Popular nontraded BDCs land on regulators' radar

Meeting investors' demand for yield and corporate borrowers' thirst for capital, the increasingly popular investments known as nontraded business development companies are drawing the attention of securities regulators. Although only about five such BDCs, which invest primarily in private company debt, are being offered through independent broker-dealers, the success of the first — FS Investment Corp., launched near the beginning of 2009 — has spurred tremendous interest among representatives. As other sponsors consider launching new products, securities regulators have begun to keep a close eye on these illiquid investments and the sponsors bringing them to market. “We're seeing a strong increase in the number of BDC filers and filings, which have necessitated us to look at whether we should draft a specific review program just for BDC issuers,” said Arkansas securities commissioner A. Heath Abshure.

WELCOMES OVERSIGHT

The largest player in the field is unopposed to such oversight. “It's a difficult and challenging regulatory environment right now, and, in large part, in our space, it's somewhat warranted,” said Michael Forman, chief executive of Franklin Square, the parent company of FS Investment. “We see a lot of scrutiny from the regulators, but we welcome it.” Indeed, independent broker-dealers must tread carefully when offering a BDC, said Tony Chereso, chief executive of FactRight LLC, a due-diligence firm. “Broker-dealers can't underwrite a BDC like a traditional nontraded-REIT or real estate deal,” he said. “They need to understand the caliber of individuals running these portfolios.” Firms should focus on what resources the sponsor has in-house to manage the portfolio and whether those managers have the technical expertise and understanding of the various sectors in which they are buying securities, Mr. Chereso said. Technically, business development companies are closed-end funds regulated under the Investment Company Act of 1940. Congress created them in 1980 in response to what had been a perceived crisis in the capital markets in the 1970s, with the intent to provide access to capital for small and growing companies. BDCs invest in the debt and equity of small to middle-market companies, with the debt instruments ranging from the senior secured level to below-investment- grade, or “junk,” an asset class typically not available to retail investors. There are about 28 publicly traded BDCs, ranging in market capitalization from $10 million to $3 billion, according to a presentation by KBR Capital Partners, Fact Right and law firm Sutherland Asbill & Brennan LLP. A BDC must invest at least 70% of its assets in eligible companies, which effectively means that they serve private or very thinly traded public U.S. companies, according to the presentation. The fact that the Blackstone Group LP is the subadviser to FS Investment clearly has helped that fund gain the attention of the marketplace, executives and reps said. Launched at the end of 2009, FS Investment Corp. posted returns of 33.3% that year and 13.1% in 2010. Year-to-date through June 30, it was up 7.3%. The sales commission in nontraded BDCs typically is 7%, and the product is supposed to be sold only to those investors with a net worth of $250,000 or more, or a net income of at least $70,000 combined with a net worth of at least $70,000. Investors also are supposed to be informed of the product's illiquidity. “It's basically a senior-secured- loan product,” said one Ameriprise Financial Inc. rep, who has sold FS Investment to clients and asked not to be identified because he didn't have Ameriprise's permission to speak. “Within a normal portfolio, we use senior secured loans such as floating-rate funds,” the rep said. “Whereas a publicly traded BDC yields lower, this yields a little bit higher, but you just have to be cognizant of the associated risks.” The lifespan of the nontraded BDC is three to six years, the rep said, adding that caution must be used in allocating to the investment because it is illiquid. FS Investment has raised $1.2 billion in equity capital and now is being sold by reps affiliated with Ameriprise Financial, Commonwealth Financial Network and LPL Financial LLC. FS Investment is “accessing private debt such as senior secured loans to private companies, smaller companies,” said John Moninger, LPL's executive vice president of advisory and brokerage solutions. “Investors are accessing debt they're not going to get in a mutual fund,” he said. “In particular, Franklin Square is buying floating-rate debt, and in an environment when rates are rising, that's good.” Through the end of June, 1,500 LPL reps and advisers had sold the FS Investment fund, Mr. Moninger said. At present, the LPL platform offers two nontraded BDCs, but that number could increase to four or five over time, he said. In assessing these investments, reps and clients should “look at the subadviser,” said Susan Kelly, manager of alternative investment strategies at Commonwealth Financial Network. She pointed to another BDC, Corporate Capital Trust Inc., which is managed by CNL Fund Advisors Co. and KKR Asset Management LLC. “Like Blackstone, KKR is an institutional-quality manager,” Ms. Kelly said. “Do I think they'll do well? They probably will.” Franklin Square recently launched another nontraded BDC, the FS Energy & Power Fund. “While a BDC may list its shares for trading in the public markets, we have elected not to do so. We believe that a nontraded structure is more appropriate for the long-term nature of the assets in which we invest,” FS Investment states on its website. “This structure allows us to operate with a long-term view similar to that of other types of private-investment funds — instead of managing to quarterly market expectations — and to pursue our investment objectives without subjecting our investors to the daily share price volatility associated with the public markets,” according to the website. Email Bruce Kelly at bkelly@investmentnews.com