As investment yields decline, business development companies are faced with a tough decision: Cut their dividends or reduce payments to their managers.
This quarter, FS Investment Corp. (NYSE: FSIC) did both, slashing its quarterly dividend from $0.22 per share to $0.19 per share, while agreeing to reduce its base management fee to 1.5% of assets, down from 1.75% of assets for at least one year.
Conflicts in the structure
Most publicly traded BDCs have only one manager, or advisor, who is responsible for managing the fund and making investment decisions. In exchange, the manager receives management fees plus incentive fees for good performance.
In contrast, FS Investment Corp., which got its start as a non-traded BDC, effectively has two managers. An affiliate of FS Investments (formerly known as Franklin Square) acts as its investment advisor, but the actual investment decisions are farmed out via a sub-advisory relationship with GSO/Blackstone, an affiliate of Blackstone Group. The fees earned from managing the portfolio are split in half. FS gets half, and GSO/Blackstone gets the other half.
My understanding is that the relationship between these two entities is contentious, to say the least. What started as a humble non-traded BDC has now grown into a powerhouse in private credit. In addition to FS Investment Corp., FS has four other private BDCs with a sub-advisory agreement with GSO/Blackstone that together had equity capital of approximately $9 billion as of March 31.
As yields come down, investors naturally look to outsize fees as a source of cost savings to spare BDC's dividends. But who, exactly, should pay for it? FS or GSO?
That's an important question. FS Investments' value may have been more clear during the fundraising process, when it relied on an army of financial advisors to sell shares of the then-non-traded BDC. But when it comes to the actual performance of the BDCs as they stand today, GSO/Blackstone plays the most important role in investment selection. See the diagram below from a December presentation.
GSO/Blackstone's responsibilities include identifying and originating investments and monitoring credit aspects of the portfolio, among others. FS's roles appear to include duties that fall more into the spectrum of administrative tasks, providing only a secondary layer to GSO/Blackstone's investment selection process.
Where the incentives lie
GSO is a highly regarded credit fund manager with approximately $95 billion of capital under management across a number of public and private funds, which collectively dwarf the BDCs it manages under a sub-advisory relationship. The FS Investment BDCs may be getting lost in the fray.
After all, GSO/Blackstone isn't exactly striking it rich with the FS Investment BDCs. The company stands to collect just half of the management fees (1.75% per year) and incentive fees (20% of returns in excess of 7.5% annually).
Assuming the new fee waiver is split equally between GSO/Blackstone and FS, GSO/Blackstone is effectively collecting just 0.75% on assets plus a 10% incentive fee on returns in excess of 7.5% per year. On that basis, GSO/Blackstone is the lowest-paid external manager of any publicly traded BDC.
While I've taken the position against many high-cost external managers in the BDC industry, there comes a point where the fee structure no longer incentivizes the manager. If GSO stumbles on an exceptional credit investment, is it likely to allocate a large share to the FS Investment BDCs, where it earns only half the incentive fee, or to one of its many other funds, where it doesn't share the rewards with a partner?
FS calls the shots
Fees aside, the operational aspects of FS Investment Corp. are interesting. The company's eleven member board of directors has substantial FS representation. As for GSO/Blackstone's role on the board, it appears to be nonexistent from my cursory view.
That may seem like a mere detail, but BDC boards are entrusted with more responsibility than your average publicly traded company. The board of directors has the very important responsibility of signing off on the value of the investment portfolio each quarter. It's interesting that credits picked by GSO/Blackstone are valued by a board that doesn't seem to include any GSO/Blackstone representatives.
Of course, this likely comes back to another important role of BDC boards: Selecting an investment advisor. Most BDCs stuff their boards with management allies, so as to minimize the risk that the board decides it's time for new management. FS Investment Corp.'s board could, at least in theory, decide that it's in the shareholders' best interest to cut FS out of the picture. That seems unlikely to happen, since FS Investment Corp's independent board members make substantially more in director fees than dividends, and generally own very little of the company's stock.
Admittedly, even the most thoughtful fee and incentive structures have their faults. And the truth is that from a shareholder perspective, the FS Investments' fee structure isn't the worst. At a minimum, it at least somewhat shelters investors from capital losses, given that the incentive fee is based on a metric that includes gains and losses, something that other BDCs don't have.
That said, other BDC managers are choosing to waive fees to spare their dividends, building up valuable goodwill with investors, and ensuring that the BDC trades at a premium to net asset value, thus allowing the management team to grow assets and thus future profits from a growing stream of fee income. That simple process is made more complicated when two entities collect a share of the fees.
The decision to put the burden of lower income on the backs of shareholders, its sub-advisor, and itself, puts it at odds with many similarly sized BDCs that have spared their shareholders from dividend cuts. It may also put it at odds with its sub-advisor. The relationship between GSO/Blackstone and FS, which I'm told isn't as friendly behind closed doors, may be its undoing. Individual investors who own the BDC are thus left to pay the price from a relationship they have nothing to do with.