A middle-market debt offer for retail investors
Planning on staying on Robert Grunewald’s good side? Then don't casually throw around the term alternative investments.
"I really want to find a way to get rid of the term alts," says Grunewald, CEO and founder of Flat Rock, which is described as "a new alternative asset management firm focused on developing yield-driven investment strategies in sectors deemphasized by banks."
Grunewald sighs, acknowledging the term has gained a life of its own. "I wish that we would instead use the term non-liquid equities and fixed income. When you say the term 'alternative,' it seems to suggest something strange or funky ."
Innovative, however, is acceptable, he says. And Grunewald, a former head of Business Development Corp. of America, is confident a new offering developed by the firm he co-founded this year, Flat Rock Global, gives investors access to middle-market debt in a way they have not had previously.
"Retail investors deserve the right to access this unique asset class in the same manner as institutional investors: with no load and no sales commission," Grunewald says.
There are high costs for a real distribution effort, he acknowledges.
"But we believe that the right thing to do is for the advisor to absorb 100% of those costs so that when you're investing in a fund, 100% of your dollars go into the investment and not into some sales commission."
Grunewald spoke with Money Management Executive about launching Flat Rock Global. An edited transcript of the conversation follows.
What was the inspiration for your firm to offer this fund?
I started my career in investment banking. I ran what today is Wells Fargo's financial services investment banking practice, and then eventually worked at one of the largest publicly traded business development corporations, American Capital Strategies, and then later started as president and chief investment officer of Business Development Corp. of America, or BDCA. My experiences helped inform me about what, in many cases, many BDCs have done well, but also what many of them have not done as well.
Most BDCs operate at much higher fee levels than we've established at Flat Rock Capital. The average BDC is somewhere between a 2% management fee and a 20% carry, to maybe a 1-1/2% management fee and a 20% carry.
Flat Rock Capital is a management fee of 1-3/8 and a 15% carry. The reality of management fees and incentive fee structure is that it dictates the types of investments that you can make. By having a lower fee structure, we position Flat Rock Capital so that it can invest in higher quality, lower yielding loans. We've established what I believe is the first BDC that is exclusively dedicated to investing only in first lien senior secured debt.
We offer a product that is delivered on the exact same terms as an institutional investor would want. That is, no fees, no load, no distribution capability. Whatever distribution costs are, all are borne by the advisor, none of them are ever passed on to the investor.
With our first fund, a dollar invested with us means the dollar is invested in the fund and there's no initial load or sales commission whatsoever.
Providing retail investors the same access as institutional investors - do your peers consider this a radical idea?
There are probably a lot of money management firms out there that are marketing alternative asset products to retail investors.
What really differentiates us is delivering those products to those investors on the same terms as an institutional investor. As near as I can tell, it's almost unheard of. That's understandable. It's expensive from a distribution standpoint to develop a nationwide calling effort on RIAs and family offices, and institutional investors as well.
But we believe that the right thing to do is for the advisor to absorb 100% of those costs so that when you're investing in a fund, 100% of your dollars go into the investment and not into some sales commission. In the long run we believe the advisor will do well, but our tagline is, "Investors come first," and we take that very seriously.
How well have advisors taken to alts?
I really want to find a way to get rid of the term alts, but everyone uses it I have to come back to it. I wish that we would instead use the term, non-liquid equities and fixed income. The reason for that is when you say the term alternative, it seems to suggest something strange or funky and that's not how I think of the asset classes that we want to offer to investors.
If you look at smart institutional investors, smart endowments, well over 50% of their portfolios are usually allocated into asset classes other than liquid equities and liquid fixed income. And I think that's underappreciated by most of the investment public. For the most part they are paying a significant liquidity premium, meaning they are getting much lower returns in exchange for having more liquid assets. A unique opportunity that exists today, and quite frankly has probably always existed, is the opportunity to capture what I'll call that illiquidity premium in these other asset classes. That can add up to a significant return differential over time.
So, smart wealth managers are increasingly turning to alternatives. In today's environment, they're dipping their toe in the water thinking, "Maybe allocating 10% of a client's assets is sufficient." Again, you've got to make sure that your asset allocation as a wealth advisor is appropriate for a given client's particular situation. There's a tremendous opportunity to significantly increase allocations to alternative assets.
How has the low interest environment affected the credit market? Has there been a return of capital to the market?
It's definitely been a 20-plus-year trend that continues, where banks have essentially abandoned lending to the middle market, which is our target market here at Flat Rock Capital. A lot of bank share of middle market lending according to some S&P data that I reviewed recently has gone, over the last 10 years, from more than 70% to less than 15%. So that trend clearly is in place and that creates an opportunity. That said, it is also true that in the last couple of years institutional investors, in particular, have recognized this opportunity and a lot of capital has come into the direct lending middle market. There have been some loosening of terms in the market, but we still see a tremendous opportunity because it's just not a very efficient market. We define the first lien middle market lending space as being about $300 billion in total size, and that's a big opportunity for BDCs like ourselves and other non-bank lenders to participate in.
How has your firm educated advisors about the products being offered?
We're offering an alternative investment, to use your term, but many alternative investments the pitch is, 'Hey, let me tell you where I can get you a higher yield, let me tell you where I can help you hit a home run.' And our story is almost the opposite. We want to tell you where we believe we can get you lower volatility, a steady dividend yield, more dependability and that is not something advisors are used to hearing about when being pitched or hearing those terms associated with an alternative investment. Flat Rock Capital is definitely a defensive strategy.
What expectations do you have of client money from advisors coming into the middle market? Do you expect it to be more volatile than institutional flows?
A business development company like Flat Rock Capital is a common capital vehicle. So while we allow for a tender offer of up to 20% of our shares on an annual basis, one of the important structural aspects is that we have essentially permanent capital; we're not a hedge fund, we're not an open end fund, and I think that's important because that structure is consistent with the relatively illiquid nature of middle market loans. We don't put ourselves in a position where we could have excess of redemptions through an open end structure while we have otherwise illiquid assets on the other side.
"We want to make sure what we have is a permanent capital structure that allows us to capture that illiquidity premium ... by investing in liquid loans, but knowing the capital will be there."
I would point out our goal is to raise $1.5 billion of equity. That's what's written into our prospectus. We believe with some modest leverage that puts us at about $2.6 billion of assets under management. We haven't set a specific target for how long it will take to raise that capital, but once we achieve economies of scale we then hope to put ourselves in a position where Flat Rock Capital is an entity that can go public. We believe that BDCs with strategies similar to ours are trading at attractive premiums to book value. That becomes another attractive opportunity for the investors in Flat Rock Capital.
Can you talk about your firm's experience with fund regulators while developing this offering?
We are SEC registered so we needed approval from the Federal Trade Commission to become effective. We file 10-ks and 10-qs, so again, in the less liquid alternative investment there is a tremendous amount of transparency there. You are getting the same type of public reporting that you would get from any other public company.
But interestingly, we filed with the SEC without any need to refile and became effective in only 60 days, which is almost unheard of. We looked back on that and sort of asked ourselves why did we sail through the SEC so seamlessly. It certainly appears that one of the SEC’s biggest areas of concern is the fee structures of these non-traded illiquid products. When you take a prospectus and you eliminate all the talk about sales load, all the talk about multiple share classes, scrap the distributor - you've actually created a simpler story both for the SEC and for investors. And I think that's really helped across the board.
What does the firm hope to achieve with its offerings?
The overarching vision for Flat Rock Global is to create an alternative asset manager that's delivering high quality, dependable products to registered investment advisors and family offices around the country. The first product obviously is Flat Rock Capital, focused on investing in first lien senior secured debt with a dividend yield that's anticipated to be in the 6 ½% to 7 ½% range.
We have not registered any other products at this time, but we are working on two other products that we think are sort of the most likely next launches for us. One of them is an interval fund that will focus on investing in really two asset classes that are essentially getting investors exposure again to senior secured debt but through a different mechanism.
What the interval fund is going to do is invest in both the public equities of publicly traded BDCs, and that allows the interval fund to have a healthy amount of liquidity to address the redemption of requirements of an interval fund, but the preponderance of the assets and the focus of the investment strategy is to invest in the equity tranches of collateralized loan obligations, or CLOs.
Most CLOs are invested in senior secured debt. They are structured investments that have more leverage than a typical BDC, although typically investing in more liquid, more highly weighted single B+ to single B rated loans. But they also generate higher yields because of the higher leverage, so we expect that the gross yield on this interval fund, which we are tentatively calling Flat Rock Opportunity Fund, would be double digit gross yields on the fund.
Flatrock Capital will be a boring, less volatile, steady, 7 percent-ish dividend yielding investment, while Flatrock Opportunity Fund will have more volatility, but will generate higher returns.