We will get back to fire-breathing shortly, but we wanted to say that there are good private debt funds out there. We are not dismissing the entire space. Our approach to analyzing private debt funds is to watch out for red flags. There are thousands of investment products, so investors can afford to be selective. Even a single red flag should be sufficient to eliminate a fund from consideration. Conversely, green flags are not conclusive by themselves, just an initial filter. We write about Penfund here to illustrate some of the characteristics of good private debt funds. It so happens, we found out, that they have great performance too - in the mid-teens, using mostly debt investments.
Penfund was founded in 1979, they are among the oldest private lenders in Canada. But its current incarnation started when John Bradlow and Barry Yontef acquired the firm in 2000 out of its then parent, CIBC. John Bradlow is a Harvard MBA who once worked for Sam Belzberg’s First City Financial. John Bradlow retired in 2020. Today, Penfund is run by a group of five partners, including John’s son Richard Bradlow, also a Harvard MBA.
Penfund’s focus is on borrowers in the upper-middle market in the US and a little bit in Canada. They fund expansions, acquisitions and recapitalizations. They are particularly active in providing debt capital to private equity sponsored transactions. They work with some of the best-known private equity players, such as Bain Capital, J.H. Whitney, Leonard Green & Partners, OMERS Private Equity, ONCAP (Onex) and Thomas H. Lee Partners
Penfund raises money on structures similar to private equity funds - their funding is not redeemable on demand. This eliminates one of the biggest bugaboos with these products, ie the liquidity mismatch between the maturity of the loans vs the monthly redemption feature offered to investors.
Green flag no. 1: They don't target retail investors
Penfund has invested more than C$3b in about 225 companies over the years. Their current fund no. 6 has committed capital of C$ 1.15 billion. Of that amount, US$130m came from 15 investors in the US, using placement agent Park Hill Group (paying a commission of about 1.18%, which is much less than commissions typically paid to retail distributors). They are currently raising fund no. 7 (target first close is November with expectations of high rates of current limited partners re-upping their investments). Penfund has all kinds of institutional and even high net worth investors, but no retail investors. This is again different from the other firms we have named, which rely heavily on retail distribution.
As a general rule, retail investors don't have access to the very best money managers (the problem known as adverse selection). Individual investors have been told to use Liquid Alts to replicate the portfolio of institutions and endowments. But the reality is that individual investors don't have the same investment horizon as those big institutional investors. David Swensen, who revolutionized endowment investing by using alternatives, advocated that individual investors steer clear of the approach he developed for Yale University.
Green flag no. 2: They disclose their borrowers' names...unlike certain other people
Most of Penfund’s transactions are press released. Anyone can see on this page a fairly extensive list of Penfund borrowers. You will see names like: Del Monte, Mister Car Wash, GoodLife, PetSupermarket. In contrast, many other funds we have studied are cagey about their borrowers, claiming commercial confidentiality.
Green flag #3. They have not found a magic bullet that allows them to enjoy premium returns with no risk.
Many funds claim that they invest in can’t-lose “senior secured first lien over-collateralized super priority” situations. In essence, they are saying that they have transcended the classic risk-return-liquidity trade-offs that hold down much of conventional finance and that are so crucial to you passing the Canadian Securities Course.
In contrast, Penfund offers a variety of debt products, mostly subordinated and sometimes even unsecured. But they don’t compromise on the quality of the underlying business. They stay away from complex situations, the “too hard pile”. Richard Bradlow has said:
“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....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.”
Consistent with this conservative approach, Penfund has only had one realized loss, amounting to $1.4m during the reign of the Bradlows. Some funds we know are not willing to acknowledge any losses, despite being frequent attendees of bankruptcy courts.
These are some good filters in picking a fund to research in-depth. One additional positive sign is that Penfund managed to build an entire website without boasting about some arbitrary award they won.
We did find some vexing information about Penfund. A small part of their stated strategy (about 5-10%) involves making equity co-investments in transactions in which they provide debt. This has resulted in some homeruns, such as when they invested in Leonard Green’s buyout of Mister Car Wash in 2014. That company is now public and has been a 10-bagger. That is vexing because, at the risk of sounding like annoying pension fund consultants, we believe in style purity. Penfund also tends to make concentrated bets, with the flexibility to invest as much as 20% of committed capital in a single borrower. We were surprised that the firm has generated returns in the mid-teens since 2000. That is higher than we would have thought.
Some additional quotes from Richard Bradlow we found illuminating:
“Most firms are looking to maximize the returns. 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.”
“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.”