Tuesday, November 26, 2013

BDCs as the New REITs

By Tim Husson, PhD

Brendan Conway at Barrons had an interesting piece back in September about business development companies (BDCs) and their similarities to real estate investment trusts (REITs).  His story highlighted that BDCs in some sense resemble REITs in the 1990s, in that they are considered "previously exotic areas that went mainstream."  Indeed, we are seeing more and more coverage of BDCs in the mainstream media, along with the troubling development of non-traded BDCs, just as we have seen non-traded REITs.

We discussed the similarities between non-traded BDCs and non-traded REITs back in February 2012.  Essentially, both BDCs and REITs are unique types of companies that are required by the IRS to distribute the vast majority of their earnings as dividends each year.  REITs invest in real estate, while BDCs invest in privately owned companies.  There are a number of traded REITs and BDCs on the New York Stock Exchange, which in turn are held by REIT or BDC mutual funds and exchange-traded funds.

But there are also a growing number of non-traded BDCs.  Non-traded BDCs, like non-traded REITs, are not traded on a public exchange, but are sold to retail investors through brokers who receive very large sales commissions.  The total upfront fees for non-traded BDCs are very high; for example, the most recent prospectus for Corporate Capital Trust notes upfront sales loads of 10%.  In addition, non-traded BDCs also charge '2-and-20' management fees:  2% of total assets plus 20% of profits.  This fee structure is characteristic of hedge funds--where it is widely criticized--but not of retail investments.

So just as we warned investors that non-traded REITs are not the same as traded REITs, we also want investors to appreciate the difference between traded and non-traded BDCs.  But this issue raises a larger question.  Given that there are traded BDCs and REITs, which can be bought and sold as cheaply as any other stock, are high-cost non-traded BDCs and REITs ever appropriate?  After all, they are in the same market for properties or private companies.  Is there any reason to believe that non-traded REITs or BDCs would be able to pick better investments than than their publicly listed counterparts?  We think the answer is no.

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