The figures are in and they're miserable. During the first three quarters of this year, BDCs raised just $624 million ($832 million annualized) versus $1.5 billion last year. Worse, capital formation is off from the 2014 peak of $5.5 billion, according to Robert A. Stanger.
This trajectory is all the more disappointing given global trends. Specifically, middle market lending — the bread and butter of BDCs — is one of the hottest alternative investment allocations among institutional investors right now. It's not hard to see why: middle market lending offers attractive risk-adjusted yields, and with floating rates, a good hedge in a rising rate environment.
BEHIND THE FEES
The story behind faltering BDC capital formation is a pretty simple one in our view. Business development companies, which historically depended on large upfront commissions, i.e. 11.5% in some cases, to raise capital, no longer have that option in a post Department of Labor/fiduciary standard environment. While non-traded REITs have alternatives to mitigate the fiduciary standards imposed on fees by spreading them out, BDCs do not.
Some might see the circumstances as dire, but we don't. In our view the current environment is one step along the continuum toward transparent pricing in alternative assets. As far as upfront loads and other hidden and not so hidden fees are concerned, institutional investors would never tolerate these fees and might literally laugh at them.
So why should or would retail investors accept an eye-popping 10% load? Our experience is advisers overall are becoming more aware of all the fees and until issuers get serious about offering a true institutional fee structure their capital raising will likely continue to suffer.
Without the DOL rule, fundraising might have continued in the same manner with the same loads, but we don't think it was sustainable. Sooner or later, rational economics would have taken hold.
To see why, consider the deleterious effects of fee discrimination in the mutual fund industry. Here the complex fee structures of mutual funds — where what you paid depended on who you were — provided a competitive entry point for ETFs. Lower expenses helped, but so too did the realization among individual investors that they were getting the same pricing as institutional investors.
PUTTING INVESTORS FIRST
For an industry that got its start on loads of approximately 10%, a fee structure with no loads might seem like sacrilege. However, investors respond favorably when they feel you're working in their best interest. If you don't charge upfront fees and perhaps, simply an advisory fee of say 1.375% and an incentive fee in the form of a 15% carried interest, capital will more likely return as investors view the product in a more favorable light.
We think that as a model, this fee structure offers important benefits. First, it keeps investors from starting out in the hole. How can an investor truly prosper when $100 allocated nets the just $90 invested? Second, the carried interest represents a practical and appropriate application of incentive.
Specifically, successful private middle market lending requires much more expertise than say global large cap equities, where the universe of opportunities is easy to identify, and liquidity is high.
As the fundraising figures for BDCs demonstrate, the realignment of fees to comply with the DOL rule, and the changing economics of alternative assets, is tough medicine. But still, it's medicine, and we see a bright future for BDCs and their investors.
Robert Grunewald is CEO and founder of Flat Rock Global, an alternative asset manager.