These High-Fee, Unlisted, Junk-Based Funds Aren’t Working Out
Investors are pulling out as performance slips
An obscure Wall Street product popular in the easy-money years after the financial crisis is starting to show some cracks.
Investors who poured $22 billion into funds called “nontraded business development companies” are now pulling out record sums as the value of those investments flags, according to a review of public filings done for The Wall Street Journal.
The funds carry a number of unusual risks that haven’t provided much of a deterrent to investors reaching for yield amid record-low interest rates. They are built out of loans to small and medium-size companies with less than stellar credit, are less transparent than regular mutual funds, typically make investors pay upfront fees of at least 10% and only accept withdrawal requests once a quarter.
But the move to the exits is accelerating. Investors pulled $47.3 million out of nontraded BDC’s in the third quarter of 2015, up from $25.7 million in the second quarter, according to an analysis by Summit Real Estate Advisory Services.
Performance has been slipping, too. Across the industry, the value of the funds’ assets at the end of September was on average 16% lower than their initial offering price to investors, according to a separate analysis by investment-banking firm Robert A. Stanger & Co. Only one of the 13 nontraded BDCs tracked by Stanger has outperformed the Merrill Lynch U.S. High Yield bond index since its inception.
The performance figures, which go through the third quarter of 2015, are the most recent publicly available.
Nontraded BDCs were part of a fast-growing class of alternative, high-commission investments sold to individual investors in recent years. Marketing materials promised steady dividends, yields as high as 8% and a haven from volatile markets, according to fund documents and executives.
The fees, though, exceed those of most products pitched to retail investors. For example, one nontraded BDC said in its disclosures that its 10% sales load and likely 2% offering expenses mean only $88 of every $100 of shares bought “will actually be invested in us...you would have to experience a total return on your investment of between 14% and 18% in order to recover these expenses.”
A new rule going into effect next month from the Financial Industry Regulatory Authority, which oversees brokers, is designed to give investors a clearer picture of the impact of fees. At least one nontraded BDC has already cut its upfront commission in response.
Meanwhile, Wall Street continues to push the products. In its drive for growth, the industry’s trade association is lobbying in Washington. The largest provider, Philadelphia-based Franklin Square Capital Partners, recently threw a fundraiser for Democratic presidential candidate Hillary Clinton featuring Jon Bon Jovi, according to people in attendance. The firm has thrown similar events for Republican politicians, these people said.
Regulators are watching closely. Paul Mathews, Finra’s vice president for corporate financing, said the products are an “ongoing concern” for the regulator and that “firms must ensure they are suitable for an investor’s risk profile and investment strategy.”
Stanger said nonlisted BDCs raised $341 million in January and February, the most recent data available, down about 48% from about $660 million in the same two months of last year.
Supporters say BDCs play an increasingly important role in the economy by lending to businesses that otherwise couldn’t find funding.
Big financial firms such as Credit Suisse Group AG and KKR & Co. also have launched or supported such funds through partnerships.
Generally, the issuers say the funds are suffering from pressures affecting many investments: volatility in the markets, particularly for junk-rated debt.
The U.S. junk-bond market has returned 3.13% this year through Thursday following a 4.5% decline in 2015, its first loss since the financial crisis.
A spokesman for Credit Suisse declined to comment.
A spokesman for Franklin Square cited the “volatile market” in a statement, adding that the firm has been experiencing “solid net inflows into our funds and redemptions remain at a very low level.”
KKR, which backs Corporate Capital Trust, one of the larger nontraded BDCs, announced the launch of a second fund earlier this month. “Amid the current market volatility, we believe we will continue to see a broad set of investment opportunities in private U.S. companies,” the company said in a statement at the time.
Still, J. Mark Nickell, a financial adviser in Brentwood, Tenn., said he doesn’t ever advise clients to buy private funds. He said he is having a difficult time getting a client’s money out of a nontraded BDC the investor had bought earlier. “To me, there are just red flags all over the place,” he said.
Part of what concerns regulators is that nontraded BDCs are being sold using many of the same networks of brokerage firms and typically charging the same high upfront commissions as nontraded real-estate investment trusts. These REITs, after years of explosive growth, face mounting criticism from regulators and others for their perceived high costs, lack of transparency and poor performance.
“It’s kind of like weeds,” said William Galvin, the top Massachusetts securities regulator. “You whack them in one part of the garden, but they come up in another.”