Business Development Companies (BDC) – Investment Risks to Be Aware of – Part II

shutterstock_92699377In our prior post we recently highlighted, the rising popularity of non-traded business development companies (BDCs). BDCs may be one of the latest and greatest products that Wall Street is promoting that will provide outsized yield with less risk. As usual, these “new ideas” end with brokerage firms making lots of money and investors suffering the consequences.

BDCs make loans to and invest in small to mid-size, developing, or financially troubled companies. BDCs now fill the role that many commercial banks left during the financial crisis to lend to those companies with questionable credit. While BDCs are not new products, until very recently investors had only publicly traded closed-end funds that acted like private equity firms to invest in. These funds are risky enough. During the last downturn some of the publicly traded funds fell by 60%, 70% or more.

Like their non-traded REIT cousins, non-traded BDCs utilize a non-traded REIT-like structure and promote very high yields of 10% or more. There are some differences between BDCs and REITs, BDCs are regulated under the 1940 Act that governs mutual funds. There is also a big difference in valuation. BDCs are 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 fees on BDCs range around 11.5 to 12 percent. BDCs also employ an incentive structure referred to as a “two and twenty,” where the fund charges two percent of assets in management fees and 20% of capital gains for performance. As in the case of non-traded REITs, non-traded BDCs investors need to make large gains just to break even.

A Forbes article tracked the fundraising efforts made by several DBCs issued by FS Investment Corp. The DBCs are sold through financial advisers and broker dealers with LPL Financial and Amerprise. Franklin Square’s advertising sells the BDCs as a way to be part of an exclusive investment club. According to the Forbes article, a video on the website features the message that, “Only large investors like endowments, pension plans and financial institutions could afford to enter this world,” of investing in private companies. The video then cuts to an a picture of a unhappy middle-aged couple and the narrator promises that now there is a way for investors without million-dollar accounts to enjoy many of the same benefits as institutions. The problem is institutions would probably never be caught investing in these non-traded BDCs in the first place.

In addition, when Forbes looked at the BDCs returns, the investments appeared hard to justify.  FSIC and FSIC II had returns of 5.2% through June 30 2013, and FS Energy and Power returned 4.8%. The Wells Fargo BDC Index, an index that tracks a basket of BDCs returned 5.58%. Moreover, for the full year 2012 FSIC and FS Energy & Power returned 15.8% and 14.07% respectively while the index returned 34.48%. The FS Investment funds not only fell behind the indexes but also trailed publicly traded funds in the same space including Main Street Capital (53.5%), American Capital Mortgage (45.5%), Prospect Capital (30.7%) and Fifth Street Finance (21.8%).

A the spokeswoman replied that “While the funds may trail listed BDCs when markets rally, they may or could significantly outperform when markets fall.” However, in my opinion it is more likely that investors will be misled during market downturns due to conflicts of interests that will unfairly value the funds providing investors with a false sense of security. History has shown that when the dividends drop or dry up completely a few years after the downturn only then will investors realize that the lofty valuations aren’t matching reality.

The attorneys at Gana LLP are experienced in representing investors in cases involving flawed or unsuitable investment products. Our consultations are free of charge and the firm is only compensated if you recover.