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.
The time (at Blue Vault's 2nd Annual Broker Dealer Educational Summit) proved extremely informative.