Reflections on COVID-19

Penfund’s portfolio is heavily concentrated in consumer-facing, service-based multi-unit businesses. The multi-unit model benefits from many attractive characteristics, some of which typically include:

• High levels of diversification
• Local economies of scale
• Clear and measurable unit economics
• Discrete and therefore modular growth opportunities
• Insulation from broad-based technology disruption
• Constrained scope for competitor incursions
• Low risk of disintermediation

The subset of multi-unit businesses targeted by Penfund also are characterized by low levels of demand and supply volatility. Simply put, these businesses have historically been excellent credits.

Multi-unit businesses are dependent on in-person interactions and a physical footprint to generate sales. Under normal conditions this feature is a strength as it is in large part what gives rise to many of the strengths noted above. However, 2020 was far from normal. COVID-19 has made it abundantly clear that pandemics hit multi-unit businesses particularly hard. We therefore had front row seats as many of our portfolio companies initially struggled to cope with the effects of COVID-19 as locations were forced to close and revenue fell precipitously. As management teams and financial sponsors reacted to market conditions, and as a broad resumption of business activity began in the summer, our portfolio responded in kind and largely stabilized. Despite being hit hard initially, most of the companies in our portfolio recovered quickly. While COVID-19’s story is not yet fully written, we have reflected on key learnings from our experience thus far.

Most importantly, we think it is impossible to predict the ultimate form or timing of low probability high impact macro events like pandemics. These events are randomly distributed over time and while we can be sure there will be other shocks in the future, the fact that this one was a pandemic does not mean the next one will be. Specific learnings from COVID-19 are therefore unlikely to be transferrable to the next macro shock. Therefore, in trying to identify lessons learned we have focused on trying to discern generalizable principles that will be applicable to other shocks in the future, rather than fighting the last battle and focusing on COVID-19 specifically.

In our view, the unifying theme of 2020 is the importance of business resilience. Resilient businesses benefit from prewired downside protection that enables them to absorb and adapt to shocks and therefore to survive them. Fortunately for Penfund, our underwriting criteria already implicitly select for resilience. High quality and established businesses with strong market positions, attractive financial characteristics, necessity demand, recurring cash flows, in-place management teams and reputable financial sponsorship are inherently able to withstand shocks and adapt to changes in the macro environment. For this reason, while our portfolio companies experienced significant volatility in 2020, we do not believe any have experienced enough enterprise value destruction for our capital to be permanently impaired.

That said, identifying the theme of resilience has led to a newfound appreciation for certain risk factors we have always considered during our underwriting process but that were not necessarily central:

• Financial sponsorship. A crisis requires shareholder engagement. Financial sponsors across our portfolio have stepped up to provide advice, human resources and, in some cases, additional capital to portfolio companies. Our sponsor partners have been very responsive to us and other lenders with the shared goal of building bridges back to normal. High quality sponsorship is critical during periods of extreme change and we have an enhanced appreciation for the value added by our sponsor partners.
• Management. A crisis also requires active management. The number and importance of decisions made by management teams increased significantly in 2020. Teams initially focused on diagnosing and defending against COVID-19. Managers across our portfolio took the necessary steps to ensure survival, all while taking pay cuts and working tirelessly. The best-in-class looked beyond the crisis and positioned their companies to press their advantages coming out the other side. Penfund has always backed proven management teams and the quality of management at our portfolio companies proved invaluable in 2020.
• Financial covenants. Some of Penfund’s loans have maintenance covenants and some are cov-lite. Cov-lite loans have fewer trigger points for restructuring events, but these events tend to be serious if they occur. For example, a liquidity crisis or interest payment default. Financial covenants force engagement with lenders far sooner. This can be positive, but it can also create more risk for both equity and junior debt investors since senior lenders effectively retain control of negotiations. For equity and sometimes even junior debt investors, a lack of covenants combined with trusted sponsorship can often produce a better outcome than strict covenants as the absence of covenants eliminates the risk that capricious actions by senior lenders prevent a company from having the time it needs to recover. 

More generally, COVID-19 has led to several new insights that we plan to incorporate into our underwriting process:

• Cost structure. Operating leverage measures cost sensitivity to changes in revenue. Fixed costs make profitability more sensitive to changes in revenue since these costs do not naturally change as revenue changes. For example, rent expense and a large part of salary expense would historically be considered fixed. COVID-19 showed that not all fixed costs are created equal and that operating leverage can be more dynamic than we had imagined. Our portfolio companies reduced previously non-discretionary fixed expenses, applied broad or targeted salary cuts and changed compensation models to vary with financial performance. While some companies were able to defer rent payments, in general rent proved more fixed than many other expenses that were also viewed as fixed. We also learned that governments are more willing to subsidize jobs than landlords. Labor costs – even fixed labor costs – can clearly be made more variable than we had anticipated in a severe crisis.
• Liquidity. Much like everything else, liquidity becomes more valuable as its scarcity increases. There is a tension between optimizing cost of capital and maintaining excess liquidity. Good times can push companies to minimize liquidity in order to maximize returns on equity, which ill prepares them to absorb shocks. COVID-19 provided an extreme liquidity challenge for many companies. Some of our portfolio companies generated no revenue for an extended period and, despite heroic efforts to minimize cash burn, were forced to rely on cash on hand, revolving credit facilities and other liquidity boosting measures (stretching payables, rent forbearance, etc.) to survive. Had they not rebounded as quickly as they did, many would have faced crises. In retrospect, many of our portfolio companies had too little liquidity heading into COVID-19, which we expect to reverse going forward.
• Channel diversification. Businesses with multiple pathways to market are clearly more resilient than those reliant on a single channel. The ability to sell to customers on and off-line was critical in 2020. Within brick and mortar, having a presence in a variety of retail settings was also key to maintaining operations. In some markets, small format stores were forced to close while big box retailers remained open. The ability to sell direct-to-consumer also allowed companies to control their own destiny. However, simply selling through multiple channels is not sufficient. The various channels must be scalable and offer reasonably similar economics for channel diversification to be truly beneficial.
• Geographic diversification. Business conditions and risks clearly vary by local market, especially for multi-unit businesses. While the pandemic has had global effects, the policy and consumer response has varied widely by jurisdiction. Our portfolio companies in Canada have significantly underperformed those in the U.S. Within the U.S., companies in the sunbelt have outperformed those based in California and the Northeast. Much like diversification in sales channels provides insulation from conditions in a particular channel, geographic diversification provides insulation from conditions that adversely impact particular local markets. 

Finally, and perhaps most importantly, we believe COVID-19 has clearly demonstrated that the most important aspect of resilience is the criteria that is most central to our underwriting – strength of market position. The pandemic has and will continue to accelerate the divergence between the haves and have-nots in many industries. Most companies initially cut costs to minimize cash burn. However, certain discretionary costs, like travel & entertainment, marketing & advertising, research & development, and even employee compensation, have implications for short and long-term sales generation and therefore cannot be permanently reduced without damage. Better resourced companies were able to resume spending earlier. Stronger companies received more support from capital providers and in some cases were able to opportunistically raise capital to build “war chests” that will enable them to take advantage of increased consolidation opportunities. The best companies were able exit survival mode and re-enter growth mode more quickly which will reinforce or enhance their market positions in the future.

While COVID-19 has obviously created numerous challenges, it has also presented us with the opportunity to learn valuable lessons. These lessons will be incorporated into our underwriting process going forward and we believe will make us better prepared for the next big shock – whatever it may be.