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Are Nontraded Business Development Companies The Next Big Problem For Brokerage Firms?

 November 29, 2012 06:27 PM

With non-traded REIT sponsors moving in to the new nontraded business development companies (nontraded BDCs) space, are nontraded BDCs the next bubble?

BDCs are closed-end funds regulated under the Investment Company Act of 1940. Congress created them in 1980 in response to what had been a perceived crisis in the capital markets in the 1970s, with the intent to provide access to capital for small and growing companies.

BDCs invest in the debt and equity of small to mid-market companies, with the instruments ranging from the senior secured level to below investment grade or "junk," an asset class typically not available to retail investors.

Some of the largest BDC companies are FS Investment Corp. II, Corporate Capital Trust, FS Energy Power Fund, Business Development Corp. of America, VII Peaks- KBR Co- Optivist Income BDC II, Sierra Income Corp., and HMS Income Fund.

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According to a report in the Investment News, nontraded BDCs continue to enjoy strong sales from independent contractor reps and advisers.  As such, these products appear to be being sold by the small broker-dealers, just as non-traded REITs were.

Nontraded BDCs apparently raised almost $592.4 million in the third quarter and $820 million in the second quarter.  This represents a large influx of capital in to these investments and certainly raises the question as to whether all investors buying in to this space have the sophistication to understand the pitfalls of these high return, high risk investments.

Nontraded BDCs became popular in 2009 with the launch of the first such fund, FS Investment Corp. Its success spawned many other funds.

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Another question about the product is the role of nontraded real estate investment trust sponsors. A number of nontraded REIT sponsors have BDC offerings, which raises the question of whether real estate managers have the knowledge and background to invest in a potentially volatile area such as private-company debt.

The risk, of course, is that these products (similar to nontraded REITs) get sold to the wrong investors (i.e. retirees attracted to the high yield but unaware of the enormous risks) or that the investment sponsors lack the expertise to properly vet these offerings and sell BDCs with higher risk than is disclosed to the investors.

The Investment News report indicates that several real estate sponsors are working with outside managers to launch nontraded BDCs. For example, CNL Financial teamed up with leading global alternative asset manager KKR & Co. LP last year to launch Corporate Capital Trust.



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