What are Subordinated Investments?
April 6, 2017 | by Beth Glavosek | Blue Vault
The topic of fiduciary responsibility is on everyone’s minds this year. One unique approach to protecting investors’ interests is subordinated co-investing. It’s one possible way to address the mandates for transparency and fiduciary responsibility imposed by FINRA’s 15-02 rule and the pending Department of Labor (DOL) Fiduciary Ruling. Several product sponsors have employed this approach.
So what are subordinated co-investments? In simplest terms, it means that the sponsor is contributing its own money to the offering in order to offset investor fees. It also means that the sponsor has a vested interest – or ‘skin in the game’ – to manage the REIT fairly and prudently. Sponsors will only receive their upfront co-investments back after investors have gotten a complete return of capital plus a preferred rate of return. From a risk perspective, if the investment fails, the sponsor loses its money before anyone else does.
If, for example, a sponsor pays $36 million into its product offering and the investment somehow loses $30 million, investors would still receive their capital and preferred return back. The sponsor would take the hit of $6 million in loss.
It’s a novel approach that not only expresses confidence in the company’s investments; it also overcomes the DOL and 15-02 hurdles.
Here are the important points for advisors to understand about how subordinated co-investment overcomes 15-02 and the DOL rulings.
- FINRA’s 15-02 rule was about disclosing on client statements the impact of fees and how they reduce the amount of investor capital that actually gets invested. A sponsor’s subordinated co-investment effectively covers these fees by committing funds that directly offset them. As a result, broker-dealers and advisors continue to receive standard compensation, and 100% of the client’s proceeds are invested immediately ‘in the ground.’ Clients will continue to see the stable share price that they paid on their statements, unless there is a valuation that changes the share value.
- With regard to the DOL’s fiduciary standards, the ‘first loss’ position addresses the issues of risk tolerance and will assist advisors in securing a Best Interest Contract Exemption (BICE). Therefore, they should be able to continue to earn a reasonable commission for their services.
We will see if the trend of subordinated co-investing continues to gain traction, especially if the DOL ruling does eventually go into effect.
Blue Vault helps me to stay well informed on the financial status of both open and closed nontraded REITs and BDCs, so that I can help my clients better understand the product, before they make the decision to invest and after.