By Adam Weinstein
As one of the largest non-traded real estate investment trust (Non-Traded REIT) companies, AR Capital, closes shop on new offerings, a growing non-traded product lines up to take retail investor’s money. Enter the non-traded business development company (BDCs). BDCs have been a growing asset class that markets itself to investors as a non-stock market, non-real estate, high yield alternative investment. However, BDCs appear to be just as speculative, suffer from high commissions and fees, and are inappropriate for most investors just like Non-Traded REITs. Indeed, according to a Wealth Management Article front-end load fees on Non-Traded BDCs are typically around 11.5 to 12 percent. In addition, BDCs also usually have an incentive compensation following the “two and twenty” rule where the fund charges two percent of assets in management fees and 20% of capital gains based upon performance.
As we have reported in the past, BDCs make loans to and invest in small to mid-size, developing, or financially troubled companies either broadly or in a particular sector, such as oil and gas. BDCs have stepped into a role that many commercial banks left during the financial crisis due to capital raising requirements. In sum, BDCs lend to companies that may not otherwise get financing from traditional sources. Non-Traded BDCs offer investors similar risks as Non-Traded REITs including higher fees, less liquidity, and less corporate transparency. The major difference is that Non-Traded BDCs are regulated under the 1940 Act that governs mutual funds and that a BDC is valued quarterly.
The largest player in this space is Franklin Square Capital Partners which manages multiple Non-Traded BDC funds including the FS Investment Corporation (NYSE:FSIC) FS Investment Corporation II (FSIC II), FS Investment Corporation III (FSIC III), FS Investment Corporation IV (FSIC IV), FS Energy and Power Fund (FSEP), and FS Global Credit Opportunities. Franklin Square’s BDC assets were approximately $14.5 billion under management as of March 31, 2015. Other firms seeking to capitalize on the BDC wave including CNL Securities’ Corporate Capital Trust, ICON Investment’s CĪON Investment Corporation fund (CĪON); and American Realty Capital’s Business Development Corporation of America II.
The growth of Non-Traded BDCs comes while the largest Non-Traded REIT marketer, AR Capital is existing the business. According to the New York Times, AR Capital built by Nicholas S. Schorsch and William M. Kahane stated that it would stop creating new investment products and close existing ones to new investors to focus on managing the $19 billion it has in current investments. AR Capital’s current offerings include Business Development Corporation of America II, ARC Healthcare Trust III, New York City REIT II, ARC Hospitality Trust and ARC Global Trust II.
According to the article there were a couple of reasons for closing the funds to investors including serious problems with their lack of transparency and the interrelationship with affiliated companies. In addition, the proposed new fiduciary standards for advisers and mandated fee disclosures is causing the industry to question whether these products can be sold anymore. Basically, the industry is worried that Non-Traded REITs are not in investors best interests, an opinion our firm has echoed before. See Controversy Over Non-Traded REITs: Should These Products Be Sold to Investors? Part I
One would think that given the pending collapse and/or major shakeup of the Non-Traded REIT market Non-Traded BDCs would be similarly effected with the same concerns. Not so fast. Slap the “small business” label on any investment and lawmakers line up to make this failed investment class even riskier for retail investors. According to InvestmentNews, The House Financial Services Committee on November 4, 2015, approved the Small Business Credit Availability that would allow BDCs to raise their leverage limits from 1:1 to 2:1 and increase the amount of money that they can invest in financial firms among other changes.
Non-Traded BDC investors are likely to face the same dismal returns as Non-Traded REIT investors. Now investors may also be exposed to loss exacerbating leverage if Congress enacts changes to the law. Investors beware.