With so much investor capital committed to so many non-traded REITs, non-traded business development companies (BDCs) have now emerged as a relatively new structure that is getting a lot of attention. Is it really a horse of a different color? With the similar high up-front fees and similar limited liquidity issues, it seems like it could be a new name with some novelty, but in the end, it’s just a different wrapping on a similar box that is ultimately good for the financial advisor and broker-dealer firm, but not so good for the investor client.
In the world of investing, product and marketing departments are constantly trying to create a new spin on an old idea, confident there will always be investors looking for the next best thing that will provide outsized yield, or at least financial advisors with hefty commission opportunities willing to try to sell it to them.
With the performance and illiquidity issues catching up with many non-traded REITs, it is no surprise to see a “new” wrapping on a similar box, and that’s where many non-traded business development companies (BDCs) have come in to fill the gap. With a new name and a new twist on the same old story, and a similar structure, non-traded BDCs have emerged as a relatively new structure that is getting a lot of attention. But with high up-front fees, limited liquidity and sometimes a reliance on leverage to goose returns, it sounds a lot like the same reasons why so many non-traded REITs have imploded in the past, and these new BDCs should be “buyer beware.”
As one industry pundit put it very succinctly, “… brokers should not be selling private anything—private placement, private REIT, private business development corporation—because it limits the flexibility, it limits liquidity, it limits transparency, and it almost always means higher fees internal,” said Joshua Brown, vice president of Investments at Fusion Analytics Investment Partners. “The only reason [non-traded BDCs] get sold is because it’s product and it’s sexy and it’s a way for a broker to get a higher fee for the same dollars that they would put into a public version.” According to Tony Chereso, president and CEO of FactRight. The front-end loads on BDCs are fairly similar to non-traded REITs, which are high – typically around 11.5 to 12 percent. On top of that, BDCs also typically have an incentive structure of “two and twenty,” charging two percent of assets in management fees and 20% of capital gains, based on performance.
What does this mean for investors purchasing these non-traded REITs, or now, more recently, BDCs? It means “… it’s a huge hurdle just to get back to even…” because of the up-front fees, Brown said. “Do you know how hard it is to generate 11 percent in this day and age? With flat stock markets and Treasuries yielding 1.5 percent?” Non-traded BDCs are pitched as high-yield vehicles, Brown said, so that’s their sex appeal. But they also exist in the public markets, “so why would you look for one outside of that? Is the yield going to be that much better? Probably not.”
Whatever the sales pitch by the well-compensated financial advisor, there are no magic beans that will suddenly generate higher returns simply because an investment is labeled a non-traded REIT or a non-traded BDC. As a result, it is rare that these private placement investments can recover from the high upfront costs, and most investors wind up with illiquid investments that do not produce returns that are in line with the level of risk exposure or that make the trade-off for illiquidity worthwhile.
BDC Investments – Is it more than the same old wrapping on a new box?
While some firms just look for a novel name and a different twist to help the marketing and sales efforts, those firms that actually engage in new investment strategies, raise additional questions: “I worry about firms that are in the real estate business, then all of a sudden they’re in the business of doing what Franklin Square does,” Dunne said. “Do you really understand credit? Do you have the wherewithal internally? Do you have a relationship with firms that have a long track record of making loans to private companies? I just hope that the BDC concept doesn’t get confused.”
BDC VS REIT
Just as small, inexperienced managers entered the REIT space over the last decade, Dunne fears the same thing could happen in the BDC space. “There have been quite a few firms that have gravitated to this investment structure,” said Chereso. “Some of them have some direct experience,” such as on the publicly traded side of BDCs, but if a firm’s core competency is in another area, such as energy or real estate, and they don’t understand credit or credit underwriting, “That causes some concerns,” Chereso said.
Many of these firms launching BDCs have strong financial positions and resources, but the question is whether they have the depth of talent and capability to manage these strategies effectively, he said. “My biggest concern is there are lots of folks that are jumping into the space, particularly the sponsors, who don’t have a lot, if any, experience in corporate credit in writing BDCs,” Michael Forman, CEO of Franklin Square.
How Do BDC Make Money? The Structure of BDCs
BDCs provide financing to small and mid-sized businesses. In recent years, they’ve sought to capitalize on the relative lack of debt capital in these markets, as banks restricted lending to build their capital reserves, Stanger says. BDCs use a structure similar to non-traded REITs in that capital is raised in a continuous private offering, but BDCs are regulated under the 1940 Act that governs mutual funds. The big difference is that they’re valued quarterly, while non-traded REITs are required to publish their valuations no later than 18 months after the conclusion of the offering. “I think there’s a lot of concern and skepticism with respect to the REITs, and they look at us as being different,” said Forman. “I think we’ve kind of forced the REITs to have to change their business model a little bit.” Whether or not that actually takes place, remains to be seen.
For now, whether it is a non-traded REIT or a non-traded BDC, and whether or not there is a quarterly valuation available, they are private vehicles, they don’t have the daily liquidity that comes with the public markets. “When you have the opacity and you’re away from the public market, your filing requirements are different, you don’t have to disclose as much financial metrics as you would if you were public; it gives you the opportunity to fudge numbers, prolong taking of losses, prolong taking of marks in the portfolio,” Brown said.
Risky, opaque, illiquid investments are rarely sound recommendations for most public retail investor clients.
Seek Compensation for Your Investment Losses
If you are an investor that purchased non-traded REITs or Non-Traded BDCs and you have incurred losses, you should consider your potential options for recovering your investment losses. At least one option for some investors includes a Financial Regulatory Authority (FINRA) customer dispute. The customer dispute process at FINRA is private, and quicker and more efficient that traditional court litigation. In addition, there are typically no depositions, as it is almost entirely paper-based discovery. You should contact experienced attorneys who might be able to assist you with these types of disputes.
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Haselkorn and Thibaut, P.A. is a nationwide law firm specializing in handling investment fraud and securities arbitration cases. The law firm has offices in Palm Beach, Florida, on Park Avenue in New York, as well as Phoenix, Arizona and Cary, North Carolina. The two founding partners have nearly 45 years of legal experience.
Haselkorn & Thibaut, P.A. has filed numerous (private arbitration) customer disputes with the Financial Industry Regulatory Association (FINRA) for customers who suffered investment losses relating to issues similar to those matters mentioned above. There are typically no depositions involved, and those cases are typically handled on contingency with no recovery, no fee terms.
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