Business Development Companies (BDC) – The Next Risky Wall Street Cash Cow?

shutterstock_57938968Since the financial crisis, the product development squad on Wall Street has been hard at work putting new spins on old ideas. The usual plan is merely to rebrand an old idea with a new label and convince investors looking for the latest and greatest product that the investment will provide outsized yield with less risk. It’s no coincidence that these new ideas make lots of money for the brokers selling them.

Enter the non-traded business development companies (BDCs). Now that many regulators and investors have begun to wise up and sour on the high commission and uncertain return approach offered by non-traded REITs, BDCs have entered into the fray as the non-stock market, non-real estate, high yield alternative. However, BDCs appear to be just as speculative – likely even more so – and inappropriate for most investors as non-traded REITs with many of the same failings such as obscenely high up-front fees, limited liquidity, and reliance on leverage to juice returns.

BDCs make loans to and invest in small to mid-size, developing, or financially troubled companies. 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. While BDCs are not new, until very recently the market has been served by publicly traded closed-end funds that act like private equity firms. Just like the market was served just fine by publicly traded REITs before the non-traded variety showed up on the scene. One would think that the publicly traded BDCs provided high enough returns and were risky enough for even the most speculative investor considering that during the last downturn some of the funds fell by 60%, 70% or more. But greed is good.

The private placement BDCs offer higher fees, less and perhaps in some cases no liquidity, and less transparency than their publicly traded counterparts. Non-traded BDCs utilize a REIT-like structure and promote very high yields of 10% or more. There are some differences between BDCs and non-traded REITs such as BDCs are regulated under the 1940 Act that governs mutual funds. The is also a big difference in valuation in that a BDC is valued quarterly, while non-traded REITs publish their valuations no later than 18 months after the offering period.

According to a Wealth Management Article front-end load fees on BDCs are typically around 11.5 to 12 percent. In addition, BDCs also typically have an incentive structure which is referred to as a “two and twenty,” where the fund charges two percent of assets in management fees and 20% of capital gains based upon performance. As in the case of non-traded REITs, non-traded BDCs promise to start investors way behind the starting line with high fees that require the investor to make large gains just to break even.

Since 2012, the market for BDCs has been growing. In 2012, there were four non-traded BDCs available with another six funds in registration at that time. According to InvestmentNews, sales of illiquid BDCs last year jumped to $4.8 billion from $2.8 billion in 2012, a 70.8% year-over-year increase. In addition, many of the new players seeking to capitalize on the BDC wave including CNL Securities, using Kohlberg Kravis Roberts & Co. as subadvisor; ICON Investment using Apollo Investment Management as its subadvisor; and American Realty Capital all have a background issuing non-traded REITs. This begs the question, where did all of these real estate companies suddenly develop expertise in making private equity investments? Do these real estate players really understand this type of credit risk? Only time will tell.

However, history has always shown that whenever many investors jump on the same trend in the same sector dramatically increasing the amount of funds available, losses often follow in large quantities as unjustified risks are taking.