B. Riley retail brokers exposed to deal that's under pressure

In August, B. Riley Financial Inc., which provides services ranging from investment banking to wealth management, said it had invested $216.5 million as part of the $2.8 billion management-led acquisition of Franchise Group Inc.

Now the Franchise Group's CEO, Brian Kahn, is under scrutiny, after a report that Kahn has links to a hedge fund manager who pleaded guilty of fraud.

And some B. Riley brokers and financial advisors are facing uncomfortable conversations with clients. Many of those advisors were acquired as part of B. Riley's purchase last year of National Securities Corp. and raised money for a portion of the funding of the buyout.

"Around $30 million to $40 million raised for the Franchise Group was from retail brokers," said one industry source, who asked not to be identified. "The brokers are besides themselves, especially the independent brokers, the National Securities guys.”

Other institutional, financial and strategic investors invested approximately $280 million of additional equity capital in the new Franchise Group, also known as FRG, alongside significant rollover equity contributions from the company's management, according to a B. Riley press release from August. The management-led consortium acquired all the outstanding and issued common and preferred stock of Franchise Group, which controls franchise businesses such as Pet Supplies Plus, Wag N’ Wash and The Vitamin Shoppe.

B. Riley said Nov. 8 that it was forced to mark down the value of its equities portfolio, resulting in a net loss of $75.8 million in the third quarter, compared with a profit of $45.8 million a year earlier, according to a Reuters report. The next day, S&P Global Ratings downgraded the credit rating of Franchise Group to "B-" from "B" with a negative outlook, after the company reported a decline in revenue and a net loss in the third quarter.

"Our investigation first and foremost is focused on B. Riley," said Reed Kathrein, a plaintiff's attorney and partner at Hagens Berman Sobol Shapiro. "The issue is whether B. Riley knew what Kahn was doing."  

“The comment from an anonymous source about our brokers’ reaction does not even remotely reflect what has actually happened," a B. Riley spokesperson wrote in an email. "We have been in close contact with our investors and brokers on the FRG transaction, and we remain enthusiastic about the prospects for FRG as a private company.”

A spokesperson for Franchise Group did not return a call Thursday to comment.

According to Reuters, S&P also said it was monitoring legal developments relating to Franchise Group's Kahn. Bloomberg reported this month that Kahn is one of two co-conspirators named by John Hughes, co-founder of hedge fund Prophecy Asset Management, who this month pleaded guilty to securities fraud, according to the Reuters report. It's not clear whether Kahn is also facing charges.

Kahn told Reuters earlier that he was not involved in any fraud. "At no time during my former business relationship with Prophecy did I know that Prophecy or its principals were allegedly defrauding their investors, nor did I conspire in any fraud," Kahn said in a statement to the news organization.

Bryant Riley, chair and co-CEO of B. Riley, gave his full-throated approval of the firm's investment in Franchise Group during an earnings call with analysts on Nov. 9.

"I think there's noise out there, so I want to address it and be crystal clear," Riley said. "We would have bought all of Franchise Group. We are a huge fan of that business, and it's a really simple analysis. They have a great steady [earnings before interest, taxes, depreciation and amortization] in Vitamin Shoppes."

Meanwhile, the share price of B. Riley, which trades on the Nasdaq, has been on a tempestuous ride this week. On Nov. 7, the day before the company's earnings announcement that revealed the drop in earnings, its shares closed at $34.78. Thursday, B. Riley shares closed trading at $22.04, a decline of 36.6% over six days.