Brokers across the U.S. are tapping into demand for high-yield debt, and drawing regulatory scrutiny, by pushing investors into pools of risky loans that have extracted more in fees than they’ve paid out in profit.
Sales of junk-rated debt funds known as non-traded business-development companies doubled to a record $2.8 billion last year, according to estimates by MTS Research Advisors, a Gilbert, Arizona-based consulting firm. Franklin Square Capital Partners, the Philadelphia firm that created the securities about four years ago, said it took in $134 million of revenue last year, much of that passed on to Blackstone Group LP (BX:US), which picks the loans and manages the portfolios.
The funds take investor money and lend it to companies including private-equity owned BJ’s Wholesale Club Inc. and Safariland LLC, a maker of police gear. The investments are luring individuals with annual payouts of about 8 percent and access to managers including Blackstone and KKR & Co. (KKR:US) Brokerages generally take 10 percent upfront, several times the amount charged by similar junk-loan mutual funds, while management and performance fees rival those of hedge funds.
“We’re helping corporate America, especially on the smaller company side, get access to capital,” said Gurpreet Chandhoke, a Redwood City, California-based managing partner of VII Peaks Capital LLC, which started a fund last year. “In the next five years, business-development companies will get to $8 billion to $10 billion a year.”
The funds are sold by brokers at firms such as Boston-based LPL Financial Holdings Inc. and Ameriprise Financial Inc. (AMP:US) In addition to the upfront commissions, investors generally pay 2 percent management fees and about 20 percent of returns, Jonathan Bock, a Wells Fargo & Co. analyst, wrote in a January report.
Investors in Franklin Square’s initial $2.5 billion fund have paid a total of $323.5 million in commissions and fees since 2008, Bock wrote in the report. That’s 25 percent more than the $258 million it has distributed to investors, according to data compiled by Bloomberg.
Non-traded business-development companies on average have generated $2.40 in fees for every $1 in profit delivered to investors, according to Bock.
“There are certain products that are bought,” said Troy Ward, a research analyst at St. Louis-based Stifel, Nicolaus & Co. “This is definitely a product that’s sold.”
The rapid increase in sales has drawn scrutiny from the Financial Industry Regulatory Authority, which said in a January letter to brokers that monitoring the investments is among its priorities this year. The non-traded securities may be hard for investors to sell, according to Finra.
Spokesmen for Bank of America Corp.’s Merrill Lynch and Wells Fargo said their companies don’t sell the funds. Morgan Stanley (MS:US), owner of the world’s largest brokerage, has sold them on “rare occasions,” said Christine Jockle, a spokeswoman for the New York-based firm.
Stifel’s Ward also said he’s told his firm’s brokers to avoid the securities. Non-traded business-development companies invest mostly in corporate debt known as syndicated loans, which are also held in low-cost mutual funds, he said.
“Syndicated loans at that expense level, they just can’t deliver a quality return,” Ward said. “The math just doesn’t work.”
Business-development companies have been around since the 1980s. There are several listed on stock exchanges that don’t charge upfront fees and can be good investments, Ward said. The funds generally raise money from investors, borrow more and then lend it to smaller private companies.
They’re able to charge high interest rates on the loans because the borrowers are generally rated junk, meaning at higher risk of going bankrupt, or don’t have ratings at all. The debt generally pays a floating rate, meaning investors will earn more if benchmark interest rates rise.
Franklin Square, run by Chief Executive Officer Michael Forman, 52, and real estate investor David Adelman, created the unlisted version in 2008, as brokers were raising billions of dollars selling another type of non-traded investment, real estate investment trusts.
“It’s really about bringing institutional-quality alternatives to the investing public,” Forman said in a phone interview. “Everybody wants to invest in alternatives.”
Franklin Square’s pitch is that the new structure allows investors who don’t have enough money to buy private-equity or hedge funds to diversify into loans to smaller companies, according to its website, which features an explanatory video illustrated with photos of a smiling couple hugging. The minimum investment is $5,000.
“As these are private investments, there are fewer investors and much less competition, which can result in better terms and returns,” according to the video. “Only large investors like endowments, pension plans and financial institutions could afford to enter this world.”
Franklin Square offered other broker-dealers, along with a brokerage it runs itself, 10 percent of the money raised for FS Investment Corp., its initial $2.5 billion fund, according to a 2008 regulatory filing. About 10,000 brokers have sold the funds, Forman said.
About half of the securities held by the Franklin Square business-development company overlap with the holdings in large bank-loan mutual funds, according to Stifel’s Ward. Those mutual funds are available with small upfront costs and an average annual fee of 0.9 percent, according to Sarah Bush, an analyst at Morningstar Inc. in Chicago.
“They’re not giving you access to something you can’t otherwise have,” Ward said.
Forman disputed that analysis. The fund’s returns are bolstered by loans that New York-based Blackstone’s credit arm, GSO Capital Partners LP, puts together itself and the fees are reasonable when spread over time, he said.
“We don’t think the fees on these products are all that much different than we see with variable annuities or with mutual funds,” Forman said.
Peter Rose, a Blackstone spokesman, said the firm’s partnership with Franklin Square has led to an “excellent investor experience.”
Still, investors would have done better buying publicly traded business-development companies, said Bock, the Wells Fargo analyst. Franklin Square’s fund returned a total of 71 percent since it started making loans at the beginning of 2009 through the third quarter of last year, he said, compared with a 150 percent gain for an index of such companies.
The average bank-loan mutual fund returned 73 percent in the period, Morningstar’s Bush said.
Finra said in the Jan. 11 letter that it’s looking into the risks of both traded and non-traded business development companies. Nancy Condon, a spokeswoman for the Wall Street-funded regulatory group, declined to comment.
Since Franklin Square’s success, there have been a flurry of new non-traded business-development companies. CNL Financial Group Inc., a closely held real estate investment company based in Orlando, Florida, raised about $800 million for Corporate Capital Trust, which is managed by KKR, the New York-based private-equity firm, said Monty Hagler, a spokesman for CNL.
Andrew Hyltin, CEO of Corporate Capital Trust, said in an interview that the fees are fair and the securities give investors access to the same sophisticated strategies that pension funds use.
“Where else would a guy with $5,000 go to do that?” Hyltin said.
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