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, 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. 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. 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, 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.