The Dazzling Future for These High-Yield Companies

Banking just isn't what it used to be.

Banks are prepping for the implementation of Basel III, a regulatory framework that will govern how and to whom banks can lend. Basel III hits hardest in the commercial lending business. 

For nonbank finance companies, Basel III is a gift from the heavens. Companies like Prospect Capital and Ares Capital now have the industry in their back pocket.

The future for nonbanks
REITs and MLPs, which finance real estate and oil and gas pipelines, respectively, grew to a size few could ever predict. Both industries are worth more than $100 billion, as investors ate up the prospect of high yields from asset-heavy companies.

Some, myself included, think such a booming future is possible for business development companies. Though publicly traded BDCs are a relative new "thing" on Wall Street, Basel III could spawn a rebirth of the industry as banks pull out of commercial lending in favor of mortgage banking.

But it's not an easy, clear path for BDCs. For one, as the industry grows, it will only attract more scrutiny. We've already seen BDCs take heat for their high fees, which resemble the hated 2-and-20 fee schedule of hedge funds.

Why management fees have to decline
There are substantial economies of scale in the asset management industry. Costs do not grow proportionately with assets, thus a fund with $100 billion under management should have significantly lower costs per dollar than a fund with $1 billion of assets.

Given the number of BDCs that have gone public in recent years, competition will -- hopefully -- force down management fees as a percentage of assets.

I've noticed a clear trend in recent BDC conference calls: At least one person brings up the subject of fee levels on each call, either directly or by implication. How can externally managed BDCs justify management fees that easily double or triple the costs of an internally managed BDC like Main Street Capital or Triangle Capital ?

On the last conference call for Fifth Street Finance , one KBW analyst asked the following: "When the Board meets in January, do you think there is going to be any discussions around maybe 2 and 20 isn't the appropriate fee structure for these lower yielding assets?"

It's just one example of a very direct question: Since yields are lower in the middle market space, can Fifth Street Finance -- and all BDCs -- rightfully take 2% of assets and 20% of earnings?

It's getting more complicated
Thanks to some of the more creative players in the BDC industry like Prospect Capital or Fifth Street Finance, defining a "correct" level of fee income is more complex than ever. For instance, Prospect Capital has a large investment in residential real estate. It collects 2% of assets invested, plus 20% of returns for the management incentive program.

Relative to other companies, that level of fee income is egregious for a real estate investment manager. Silver Bay Realty Trust, a single-family home REIT, charges 1.5% of market cap each year, putting it easily in the top of the most expensive asset REITs. I think even that fee is too high and poorly structured, but Prospect takes far, far more in management fees on its real estate investments.

The Foolish bottom line
Business development companies have a friend in Basel III, but to become a truly huge portion of the market, fees will have to come down. Luckily, relatively new BDCs are already out to break the mold -- and as they grow, I think they'll present a very important competitive threat for the older, bigger BDCs hooked to a 2-and-20 fee schedule.

Main Street Capital and Triangle Capital are leading this trend, and their growth should and, in my view, will put pressure on incumbents to lower their fee schedules to draw in more investors. Slashing costs is the next step in mainstream adoption of BDCs and their growth as a key component of the middle market financing industry. The individual investor, through messages to investor relations and questions at company events, has the onus to lead the conversation to drive costs down. 

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Fool contributor Jordan Wathen has no position in any stocks mentioned, and neither does The Motley Fool. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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