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Your 2 And 20 Fees Don't Even Get You A Toaster

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If you believe in market efficiency you might think that the fees that an investment vehicle charges should relate to the value that the vehicle provides. But be careful: that theory is not falsifiable by saying "oh, well, this fund charges 3 and 50 and is down 10% this year." Maybe that fund had a high expected return and happened to have bad luck this year, whatever that particular combination of words means to you. Maybe you're paying for a valuable financial quantity - low volatility, uncorrelated returns, etc. - other than high expected returns. Or maybe you're paying for something other than financial quantities. Perhaps your country club is the sort of country club where saying "oh, yeah, all of my money is with Blackstone" is worth $10,000 a year to you. I'm not gonna tell you how to live your life.

But if that sounds like your sort of thing oh does Bloomberg have a trade for you:

Sales of junk-rated debt funds known as non-traded business-development companies doubled to a record $2.8 billion last year .... Franklin Square Capital Partners, the Philadelphia firm that created the securities about four years ago, said it took in $134 million of revenue last year, much of that passed on to Blackstone Group LP, which picks the loans and manages the portfolios. ...

Brokerages generally take 10 percent upfront, several times the amount charged by similar junk-loan mutual funds, while management and performance fees rival those of hedge funds. ... In addition to the upfront commissions, investors generally pay 2 percent management fees and about 20 percent of returns ....

The article is hilariously devastating throughout:

Franklin Square’s pitch is that the new structure allows investors who don’t have enough money to buy private-equity or hedge funds to diversify into loans to smaller companies, according to its website, which features an explanatory video illustrated with photos of a smiling couple hugging. ... “As these are private investments, there are fewer investors and much less competition, which can result in better terms and returns,” according to the video. “Only large investors like endowments, pension plans and financial institutions could afford to enter this world.” ...

About half of the securities held by the Franklin Square business-development company overlap with the holdings in large bank-loan mutual funds, according to Stifel’s Ward.

Per the article, Franklin Square has returned 71% since inception, versus 73% for the average bank-loan mutual fund and 150% for an index of public business development companies during the same period. Bloomberg reads this to mean that "investors would have done better buying publicly traded business-development companies" but this is a non sequitur; perhaps for those particular investors the prestige of investing with Blackstone was worth 12% a year.1 Yachts are expensive to maintain too. The website is very convincing.2

It's worth pondering a question we've talked about before, which is: will loosened restrictions on alternative-investment advertising also lessen the ability of those investments' managers to charge above-market fees for market returns? I mean, Blackstone is a public company, though its PE funds are still, as the name implies, private. "Oooooh secretive private equity firm unavailable to ordinary investors" isn't quite as true as it used to be, so surely "invest your $5,000 with Blackstone" will one day lose its off-piste appeal. Eventually everyone will be like "well, okay, how does investing with Blackstone compare to investing with Brand X, money-wise?" Will they still want to pay an extra 12% a year for the Blackstone brand?

Or maybe that's dumb and broader advertising of, as Franklin Square puts it, "alternative investment products," will just broaden the mass-exclusive appeal of those products. I mean, advertising does seem to work everywhere else in life. Franklin Square: it's toasted. Franklin Square's investments are registered and offered publicly, albeit non-traded, with no "accredited investor" requirements and a $5,000 minimum. It's been advertising since day one - Bloomberg quotes an analyst saying "“There are certain products that are bought. This is definitely a product that’s sold.” - and it's raised like $2.4 billion for that first fund.

Let's talk about that fund for a minute. Basically the strategy is to raise a bunch of equity, lever it 2x, lend it to companies in the bank loan market, and take 20% of the profits for themselves. That's ... banking, right? Only banks lever it like 10x and take 40% of the profits for themselves? In fact, since Cardiff Garcia wrote about mortgage REITs today let's throw them all in the same mess. Mortgage REITs basically raise equity, lever it like a whole lot of times, and buy mortgages, which some people think may lead to disaster. They are to mortgage lending what BDCs are to business lending: the shadow-banking, possibly somewhat shady, alternative to a bank.

Here are some facts about three maybe-representative entities:

Can you guess the entities?3

You could worry I guess about the equity investors in those non-traded BDCs; they do seem to be paying rather a lot for the privilege. At the same time, though: aren't lots of people calling for banks to be simpler - "just lend to clients" - and more equity funded? BDCs are like the perfect banks. Even mortgage REITs are less levered than banks,4 and their management is positively cheap.

One thing that I like to ponder about the calls for higher bank equity capital requirements is: why would you want all that much bank equity? Funding a bank with information-insensitive debt - whether that's your checking account or your money-market fund's repo exposure - feels safe, whether or not it is. Funding a bank with equity gets you uncomfortably close to the abyss. Cypriot depositors aren't excited about the prospect of swapping a portion of their insured deposits into Bank Laiki equity. There are certain products that are bought, there are others that are sold, and then there are the select few that are forced upon their recipients during bank holidays.

But here is Franklin Square, a simple bank that is more than 50% equity funded and invests all its money in loans to companies. And people are worried about it being a little rough on shareholders? Why wouldn't it be?

Blackstone, KKR Raise Billions on Sale of Junk-Loan Funds [Bloomberg]
Relaxed about REITs [FTAV]

1.Those returns are over a 3.75-year period - January '09 to 3Q12 - so like a 27.7% CAGR for the public BDCs versus 15.4% for Franklin Square.

2.Is it? It offers:

  • New asset classes and strategies that traditionally have been out of reach for the investing public, such as the debt of private companies that we think can help investors of all kinds to build stronger, more diversified portfolios.
  • Elite asset managers, whom we deem to be among the best and brightest serving the world's most sophisticated institutions, including The Blackstone Group. We place their talents at the disposal of investors at a reasonable minimum level of investment (generally $5,000).

3.The bank is JPMorgan (comp ratio = Compensation Expense / Net Revenue). The non-traded BDC is FS Investment Corp. - the Franklin Square fund that Bloomberg is talking about (data for nine months through 3Q2012, comp ratio = [officer compensation and director fees of the fund (not material) plus management fees and incentive fees charged by Blackstone/GSO], divided by ["investment income" plus "realized gain" less "interest expense"]). The mortgage REIT is Annaly (comp ratio = compensation expense divided by [net interest income minus "other loss"]). Those are my lazy efforts to get fair measures of (1) how much the institution charged divided by (2) its net revenue on a bank-y basis. Leverage ratio is total assets divided by shareholders' equity. Fake math here.

4.It's a closer call there, but note that the mortgage REITs invest almost entirely in agency RMBS, which are 20% risk-weighted under Basel III: a bank with a pretty robust 12.5% capital ratio can lever agency RMBS forty times.