As Brokers Peddle Junk-Loan Funds, Franklin Square Raises Billions of Dollars

According to MTS Research Advisors, non-traded business-development companies, which are junk-rated debt funds, doubled their sales to a $2.8 billion high in 2012, making $134 million in revenue. Among these was Franklin Square’s FS Investment Corp., an initial $2.5 billion fund to which investors have already paid $323.5 million in commissions and fees-25% more than the $258 million that they have received, reports Wells Fargo & Co. analyst Jonathan Bock and Bloomberg. $5,000 is the minimum investment.

While Franklin Square touts its fund as having a structure that lets investors who don’t have sufficient money buy into hedge or private-equity funds to diversify into loans to smaller companies, Bloomberg notes that Morningstar Inc. analyst Sarah Bush recently observed that about 50% of the securities held by the fund overlaps with holdings found in bank-loan mutual funds, which means that Franklin Square isn’t giving investors access to anything they wouldn’t be able to obtain via other avenues.

Non-traded business-development companies lend investors’ money to companies. They can charge high interest rates on the loans because lenders are usually rated junk or aren’t rated at all. The debt usually pays a floating rate, which means investors will make more if benchmark interest rates go up.

Meantime, individual investors are brought in with the promise of approximately 8% in yearly returns and access to the fund managers, while generally the brokerage firms that sell the funds are paid about 20% in returns and 2% in management fees and commissions. (Franklin Square offered brokerage firms 10% of the funds raised for FS Investment Corp, and approximately 10,000 brokers have sold the fund.)

While Franklin Square Chief Executive Officer Michael Forman believes the fees charged on junk-rated debt funds don’t differ too much from what comes with mutual funds and variable annuities, Bock believes investors would have benefited more from buying into publicly traded business-development companies, which experienced a 150% gain compared to the Franklin Square fund, which saw a 71% return between early 2009 and 2012’s third quarter.

FINRA now is examining the risks involving traded and non-traded business development companies.

Shepherd Smith Edwards and Kantas, LTD, LLP represents victims of investment fraud throughout the US.

Blackstone, KKR Raise Billions on Sale of Junk-Loan Funds, Bloomberg, March 20, 2013

Read the FINRA Notice (PDF)

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