Is Franklin Square Capital Partners, the sponsor of a series of nontraded business development companies, starting a price war in the nontraded investment industry?
Franklin Square, with $17 billion in assets under management, may have lobbed its first grenade last fall when it filed the prospectus for its latest nontraded BDC, FS Investment Corporation IV. In its past BDCs, Franklin Square, like the vast majority of nontraded BDCs and real estate investment trust sponsors, have capped the total commissions paid to broker-dealers and registered reps at a hefty 10%.
(More: SEC's Mary Jo White rips bill to ease restrictions on BDCs)
Ten percent for commissions and underwriting fees is the maximum allowed by industry rules. Ten percent for illiquid investment products like nontraded REITs and BDCs have been the standard for REIT and BDC sponsors, managers and the broker-dealers that sell the products.
Indeed, when I have asked industry executives over the years why they have slavishly adhered to the 10% rule and asked whether it could ever go down, they typically responded by going all M.C. “U Can't Touch This” Hammer on me.
But the independent broker-dealer industry has faced a torrent of criticism for being tied at the hip to nontraded product sponsors for that eye-popping 10%. When selling a nontraded BDC or REIT, the broker is typically paid 7%, his broker-dealer takes 1% or 2%, and the wholesale broker or manager, which is usually controlled by the product sponsor, takes the rest.
That 10% fee structure, which can be onerous to the investor if a deal goes sour, may finally be changing. FS Investment Corporation IV just sliced off 105 basis points from the standard commission and underwriting fee nontraded BDCs and REITs typically charge clients.
According to the company's prospectus, which was filed in October, the BDC is placing a hard cap on fees and commissions and will stop paying fees to reps and broker-dealers when the “total underwriting compensation” equals 8.95% of gross offering proceeds. The BDC, which broke escrow this month, is seeking to raise $2.65 billion and will invest in senior secured debt of private middle market U.S. companies. It's currently being sold at $10.60 per unit as a “T share,” a share class that pays less of an upfront commission to the broker but creates an annual trailing commission.
(More: Franklin Square's Kelly: Growth, consolidation on tap in the BDC space)
One Franklin Square executive wasn't about to admit to launching a price war with its competitors.
“I don't see it that way,” said Zachary Klehr, executive vice president with Franklin Square. “The product's price is an important component and investors should look at it, but there are many fabulous features for investors in the 'T share' class.”
It appears, however, that there is a bit of pricing voodoo in Franklin Square's ability to undercut its competition. In FS Investment Corp IV, the sponsor, Franklin Square, is kicking in 27 cents per share for a commission to the broker, thus allowing for a greater amount of the investor's money to go to work and buy assets. Part of the trailing commission pays back the sponsor over time.
“The sponsor advancing commission, the alignment of interests between investors, advisers and the sponsor, that should generate a positive outcome for all,” Mr. Klehr said.
The cut in underwriting compensation by Franklin Square comes at a time of incredible change for the nontraded investment industry, which took a huge hit last year. According to investment bank Robert A. Stanger & Co., nontraded REIT sales in 2015 dropped 36.1% from a year earlier to slightly less than $10 billion. Over the same time, nontraded BDC sales decreased 28.9% to $3.9 billion.
There is no doubt that the Department of Labor's proposed fiduciary rule for retirement accounts and the Financial Industry Regulatory Authority Inc.'s new account statement rule to take effect in April have contributed to that drop.
While it is often roundly criticized by the brokerage industry for being ineffectual, Finra has gone through the hard work of making its new account statement rule. Finra's goal was to bring greater pricing transparency to illiquid products and to put more investor money to work immediately rather than in the pockets of advisers and their broker-dealers.
Franklin Square's new offering raises the question of whether other nontraded REIT and nontraded BDC sponsors are living up to the spirit of the rule, who's intent is to lower costs for the products. Nontraded BDCs and REITs remain attractive to some investors because they promise a stream of income in a near-zero interest rate environment.
Is Franklin Square truly trying to shake up the nontraded investment industry, which has been criticized for selling high-priced products to unwary investors? Or is the firm simply making a good marketing play by capping commissions at 8.95% for its newest offering?
