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:
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:
More generally, COVID-19 has led to several new insights that we plan to incorporate into our underwriting process:
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.
Penfund is a leading provider of junior capital to middle market companies throughout North America. The firm is owned by its management team and is currently investing its most recently established fund, Penfund Capital Fund VI. Penfund manages funds sourced from pension funds, insurance companies, banks, family offices and high net worth individuals and has invested more than $3 billion in over 225 companies since its establishment in 1979. Assets and capital under management currently total $1.5 billion.