Call a Spade a Spade

I remember the first time I sat through a product pitch I could not understand. It was a sales presentation for the equity tranche of a subprime mortgage CDO (collateralized debt obligation) back in 2007. You may have read about these products, and how they almost brought down the global financial system. This pitch was garbage, to put it nicely. The equity tranche owners of a CDO are the last investors to get paid if any of the underlying loans default. For this privilege, clients received a juicy interest rate a little higher than long-term bonds. High risk, small reward.

Financial salespeople bombard clients with pitches for crappy investment products all the time. You can tell a piece of crap because it will display the following three characteristics:

  1. High Fees
  2. Too Complicated to Explain to a Sixth Grader
  3. A Motivated and Pushy Salesperson

Today’s iteration of this pitch are BDCs (business development companies).

A BDC is a closed-end investment fund and public company with shares traded on a major stock exchange. The original intent of BDCs was to allow small, non-accredited investors to invest in start-up companies. These non-accredited investors cannot access such investments through private investments such as venture capital funds, hedge funds, and limited partnerships. Your antenna should be up at this point.

New BDC creation looks like this.  It begins with a period of illiquidity for the first investors.  The entity sponsoring the BDC (the distributor) hires an underlying investment manager to invest the proceeds in a variety of equity investments and/or loans to risky companies. The distributor pays up to a 12% commission for “advisors” to sell the product their clients.[1]

During the fund-raising period, clients fork over 100% of their committed capital. The manager charges the full 2-3% management fee on a levered portfolio while part of the funds may sit in cash. Once the fundraising period is over (the timing of which is unknown in advance), the BDC is listed on an exchange, allowing investors liquidity to exit the product. I’ve seen clients sitting in these products for over 3 years with limited liquidity.[2]

This is one of several products promising individual investors an “opportunity” to lend money to risky companies. The rationale is that banks are burdened with regulation in the wake of the financial crisis, and they no longer offer this financing. These strategies involve the use a leverage to juice returns, and all of them charge exorbitant fees, including hefty sales commissions.

Why do these growing companies need money from smaller, non-accredited investors? There is no shortage of capital. Venture capital firms are throwing hundreds of millions of dollars at unprofitable start-up companies daily for fear of missing the next Uber or Netflix.

These products are nothing more than a money grab from “retail” investors. Wall Street may have changed its stripes, but it’s the same story, different day. If you are being sold something that is: expensive, complicated, and brought to you by a pushy salesperson, the easy answer is no.

 

[1] I’m told 12% sales charges went away when the DOL Fiduciary Rule was supposed take effect, but 5.75% sales charges are still advertised.

[2] Most BDCs offer quarterly liquidity with 90 days’ notice but reserve the right to limit withdrawals.

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