Ever Wanted to Work at a Hedge Fund? Take a Look Inside

The hedge fund industry, and investment management in general, has some of the highest turnover of all the sectors. In this case, turnover refers to companies, not employees. Especially in turbulent times like in 2008 and 2009, hundreds of hedge funds had to close down due to poor investments. During the same time, a few funds made the right call and profited handsomely. For a professional in financial services, trying to find a hedge fund that is not likely to implode in the next few years is very important.

An interesting investment fund that people may consider for employment or for investment is Pennant Park Investment Corporation PNNT. Pennant Park is a unique investment firm in that it is a business development company (BDC), complying with the Investment Company Act of 1940. The guidelines for BDCs results in a type of company that may appease some investors, as the rules restrict the investment strategies and the capital structure for BDCs.

First and foremost, business development companies cannot excessively leverage themselves; in fact, the debt to equity ratio cannot surpass 1:1. Likewise, the BDC does not have to pay taxes if it pays out its net income as a large dividend. BDCs also tend to invest in small and medium sized businesses, having the ability to invest in all parts of the capital structure.

To learn more about Pennant Park's nuances and business strategy, Benzinga reached out to Stifel Nicolaus' Greg Mason, a Director covering Specialty Finance.

Pennant Park specializes in making loans to small and medium businesses. According to Mason, Pennant Park has invested 38% of its capital in 1st lien senior debt, 53% in 2nd lien and unsecured subordinate debt, and 9% in equity. While some investors may be wary of specialized credit funds, they need to understand that there are professionals who are able to invest in debt without putting themselves in significant debt.

According to Mason, "Pennant Park deserved a buy rating because it operates better than many of its competitors. To understand business development companies, you have to look at credit quality. No matter how much money a firm has under management, the credit quality of its investments trumps all. Since 2006, Pennant Park has had the fourth best performance in terms of credit losses. When you look at the whole universe of BDCs, have the fourth smallest amount of credit losses is very impressive."

Investors, however, like to see more. While knowing the underlying business seems to be promising, do the numbers actually back up the buy rating? Mason stated that "Pennant Park's portfolio signifies a strong history of investments. Currently, Pennant Park contains $779 million of loans at fair value. The balance sheet contains about $230 million of debt while having $505 million of book equity. It also has about $150 million in cash for new investments."

When companies have properly diversified their investments and have been able to reap profits without significant leverage, investors will notice. It is also interesting to mention that the firm is sticking with a traditional fee structure, charging 2% of assets under management and 20% of profitable returns.

Mason also mentioned that the stock is undervalued compared to competitors. "The stock is fairly cheap when it is trading at about 0.94 times book value. Using this metric, you have to consider the earnings yield when you compare firms. Understanding that BDCs pay the majority of their profits as a dividend, Pennant seems to be underpaying its equity investors. The current dividend is $0.27, resulting in a yield of about 10.8%. If earnings continue to increase, the yield could increase to 11-12%. When you translate this forecast to the price/book metric, the stock could be trading at around 1.2 times book value next year."

Other metrics also offer a compelling story for Pennant Park. It is currently trading at 8.5 times earnings, while competitors are trading, on average, at 14.5 times earnings. Moreover, it has had extremely high revenue growth over the last three year. Annualized, revenue growth is about 66.5% for the firm, while its competitors average at about 0.6%. Its operating and net margins are also much higher than its competitors' margins. As mentioned earlier, it operates with fairly low debt, and seems to be much lower than the rest of its financial services competitors. Lastly, its return on equity is about 11.3%, while its competitors' returns are about 10.9% on average.

Financial services and investment management in general make many investors nervous. While there are inherent risks associated with the industries, investors need to remember that there are firms that know how to gain profits without excessive leverage and by monitoring calculated risk. If investors are interested in learning more about investment management firms, Pennant Park Investment Corporation could be a good place to start.

Pennant Park is currently trading at about $10.30, down over 15% for 2011.

ACTION ITEMS:

Bullish View:
Traders who believe that Pennant Park is an appropriate long investment might want to consider the following trades:

• Despite being in an industry where profits are commonly bolstered by leverage, Pennant Park is lowly levered compared to most of its competitors.

• Pennant Park is undervalued compared to direct competitors, despite having better revenue growth, net margins, and return on equity.

• The debt capital markets are heating up, as evidenced by increasing deal flow in debt issuances across all tranches, even high-yield debt.

Bearish:
Traders who believe that Pennant Park is more suited for a short play may consider an alternate position:

• The company is not as diversified as many other investment managers. There are inherent risks associated with debt investing, and Pennant Park has an extremely high exposure to the debt side of the capital structure.

• Pennant Park's dividend yield is lower than many other business development companies. While this may not mean that the company is floundering or struggling to survive, there may be better opportunities for investors.

• The global economic dynamics are incredibly fragile right now, and if any downturn occurs, the financial services industry will be the first to be affected. Many investment managers will also become dissolute as their investments crumble.

Neither Benzinga nor its staff recommend that you buy, sell, or hold any security. We do not offer investment advice, personalized or otherwise. Benzinga recommends that you conduct your own due diligence and consult a certified financial professional for personalized advice about your financial situation.