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Articles Posted in Business Development Companies (BDCs)

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Money MazeBased upon recent secondary market pricing, investors in certain publicly registered, non-traded business development companies (“BDCs”), may have suffered losses on their illiquid investments.  In the wake of the 2008 financial crisis, many retail investors have been steered into so-called non-conventional investments (“NCIs”), including non-traded REITs and BDCs, often premised upon a sales pitch or marketing presentation from a financial advisor touting the investment’s lack of correlation to stock market volatility and enhanced income via hefty distributions.  Unfortunately, in some instances, investors were solicited to invest in such NCIs without first being fully informed of the risk components embedded in these products.

In January 2017, FINRA issued the following guidance with respect to investments in non-traded NCIs:

“While these products can be appropriate for some customers, certain non-traded REITs and unlisted BDCs, for example, may have high commissions and fees, be illiquid, have distributions that may include return of principal, have limited operating history, or present material credit risk arising from unrated or below investment grade products. Given these concerns, firms should make sure that they perform and supervise customer specific suitability determinations. More generally, firms should carefully evaluate their supervisory programs in light of the products they offer, the specific features of those products and the investors they serve.”

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Money MazeSierra Income Corporation (“SIC”) recently extended a tender offer to its shareholders, which terminated on December 22, 2017, offering to purchase shares for $7.89 a share.  SIC is a publicly registered, non-traded business-development company (“BDC”).  This non-traded BDC invests primarily in first lien senior secured debt, second lien secured debt, and certain subordinated debt of middle market companies with annual revenue between $50 million and $1 billion.  Investors who participated in the tender offer likely sustained losses on their initial capital investment at $10 per share (exclusive of fees, commissions and any distribution income received).  According to publicly available information, a total of 4,923,026 shares were validly tendered.

According to publicly available information, SIC is externally managed by SIC Advisors LLC, which in turn, is affiliated with Medley Management (NYSE: MDLY, “Medley”).  Medley operates a national direct origination franchise through which it seeks to market its financial products, including SIC.  As of December 31, 2016, Sierra reported that it had raised in excess of $900 million in connection with its equity capital raise.

Investors who purchased shares in SIC’s offering acquired shares at $10 per share.  Further, as outlined in SIC’s prospectus, investors who participated in the offering were subject to hefty up-front fees and commissions of nearly 10%, including a “selling commission” of 7.00%, in addition to a “dealer-manager fee” of 2.75%.

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As we highlighted in a previous blog post, investors in FS Energy and Power Fund (“FSEP” or the “Fund”) may be able to recover losses on their investment in arbitration through arbitration before the Financial Industry Regulatory Authority (“FINRA”), if the recommendation to invest in FSEP was unsuitable, or if the broker or financial advisor who recommended the investment made a misleading sales presentation.  Headquartered in Philadelphia, PA, the Fund is structured as a non-traded business development company (“BDC”) that invests primarily in the debt of a portfolio of private U.S. energy and power companies.

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BDCs first emerged in the early 1980’s when the U.S. Congress enacted legislation that amended the federal securities laws.  These legislative changes allowed BDCs — which are a type of closed-end fund — to make investments in developing companies and firms.  BDCs are in the business of providing various debt and mezzanine financing solutions for small and medium-sized businesses that otherwise could not access credit in the same way as more established companies.

By providing credit solutions to less established companies, BDCs frequently collect much higher than average interest income and seek to pass along such income to investors in the form of dividends.  While an investment in a BDC may seem like an attractive option for an investor seeking enhanced income, our office has frequently encountered situations in which financial advisors recommended unsuitable nonconventional investment products to their clients, including non-traded BDCs, such as FSEP.

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financial charts and stockbrokerInvestors in Business Development Corporation of America (“BDCA”) may be able to recover losses on their investment through initiating an arbitration proceeding with FINRA Dispute Resolution, if a broker or financial advisor made the recommendation to invest in BDCA without a reasonable basis, or misled the investor as to the nature of the investment.  BDCA is a non-traded business development company headquartered in New York, New York.  As a business development company (“BDC”), BDCA focuses on providing flexible financing solutions to various middle market companies, including first and second lien secured loans and debt issued by mid-sized companies.

As an investment vehicle, BDCs first emerged in the early 1980’s following legislation passed by Congress making certain amendments to federal securities laws.  These legislative changes allowed for BDC’s — types of closed end funds — to make investments in developing companies and firms.  Many brokers and financial advisors have recommended BDCs as investment vehicles to their clientele, touting the opportunity for retail investors to earn enhanced dividend income while participating in private-equity-type investing previously unavailable to the average retail investor.

While BDCs may arguably offer an attractive investment opportunity, non-traded BDCs, such as BDCA, are very complex and risky investment products.  Non-traded BDCs, as their name implies, do not trade on a national securities exchange, and are therefore illiquid products that are hard to sell (investors can typically only sell their shares through redemption with the issuer, or through a fragmented and illiquid secondary market).  Further, non-traded BDCs such as BDCA have high up-front commissions and fees (typically as high as 10%), which are apportioned to the broker, his or her broker-dealer, and the wholesale broker or manager.

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On November 15, 2017, H.R. Bill 4267 (the “Bill”), entitled the Small Business Credit Availability Act (the “Act”), passed the House Financial Services Committee by an overwhelming 58-2 vote.  This Bill seeks to amend the Investment Company Act of 1940 (’40 Act), specifically the regulations currently governing business development companies (“BDCs”).  In recent years, financial advisors have increasingly recommended BDCs, allowing for Mom and Pop retail investors to participate in private-equity-type investing.  Many income-oriented investors are attracted to BDCs because of their characteristic enhanced dividend yield.

As an investment vehicle, BDCs were first made available pursuant to the Small Business Investment Incentive Act of 1980, as a result of a perceived crisis in the capital markets.  At that time, small businesses were encountering severe difficulties in accessing credit through traditional means.  BDCs are a special type of closed-end fund designed to provide small, growing companies with access to capital.

BDCs are structured as hybrid between an operating company and an investment company under the ’40 Act.  Regulated as an investment company, BDCs are required to file periodic reports under the Securities Exchange Act, and further, are subject to a number of regulatory requirements.  Three of the most notable regulations currently governing BDCs are as follows:

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Investors faced the prospect of losses as Corporate Capital Trust, a former non-traded business development company listed its shares on the New York Stock Exchange this week under the ticker symbol CCT.  In early trading on November 14 and 15, 2017, the price of CCT shares fluctuated between $16.56 and $18.63 a share.  Accounting for the October 31, 2017 2.25-to-1 reverse split in CCT’s shares, this trading range means that a pre-split share of CCT is now worth between $7.36 and $8.28 a share- down from offering prices of between $10.00 and $11.30 a share at which investors purchased shares before the company was publicly traded

CCT is now reportedly the largest publicly-traded business development company, and the company raised billions of dollars in its public offerings of stock.   Corporate Capital Trust also commenced a tender offer to purchase up to $185 million in shares of its common stock at $20.01 per share, the company’s most recent net asset value per share, as of September 30, 2017.   The tender offer expires at 5:00 p.m. (EST) on December 12, 2017.  The tender offer price is a significant premium to the market price.

Corporate Capital Trust’s initial public offering was declared effective by the SEC in April 2011 and raised a total of $3.3 billion before closing its follow-on offering in October 2016.  The managing dealer, CNL Securities Corp., sold approximately 141 million shares in CCT’s initial public offering and sold an additional 168 million shares in a follow-on public offering, which closed on November 1, 2016.   CNL Securities Corp. was generally entitled to receive selling commissions of up to 7% of the gross proceeds of shares sold in the offerings and a marketing support fee of up to 3% of the gross offering proceeds of shares sold in the offerings, some of which may have been shared with other broker-dealers who sold shares to customers.

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If you have invested in HMS Income Fund (“HMS”) upon the recommendation of your financial advisor, you may be able to recover your losses through arbitration before the Financial Industry Regulatory Authority (“FINRA”).  A Maryland corporation formed in 2011, HMS is sponsored by Hines Interests Limited Partnership (“Hines”).  HMS is structured as a closed-end management investment company, and pursuant to the Investment Company Act of 1940 operates as a public, non-traded business development company (“BDC”).  HMS’s business focuses on providing mezzanine debt and equity financing to various private middle market companies.  As of June 30, 2017, HMS has provided debt financing to 119 companies across a spectrum of industries.

 
As an investment vehicle, BDCs have been available since the early 1980’s (when Congress enacted legislation making certain amendments to federal securities laws allowing for BDC’s to make investments in developing companies and firms).  Frequently, financial advisors have recommended BDCs, allowing for Mom and Pop retail investors to participate in private-equity-type investing.  Many income-oriented investors are attracted to BDCs because of their characteristic enhanced dividend yield.

 
Traded BDCs that are listed (and thus sold and resold) on national securities exchanges may offer an attractive investment opportunity (although with enhanced dividend yield comes additional risk).  However, non-traded BDCs are altogether different, and should be regarded as risky, complex and illiquid investment products.  As their name implies, non-traded BDCs do not trade on a national securities exchange, and are therefore illiquid products that are difficult to sell.  Typically, investors can only sell their shares through redemption with the issuer, or through a fragmented and inefficient secondary market.  Moreover, non-traded BDCs such as HMS usually have high up-front fees (typically as high as 10%), which are paid to the financial advisor selling the product, his or her broker-dealer, and the wholesale broker or manager.

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Building Demolished On October 24, 2017, the New Jersey Bureau of Securities (the “Bureau”) entered into a Consent Order (“Order”) with Boston-based brokerage firm LPL Financial, LLC (CRD# 6413) (“LPL”), in connection with LPL’s sales of certain non-traded investment products to residents of New Jersey.  Specifically, the Order encapsulated findings of fact that LPL agents sold to New Jersey clients various non-traded financial products, including non-traded real estate investment trusts (“REITs”), as well as non-traded business development companies (“BDCs”) and other non-traded investments such as closed-end and interval funds, hedge funds, and managed futures.

In particular, the Bureau focused on LPL’s sales of non-traded REITs (some 7,823 transactions) and non-traded BDCs (some 2,120 transactions).   Non-traded REITs and BDCs carry considerable risks, chief among them their illiquid nature (often, investors are not fully aware at the time of purchase that exiting the investment could be problematic).  As stated in the Bureau’s Order: “Non-traded REITs and non-traded BDCs are generally illiquid as they have no public trading market and a liquidity event typically occurs within five to seven years of an offering’s inception.”

Aside from liquidity concerns, there are numerous additional risks associated with non-traded financial products, including but not limited to characteristically high up-front fees charged investors (commissions to brokers and their firm run as high as 10%, as well as certain due diligence and administrative fees that can range up to 3%), as well as the fact that many non-traded REITs and BDCs pay distributions from investor capital (return of capital).  This return of capital may confuse some investors who believe that the investment’s yield is based on positive earnings and cash flows.

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Business Development Corporation of America (“BDCA”) is a non-traded business development company headquartered in New York, New York.  As a business development company (“BDC”), BDCA focuses on providing flexible financing solutions to various middle market companies (e.g., BDCA extended a second lien term loan in August 2016 to the well-known “fast casual” restaurant chain, Boston Market).

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BDCs are not a new investment product, having been around since the early 1980’s (in 1980, the U.S. Congress enacted legislation making certain amendments to federal securities laws allowing for BDC’s — types of closed end funds — to make investments in developing companies and firms).  Many brokers and financial advisors have recommended BDCs as investment vehicles to their clientele, touting the opportunity for retail investors to participate in private-equity-type investing through BDCs, as well as their typically outsized dividend yield.

Non-traded BDCs, as their name implies, do not trade on a national securities exchange, and are therefore illiquid products that are hard to sell (investors can typically only sell their shares through redemption with the issuer, or through a fragmented and illiquid secondary market).  In addition, non-traded BDCs such as BDCA have high up-front fees (typically as high as 10%), which are apportioned to the broker, his or her broker-dealer, and the wholesale broker or manager.

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