Middle market domestic companies, especially those owned by private-equity firms, face many of the same hurdles as their larger brethren, whether the tight labor market, supply chain snafus, inflation, interest-rate hikes, and the list goes on. However, their debt, often provided by a single lender or a small club, is arguably less volatile than much larger broadly syndicated loans (BSLs). And their more U.S.-centric businesses may be less impacted by financial and economic volatility, according to Art Penn, founder and managing partner of PennantPark and previously a top Wall Street executive at firms including Apollo Investment Management, UBS Warburg, and BT Alex. Brown.
PennantPark Investment Advisers is a direct lender and asset manager specializing in middle-market finance. The company started out in 2007 as a provider of second-lien debt and mezzanine finance. Eventually, PennantPark expanded to stressed and distressed debt as well as equity co-investments and senior debt. It has completed four collateralized debt obligations (CLOs) since 2019, securitizing primarily self-originated senior loans. Its $304 million PennantPark CLO IV closed earlier this year and has a four-year reinvestment period and 12-year final maturity.
Penn spoke to Asset Securitization Report about middle-market loans and the CLO markets and their performance since the start of the pandemic
ASR: Why did PennantPark begin managing CLOs?
Penn: The CLOs are focused on our first-lien, direct origination senior debt strategy, and they’re a really good structure for these lower risk, solid loans that have good capital preservation attributes, strong covenants and reasonable leverage, and where we have time to do due diligence and understand what we’re getting into.
ASR: What do you look for to provide the loans?
Penn: These are companies with between $10 million and $50 million in EBITDA that are typically owned by private-equity firms. We negotiate covenants that have meaning and protect us, and they are important relationship loans where our capital is viewed as strategic by the borrowers. So the risk/return package is very attractive.
ASR: What business sectors do you lend to?
Penn: there are five key mega sectors where the borrowers tend to fit: healthcare, government services and defense, software and technology, business services, and consumer products.
ASR: Who invests in middle-market CLOs?
Penn: It’s a broad mix. It’s a much smaller number than those investing in BSL CLOs, but it’s growing. The middle market has performed very well during the pandemic, and that has bolstered demand. Plus, by definition, it’s less volatile: the loans aren’t quoted by a broker, and they have non-public shadow ratings, so [they are not subject to] sudden moves by the rating agencies. It’s a calmer ride for investors, and the returns are higher.
ASR: What would the loans be rated if they carried a rating?
Penn: They would generally be in the single-B range.
ASR: That suggests they’re risky; has that inhibited some investors?
Penn: There’s perception and reality. The perception is that smaller companies are riskier, but in reality they’re less risky and the returns are higher. With CLOs investing in BSLs, those loans have no covenants and they’re traded by Wall Street trading desks. When you want to get out at the beginning of a crisis, you can’t because the brokers are hiding and won’t give you a bid, or a very low one.
In the middle market, you don’t have that liquidity, and that’s why the loans would get a lower rating, but we’re not telling anybody it’s liquid. The biggest challenge for middle-market CLOs is that the loans are misunderstood, because investors still have this size bias. But that creates an opportunity for investors to buy into both the debt and equity and get very attractive risk-adjusted returns, typically 30 bps to 70 bps higher on AAAs compared to BSL CLOs, and for arguably less risk. There’s an even wider gap further down the stack.
ASR: To what extent are middle-market CLOs impacted by today’s big risks factors, such as rising rates and inflation, supply-chain complications, and geopolitical upheavals such as Russia’s invasion of Ukraine?
Penn: Middle market CLOs look very attractive in this world of risk. The bonds are floating rate in a rising rate environment, and their business tends to be largely domestic.
ASR: And if the Fed raises rates beyond current expectations?
Penn: Most of the companies in our CLOs cover their interest three to one, so there’s plenty of cushion even if rates go a bit higher.
ASR: What if volatility continues or worsens, further disrupting supply chains and increasing costs?
Penn: Everyone sees what’s going on, with the supply chain, higher labor costs, etc., and customers typically understand if companies have to raise prices. We’ll see what happens with this new geopolitical risk, which is now repricing transactions and causing a bit of a pause in the market.
ASR: Does that result in greater concerns for middle-market lenders and CLO investors, given middle-market companies tend to have less capital to weather business challenges?
Penn: Standard & Poor’s shows that middle market companies have lower default rates and higher recoveries. Covenants give you a seat at the table when borrowers are in trouble and lenders can control their destinies better. The COVID crisis is a great example: we were given quarterly maintenance tests and monthly performance numbers, so we could really protect our investors.
In the BSL space you can only trade out of your position, and if you sold during COVID you lost a lot of money because you were selling at a big discount.
ASR: Were covenants breached in loans securitized by PennantPark’s CLOs?
Penn: The first part of COVID was a scary time and we probably had 15 borrowers with covenant issues. But the private-equity sponsors injected additional capital, because the loans had covenants.
ASR: Does the migration away from Libor to the secured overnight financing rate (SOFR) present a challenge this year for middle-market lenders and borrowers and a potential risk for investors in those CLOs?
Penn: Most deals are getting shifted over to SOFR pretty smoothly. Both Libor and SOFR loans usually have 1% floors, and because neither rate has been anywhere near the floor, there’s been no economic impact so far, although there would be if rates rise above the floors.
The banks who are either our partners or lend to us are insisting on pricing loans over SOFR, because their regulators are insisting on it. So even if it’s only direct lenders participating in a loan today, it’s priced over SOFR to have the option of banks participating in the deal down the road.
