Monday, February 20, 2012

Déjà Vu: Non-Traded Business Development Companies

By Tim Husson, PhD

Last week we posted an introduction to non-traded REITs that highlighted the many risks inherent to those investments.  As it happens, another non-traded investment has been growing in popularity, but has an almost identical set of risk factors and has recently caught the attention of regulators:  non-traded business development companies (BDCs).

The resemblance between non-traded REITs and non-traded BDCs is uncanny.  Both are special business classes created by Congress in the mid 20th century, whereby investors can pool capital for investments in nonpublic entities and receive most of the BDC's taxable income back in distributions every year.  To qualify as a REIT, those investments must be real estate related; to qualify as a BDC, they are typically privately-owned companies.  While non-traded REITs have been marketed heavily for many years now, non-traded BDCs have only recently found a market:  according to InvestmentNews, non-traded BDCs raised just $94 million in 2009, but $369 million in 2010, and a staggering $1.5 billion in 2011.

Because both non-traded REITs and BDCs must file financial statements and offering documents with the SEC,  under US securities law they are allowed to be sold to retail investors through brokers despite receiving little to no analyst coverage or independent analysis.  Therefore it is up to the broker and investor--really, the investor--to analyze these SEC filings on his or her own, leaving substantial opportunity for misunderstanding and misrepresentation.  Unfortunately, as non-traded investments are almost totally illiquid, it is nearly impossible to get out of these investments.

Also like non-traded REITs, non-traded BDCs appear to maintain constant share prices, even with fluctuating net asset values.  Of course, just like real estate, the value of a non-traded BDC's holdings is difficult to value, as none of its assets have liquid market prices.  But investors should be extremely cautious in evaluating any purported lack of 'price volatility' or 'losses', as share prices are set arbitrarily by the issuer and do not reflect any market value.

Finally, both non-traded REITs and BDCs are sold at very high commission levels, often 7% or higher.  Therefore brokers have a strong incentive to push these investments onto unsophisticated investors; and, of course, only about 90 cents of every dollar invested is actually used to purchase assets.  Unfortunately, investors have been on their own when considering (or attempting to liquidate) their non-traded investments--hence, sites like REITWrecks--so we believe it is time that FINRA and the SEC at least take a closer look at these highly risky products.

[You can find prospectuses and other offering materials for an example non-traded BDC here.  This issuer--you guessed it--also offers several non-traded REITs.]

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