Tuesday, February 07, 2017

The T Share Scourge

I hate T Shares.  They were a preemptive answer to a problem that did not exist.  T Shares were forced upon the non-traded alternative investment industry by sponsors scared of a pending statement rule that would require them to show investors the price of their investment net of initial fees.  The thinking was that if investors realized how much the up front costs were for non-traded REITs and business development companies (BDCs) they would never buy a non-traded product.  For example, a $10.00 per share investment with 10% in initial offer costs would show $9.00 on the first client statement, or an implied immediate 10% loss.  The initial costs of these investments is already well disclosed to investors, as well as the net investment amount, regardless whether the statement reads $9.00 or $10.00 per share.

There was a consensus that a statement value showing a decline of 4% to 6% would be acceptable, but much lower than this would raise unwanted questions and concerns.  Therefore a statement value of $9.40 or $9.60 per share was thought OK, but a value of $9.00 per share would invite investor wrath.  I do not think investors were asked their opinion.

Of course, the fees must still be paid.  A financial advisor would never sell a non-traded REIT or BDC without full commissions, right?  A sponsor must make its immediate profit, right?  T Shares led to the financial gymnastics of reclassifying, adjusting, and delaying fees to show a high statement value but maintain fees.  Key jargon terms are "above the line" and  "below the line."  Fees paid directly from offering proceeds are "above the line," and fees not paid from offering proceeds are "below the line."  Fees accounted for as "below the line" do not lower the statement value.

In T Shares, the upfront sales commission to financial advisors is reduced to 3%, with an additional 1% paid per year for up to four years, from the traditional 7% commission paid up front.  Therefore, in a T Share, only 3% of the commission is "above the line" and not deducted from the statement value, a big savings.  The 1% ongoing commission typically has a euphemism like "Distribution Supervision Fee" or some other similar nonsensical term.  How exactly does a financial advisor supervise a distribution?  If financial advisors actually supervised distributions, distributions would increase every year.

I have seen investments that now classify organization fees and expenses, typically .50% to 2.0% or more of the investment price and incurred and paid at the earliest stages of the investment, as "below the line" ongoing expenses that no longer count them against the statement value.  Sponsors, in many cases, have lowered their marketing fees (dealer manager fees) by .25% to 1.00%, which are "above the line" expenses, so the lower fees boost statement values.  Many sponsors have elected to adjust their acquisition and finance fees, which are "below the line" expenses, to offset lower dealer manager fees.  One sponsor, when it introduced its product's T Shares in 2016, lowered dealer manager fees by 1.0%, but raised its acquisition fees by 1.10%.  This adjustment of fees increased the combined above and below line fees by more than 1.50%, after leverage.

Here is where the T Shares go from farcical to putrid.  The 1% Distribution Supervision Fee is paid from a REIT's or BDC's on going cash flow, or monies available for distribution, and lowers a T Share investor's distribution by about 1% per year.  For example, a REIT that pays a 6.5% distribution on its traditional Class A shares pays a 5.5% distribution on its Class T shares.

T Shares are counter-intuitive, they have lower up front costs, therefore a higher statement value, and more money is invested rather than paid in fees, which are positives for investors.  But their distribution is lower than a share class with a higher load due to shifting and reclassification of fees. It is a Stranger Things' Upside Down World.

Financial advisors have never been the largest voice for lower fees.  As long as they got paid and believed the investment solid, they have been willing to overlook high fee investments.  Most financial advisors are not going to stand for having their clients paid less in distributions, having their commissions cut, while sponsors maintain or increase their fees.  There no great shock that sales of non-traded REITs and BDCs were so bad last year.

There have been other challenges that have helped slow the sale of non-traded REITs and BDCs: the looming DOL changes (I am not going to open that discussion here), the lack of liquidity events, the collapse of the Realty Capital sales empire, and the sharp declines in BDC NAVs that started in late 2014 and provided acute proof that high yield BDCs were high yield for a reason.  But to me to me, the largest sales impediment was the rush to T Shares and the tepid response due to their flawed structure.

Financial advisors won't continue to sell a product where their clients get a lower return and get they paid less.   Low commissions are here to stay, so its time to create a better product structure.  If commissions are lowered, distributions to investors must increase.  The sponsors that understand this simple financial physics and design products to address it are going to see inflows of capital.  The industry needs products with tangible and attainable incentive compensation for sponsors, after providing returns to investors, even if it means higher long-term sponsor compensation.  Sponsors that cling to high acquisition fees or high asset management fees that provide no incentive except to overpay for assets will lose.  Until sponsors and broker dealers address their T Share problem, expect sales to stay moribund.

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