Non-Publicly Traded BDCs: Dumb Investment of the Week by Ben Strubel of Strubel Investment Management
Our Dumb Investment of the Week is private equity investments in the form of Business Development Companies or BDCs. Investors can access BDCs through various methods including publicly traded BDCs, BDC index funds and ETFs, and non-publicly traded BDCs. It is the non-publicly traded BDCs, like non-publicly traded REITs, that are truly heinous. Non-publicly traded BDCs have no reason for existing, let alone appearing in investor portfolios.
There have been numerous articles written cautioning investors against non-publicly traded BDCs. In response to one of those articles, the CEO of Franklin Square published a rebuttal defending non-publicly traded BDCs and his company’s offerings.
I decided to take a deeper look at Franklin Square’s latest offering: FS Investment Corporation III or FSIC III. After reading through the prospectus, the three biggest issues I found were high fees, misaligned management incentives, and a fee structure that encourages excessive risk taking.
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High Fees Are Rampant
Upfront fees include selling commissions of 7%, dealer management fees of 3%, and offering expenses of 1.5%. That is 11.5% of expenses before the company makes any investments.
Ongoing fees are just as onerous and include a litany of management fees, incentive fees, interest payments, and other expenses. The graphic below was taken from the prospectus and shows a breakdown of all of the fees.
Notice what’s missing? There is no incentive fee listed in the table. (SEC regulations require fees to be calculated based on a hypothetical 5% return.) So, hey, if this thing does work out and you make more money you get to look forward to some more fees.
What fees? Twenty percent of “pre-incentive fee net investment income” after meeting a 1.875% (or 7.5% annual) hurdle rate. Miss the hurdle rate for a few quarters? No worries. FSIC III Advisor has itself covered and gets to pocket a “catch up” fee to siphon off any quarterly income between 1.875% and 2.34375% (9.375% annually) of adjusted capital to make up for lost fees. After it takes all of that income, its fees will revert back to just 20%. The prospectus includes the passage and graphic below, explaining how the fees work.
Once our pre-incentive fee net investment income in any quarter exceeds the hurdle rate, FSIC III Advisor will be entitled to a “catch-up” fee equal to the amount of the pre-incentive fee net investment income in excess of the hurdle rate, until our pre-incentive fee net investment income for such quarter equals 2.34375% of adjusted capital, or 9.375% annually. This “catch-up” feature allows FSIC III Advisor to recoup the fees foregone as a result of the existence of the hurdle rate. Thereafter, FSIC III Advisor will receive 20.0% of pre-incentive fee net investment income.
The amount of fees Franklin Capital is extracting is simply mind-boggling. It makes the traditional “2 and 20” charged by hedge funds look like the deal of the century!
Management’s Investments Are Not What They Seem
One of the most important things to look at when considering possible investments is what management is doing with their own money. When management is investing a significant amount alongside regular retail investors, it’s usually a good sign.
What is Franklin Square management doing with respect to investing in FSIC III? From the prospectus:
In October 2013, pursuant to a private placement, Michael C. Forman and David J. Adelman, the principals of FSIC III Advisor, contributed an aggregate of $200,000, which was used in its entirety to purchase approximately 22,222 shares of common stock at $9.00 per share…
In addition, we are currently conducting a private placement of shares of our common stock to certain members of our board of directors and individuals and entities affiliated with FSIC III Advisor and GDFM. We expect to issue the shares purchased in the private placement at $9.00 per share.
Not only is management investing an almost insignificant amount, $200,000 plus an unspecified additional amount, they are purchasing the shares at a sweetheart price of only $9. Retail investors? They have to pay $10 per share.
The Franklin Square website says that the sponsor commitment for FSIC III was $12M as of April 2, 2014. Additionally the website brags that Franklin Square and Blackstone have committed $100M across all funds. Below is a screenshot of the graphic from Franklin’s website.
In fact, based on how frequently and prominently it is mentioned in marketing materials, it appears Franklin Square is using the fact that a Blackstone subsidiary serves as sub-advisor to the fund and has committed what appears to be a substantial amount of money to Franklin Square funds as a major marketing point.
While $100M may seem like a large number on the surface, it actually isn’t when taken in context. As per the sub-advisory agreement GDFM (the Blackstone subsidiary) receives 50% of all fees:
The sub-advisory agreement provides that GDFM will receive 50% of all fees payable to FSIC III Advisor under the investment advisory and administrative services agreement with respect to each year.
Franklin Square manages $9,185M across four funds FSIC, FS Energy and Power, FSIC II, and FSIC III that a Blackstone subsidiary serves as the sub-advisor for. If Blackstone earns only the minimum fees each year (half of 2%) Blackstone subsidiaries would be receiving $91.85M per year in advisory fees.
Both Blackstone and Franklin Square earn far more in fees than they would from their investments in their own offerings! This leads to the next point, hidden risks.
Hidden Risks Loom Large
The prospectus includes two key passages that sum up the risks investors face from this fee arrangement.
GDFM transaction sourcing capability. FSIC III Advisor will seek to leverage GDFM’s significant access to transaction flow. GDFM seeks to generate investment opportunities through syndicate and club deals (generally, investments made by a small group of investment firms) and, subject to regulatory constraints as discussed under “Regulation” and the allocation policies of GDFM and its affiliates, as applicable, also through GSO’s proprietary origination channels. We believe that the broad network of GDFM will produce a significant pipeline of investment opportunities for us. GDFM also has a significant trading platform, which, we believe, will allow us access to the secondary market for investment opportunities.
GDFM has no incentive to give FSIC III the best deals; GDFM’s investment across all Franklin funds is minimal compared to the amount they generate in fees. Financial it appears to make sense for The Blackstone Group L.P. (NYSE:BX) and it’s subsidiaries to focus on maximum fee extraction rather than investment returns.
But perhaps the largest risk to investors is how Franklin and Blackstone get paid. The annual fees are calculated based on gross, not net, assets. This means that the managers are incentivized to use as much leverage (borrowed money) as possible to increase the amount of gross assets and hence the amount of fees. From the prospectus:
FSIC III Advisor and its affiliates will receive substantial fees from us in return for their services, and these fees could influence the advice provided to us. Among other matters, the compensation arrangements could affect their judgment with respect to public offerings of equity by us, which allow the dealer manager to earn additional dealer manager fees and FSIC III Advisor to earn increased asset management fees. In addition, the decision to utilize leverage will increase our assets and, as a result, will increase the amount of management fees payable to FSIC III Advisor.
The other problem is that a lot of the assets in the fund are going to be illiquid. Discretion for determining the value is left up to the board with assistance from management. From the prospectus:
A significant portion of our investment portfolio will be recorded at fair value as determined in good faith by our board of directors and, as a result, there will be uncertainty as to the value of our portfolio investments.
Again, the issue of conflicts of interest looms large. What incentive does management and the board have to record values that might show large fluctuations in share price when one of the selling points to investors in the fund was stable share prices?
While I’m not a fan of BDC stocks in general (for reasons I’ll reveal in a later column), if investors insist on exposure to the BDC sector, my suggestion is to stick with publicly traded companies or an index ETF such as BDC Income ETF (BIZD).