarter.  As such, it won’t yet show up in any dividend screens, although this will change next quarter.

The obvious comparison for PNNT is AINV, given the founder’s background there.  There are some distinctions.  AINV was penalized out of the gate for being uninvested.  It IPO’d around the same time as ARCC, which never traded at a discount to its IPO price, let alone its NAV.  The difference was that ARCC came public with a portfolio that it had purchased from RBC, the former employer of the founding partners.  AINV quickly went to a discount to NAV after its IPO, as it was dead money waiting to be invested.  In fact, it was difficult to purchase it as part of a pair given the positive growth and dividend characteristics of a fully invested BDC.  As such, AINV originally fell into a no-man’s land, not appealing to BDC investors who wanted full participation in the market, and lacking any immediate catalyst to transformation.  Instead, it simply offered a predictable glide path toward full investment and more typical BDC performance.

PNNT undoubtedly sought to address the lesson learned by being more ARCC like from inception.  PNNT borrowed money, which it repaid from its IPO proceeds, and assembled a portfolio of $250 million of floating rate bank debt prior to its initial offering.  These initial investments were meant to address the yield attributes expected by BDC investors until that time this initial portfolio could be redeployed in more typical subordinated debt, mezzanine, second lien, and equity investments.  Their focus is on middle-market companies with revenues of $50 million to $1 billion.

The company’s target portfolio is:

• 60% subordinated debt / mezzanine securities
• 30% second lien bank debt
• 10% private equity

PNNT is an externally managed BDC.  Distinct from AINV, it is not affiliated with a private equity firm.  This undoubtedly holds some advantages and disadvantages, the chief advantage of which is that its non-affiliation will encourage private equity sponsor clients to see PNNT as a partner rather than a competitor.

PNNT’s fee structure is essentially 2% (lower in the first year) plus an incentive fee of 20% beyond a 7%-8.25% hurdle rate.  Despite the hurdle, there is a catch up provision that gives management the entire amount of NOI between 7% and 8.25%, and then above that, the aforementioned 20%. 

PNNT’s weighted average spread on its initial portfolio is estimated to be approximately Libor + 210 basis points.

It is appropriate that PNNT’s portfolio be repriced via its public stock, given the widening of credit spreads.  Still, at $13.45 versus a previously reported NAV of $13.97, or nearly a 4% discount.

The PNNT portfolio is composed of names such as Charter Communications, Domtar, General Nutrition Centers, Jacuzzi Brands, Journal Register, Reader’s Digest, and Univision.  While high yield bond indices have generally backed up from L+250 to L+450, it isn’t clear to me that this is more an effect of the disenchantment by investors—a buyer’s strike, so to speak, in the face of the non-transparency of securitization vehicles.  From a bottom up perspective, on a company-by-company basis, it doesn’t strike me as unreasonable to assume that the PNNT portfolio is in the neighborhood of 100 bps worse on a mark-to-market basis.  That would account for the entire 4% discount to NAV (based on the simplified bond math of five year notes adjusted 100 bps would be approximately a 4% decline in value).

But PNNT isn’t levered yet.  On June 26^th, PNNT announced that they had secured a $300 million five year credit facility.  They can now deploy their additional capital opportunistically at the current market rates and ratchet up their leverage toward the normalized BDC level of 1.8 to 1.  At its current pricing, PNNT is trading more like a static portfolio of senior secured loans, rather than a BDC with a professional and highly regarded management with plenty of dry powder in an opportunistic environment.

In light of the recent moves in BDC’s—as I write, AINV is up 12.5% since Friday’s close, ARCC is up 15.6%, ACAS is up 12.5%, while PNNT is up less than 1%, it appears that the BDC’s were used as hedging vehicles for those with exposure to credit spreads.  The short-covering rally over the last few days has been swift, to say the least.  This makes sense, as many vehicles with correlations to credit spreads have experienced enormous volatility over the last month.  I imagine that some of these have become trading/hedging vehicles, and that includes the BDC’s.  In fact, earlier this week, the MLP’s had a 10% intra-hour swoon.  This just reinforces the fact that the market does relative value better than it does absolute value.

So, while on a relative value basis, it makes sense for PNNT to be repriced lower given the credit spread widening and the corresponding recent decline in the BDC sector, from a longer-term perspective, it has historically been quite lucrative to purchase high quality BDC’s near or below NAV.

And to put into perspective what Libor+350 means for senior secured debt, I’d like to refer to Bill Gross’s recent PIMCO commentary.  Gross discusses the previous inadequacy of high yield corporate bond spreads:

 

“Covenant-lite deals and low yields were accepted by money managers as
if they were prisoners in an isolation ward looking forward to their
daily gruel passed unemotionally three times a day through the
cellblock window. "Here, take this" their investment banker jailers
seemed to say, "and be glad that you've got at least something to
eat!"

“Well the caloric content of the gruel in recent years has been barely
life supporting and unhealthy to boot – sprinkled with calls and PIKS
and options that allowed borrowers to lever and transfer assets at
will. As for the calories, high yield spreads dropped to the point of
Treasuries + 250 basis points or LIBOR + 200. Readers can sense the
severity of the diet relative to risk by simply researching
historical annual high yield default rates (5%), multiplying that by
loss of principal in bankruptcy (60%), and coming up with an expected
loss of 3% over the life of future loans. At LIBOR + 250 in other
words, high yield lenders were giving away money!”

 

One can refer to the 10-Q of PennantPark and see their entire portfolio.  At an implied Libor +350, we have to run a higher rate historical default rate and/or worse recovery rate than Gross indicates.

And while I respect Gross’s tremendous marketing ability and compelling track record, I recall reading that he recently personally purchased one of their own high yield funds for the first time since the fund was opened.

Speaking of PIMCO, as a friend pointed out, an alternative to purchasing a BDC would simply be to purchase the Pimco High Income Fund (symbol PHK).  It is leveraged 30%, and yields 10.5%.  If PNNT was similarly leveraged, it’d be easily comparable on a dividend basis.  However, PNNT will be redeploying its assets into higher yielding BDC investments.

But the most predominant feature of PNNT in my mind is the AINV background of its founder.  AINV was one of my favorite risk/reward investments of the last several years.  PNNT ipo’d nearly four months ago.  Four months after AINV’s ipo, their stock had also broken NAV and was trading for $13.23.  The IRR since then has been 27.8%, for a holding period return of 108% over three years.  And during the first year of that period, the return was 42.6%.

While I hope PNNT proves its pedigree and matches that impressive performance, it isn’t necessary in order to make out decently.  I truly consider AINV to be best in class, and its performance from equity kickers via its warrant participation has been impressive.  If PNNT doesn’t do quite as well, it won’t be that disappointing.  On the other hand, with a more opportunistic environment, largely equivalent initial valuation, and many of the same principles involved, I wouldn’t discount the possibility of a 30% return over the coming year.

 

Disclaimer:

 

This is not meant to be a buy or sell recommendation, and my firm frequently has both long and short positions in many of the securities mentioned on a regular basis.   

 

Catalysts:

Recent rally in BDC sector has made this cheap by comparison.
Favorably compares to high yield bond funds, but with the additional positive attributes of being a BDC..
Opportunity for greater clarity from company via earnings call tomorrow.

 

Catalyst

Recent rally in BDC sector has made this cheap by comparison.
Favorably compares to high yield bond funds, but with the additional positive attributes of being a BDC.
Opportunity for great clarity from company via earnings call tomorrow.