It's not immediately apparent which side of the GSO Capital Partners/Franklin Square partnership has the tougher role. GSO's origination and investment responsibilities could be assumed to be the most onerous, but that's the fun part of investing. But, with almost $16 billion in assets under management across five different business development companies (BDCs), both traded and non-public, Franklin Square's administrative burden can't be straightforward. And it's a rare soul that loves the admin tasks in the office.
Almost inevitably, many assume that the more glamorous member of this particular pairing works hardest and brings most to the table. And even the hardworking members of Franklin Square won't deny that the $79 billion GSO, part of $310 billion-plus behemoth Blackstone, is the flashy one in this particular celebrity power couple.
Bennett Goodman, who founded GSO with partners Doug Ostrover and Tripp Smith in 2005, has been working on origination for the BDCs for nine years. The trio spun out of Credit Suisse First Boston after working together for years there and at Donaldson, Lufkin & Jenrette, before it was acquired by the Swiss bank in 2000.
Smith moved to London to oversee the firm's European expansion in 2012, while Ostrover left last year and has launched a new private debt shop called Owl Rock Capital Partners. GSO, which was acquired by Blackstone in 2008, sub-advises the BDCs on investment and origination. Philadelphia-based Franklin Square Capital Partners advise the vehicles on all other aspects of their activities.
In 2007, Franklin Square became the first manager to launch a non-traded BDC. It sparked a trend. Setting up a BDC privately before moving it over to public markets when it is established is the norm for new BDCs.
The Franklin Square BDCs, one publicly traded and four private, have about $15.7 billion in assets under management, making the firm the largest manager of these vehicles by assets.
Despite recent hits on the energy front, the BDCs have grown substantially while also innovating on the investment side. GSO led the charge on specialty finance deals, aircraft leasing as well as broadening its typical borrower profile.
Michael Forman, chief executive at Franklin Square, and his team took PDI through the details of how the BDCs are set up, while the GSO executives, including Goodman, Brad Marshall, who oversees portfolio management for the BDCs, and Dwight Scott, GSO's head of energy, went over their thinking on investment strategy.
THE PHILADELPHIA CONNECTION
Forman founded a private equity and credit firm in Philadelphia called FB Capital Advisors before creating Franklin Square. He already knew Marshall, who lives in Philadelphia, through the market and by coincidence both were looking to expand in private credit and considering the BDC option in 2007.
“August 2007 was the beginning of the credit crisis and we recognised that our clients were looking for capital preservation and current yield and we thought leveraged credit would be a good place to be,” recalls Forman.
He interviewed 10 other credit firms before plumping for GSO as investment sub-advisor on the basis that it was best in class.
GSO had similarly done its due diligence. Marshall tells PDI he talked to several other BDC administration providers before committing to Franklin Square.
The first Franklin Square Investment Corporation (FSIC) vehicle went public in 2014 after amassing $2.7 billion in assets.
The rest of the BDCs, FSIC II, III and IV and the FSEP (the Franklin Square Energy & Power BDC) are still private. The second vehicle is closed to new money, while the third is closed among independent broker-dealers but still open to registered investment advisors (RIAs). FSIC IV recently launched and is just starting to raise money, while the FSEP was started in 2011 and is also fundraising. All non-traded BDCs need an exit strategy. This typically comes a few years after they close to new money and the options include a public listing, selling the portfolio or liquidation. For the Franklin Square BDCs, a public listing is the most likely outcome, say the managers, which would involve a merger with the public BDC.
WHO'S IN CONTROL?
GSO is the investment brains behind the operation. And as that side has been demonstrably successful, some argue Franklin Square doesn't earn its share of the 50/50 fee split.
This line of thinking ignores the fact that Franklin Square works on the nitty-gritty of BDC administration, including managing the tax, legal and compliance side of the business. It's also undeniable that much of the firm's strength lies in its fundraising. And while a good track-record is a boon for raising money, it's not enough by itself to fundraise such huge amounts of capital from mostly retail investors.
GSO executives themselves are quick to point out Franklin Square does a great job of raising money through its coverage of the universe of broker-dealers and financial advisors.
And GSO is far from the only blue-chip credit firm to partner with a specialist who brings that kind of fundraising strength to the relationship. KKR was the first to copy the model with CNL Financial in their Corporate Capital Trust BDCs in 2011. More recently, Benefit Street Partners launched a non-traded BDC in partnership with Griffin Capital and last year Guggenheim Partners tied-up with WP Carey for its BDC.
Falling under the Investment Company Act of 1940, which also governs mutual funds, BDCs are stringently regulated vehicles. Franklin Square spends a lot of time making sure the FSIC deals are compliant with the '40 Act, as it is commonly known.
“We do just about everything other than the pure product manufacturing. So that includes legal, compliance, accounting and fundraising. We spend a fair amount of time on '40 act deal structuring,” Forman says.
Both firms hold investment committees to approve deals going into the portfolio.
Franklin Square's committee rarely turns down deals put forth by GSO with only a handful of rejections over the years, Forman says, adding that the number fell as the two firms became accustomed to working together and better understood each other's perspective on risk.
“It's a very collaborative process that includes two layers of review – one by GSO and one by Franklin Square,” says Forman. “It's very rare that we've rejected deals. But whenever there is a deal that's a little off the beaten track, where there is more risk, or it's an industry that we're not looking to have exposure to, Brad or one of the folks at GSO will call us and we'll talk about it early on.”
FUNDRAISING AND FEES
Private BDC capital raising comes with conflicts, critics argue. Some broker-dealers get paid higher commission for selling BDCs, a more expensive investment product.
The Financial Industry Regulatory Authority has shed more light on the issue with new rules on commission from sales. “Under 1502, the rule mandates that the broker-dealers provide a higher level of transparency with respect to commissions paid and that the account statements reflect these commissions either in NAV [net asset value] or the net amount after commissions,” Forman says.
Responding to the updated guidance, Franklin Square reduced commission for FSIC IV from 10 percent to 8.95 percent and will be paying it in arrears rather than fully up front.
Zach Klehr, executive vice president at Franklin Square, adds: “The investor pays 2.2 percent upfront and we [Franklin Square] advance a portion of the commissions and then there is a trail, so the adviser gets 62 basis points per year and we get 78 basis points to pay us back for the advance commission.”
That comes out to about 8.95 percent over five years, depending on gains or losses as measured by NAV. Otherwise, Franklin Square executives say they are “platform agnostic” and will work with any financial advisors or broker-dealers that are interested in their product regardless of whether they take commission or not.
That said, Franklin Square doesn't solicit investors via the so-called wirehouse platforms of the major investment banks, which usually take fees to include products. “It's a very different model,” Klehr says.
Publicly listed FSIC pays a 1.75 percent management fee and a 20 percent incentive fee. The firm implemented a high-water-mark with a three-year lookback when it took the BDC public.
Sean Coleman joined Franklin Square in 2013 from Golub Capital where he helped take the manager's BDC public in 2010. Golub has arguably the most shareholder friendly fees and terms, and Coleman has been taking a page out of its book, by implementing a management fee under the 2 percent industry standard and introducing the high-water-mark.
In the newly created chief credit officer role, Coleman is tasked with improving the manager's credit capabilities. “I was brought in to build out the credit function: evaluate deals from cradle to grave, make certain each opportunity is appropriate for our investors and work closely with GSO throughout the deal lifecycle,” Coleman says.
GSO will normally find a deal that it likes, present it to Franklin Square and then go through a rigorous due diligence process with the sponsor and the borrower.
There's no disputing that GSO does most of the heavy lifting on this front, though the firm's portfolio managers will get in touch with Franklin Square if they encounter any red flags along the way. All deals must also be fully vetted and approved by Franklin Square's investment committee.
GSO's origination machine works across the manager's various strategies. The potential deal comes first, then they figure out where it can be plugged in within the platform: mezzanine, rescue finance, BDCs, credit hedge funds or elsewhere. Most of what ends up in the BDCs are senior secured and unitranche direct lending transactions. The Franklin Square vehicles can pull capital from any of the BDCs for transactions, which are never sliced and shared with GSO's other funds.
And this is where GSO gets its edge. The firm's principles are debt encyclopedias and it has one of the most effective origination teams in the market.
GSO's coverage model involves the regional division of private equity sponsors among the team, with a few exceptions depending on various individuals' legacy relationships. Goodman tells PDI he prefers to work on sponsored deals because a sponsor brings more oversight and control over the portfolio company.
“A private equity sponsor poses very strong governance over the companies in their portfolios and they reserve the right to unilaterally make decisions. If the CEO is not living up to expectations or the guy that runs marketing isn't delivering what he should be, they have the right to go out and replace them. With a private operating company, the CEO is usually the largest shareholder, so you don't have that kind of discipline and it's harder if things go awry,” says Goodman.
“Your LBO fund can be your best friend if you're a lender. Because they're all over these companies and that outside oversight makes these deals potentially less risky. They are monitored to a higher standard.”
After the deal is sourced, GSO can leverage its own private equity-like internal network to help borrowers. GSO executives frequently call on Blackstone's global purchasing organisation (GPO) “swat team” to cut costs for borrowers by offering access to Blackstone's negotiating power on travel, accommodation or delivery services. “On average, we'll increase the company's EBITDA by 5 percent. It's not a big number, but it's impactful,” says Marshall.
Marshall cites one instance where an audio company was about to breach its leverage covenant before GPO helped the company save $1.5 million.
PSAV, an audio-visual provider for conferences and conventions, has scored several loans, says Coleman, indirectly made easier by one of its largest customers, Hilton Hotels, as the hotel chain is in turn owned by Blackstone. “We talked to the Blackstone folks and they said it's a great company. They're the 800lb gorilla in this space,” Coleman recalls.
The BDCs can also tap into GSO's large CLO business. “They cover thousands of corporate credits, so as a matter of doing due diligence on sectors, we have specialists that focus on those sectors and it's also a source of idea generation,” says Marshall.
THE ENERGY PRESSURE POINT
Looking across the five BDCs, the firm's energy exposure is, for the moment, the obvious Achilles' heel.
Franklin Square runs a BDC dedicated to energy and power, which has notched up realised and unrealised losses. Energy is GSO's only industry vertical, with 20 people dedicated to the sector and a large asset base, including $3.8 billion in the FSEP BDC. It was down 16 percent in 2015.
Industry experts question whether a dedicated energy BDC is a good idea when oil prices have nosedived for more than 12 months (though they were on a slight upswing to around $40 per barrel when PDI met Franklin Square and GSO in March).
Nevertheless, GSO executives are stalwartly sticking to their guns on energy.
They point out that the FSIC BDC's losses and mark-to-market declines are nowhere near losses in broad energy or high-yield indices. They also claim that being a direct lender with hands-on input with borrowers gives them an edge.
Franklin Square said on the BDC's fourth quarter earnings call that some of their largest energy borrowers have raised equity capital behind the debt. Equity investors seek to avoid pouring good money after bad, so these moves to support the companies should be considered credit positive, they argue.
Management admits that the pain isn't over. Further restructurings and defaults in the energy portfolio are expected. But, they point out, many situations have a silver lining. Marshall tells PDI the firm has usually made money on its public loan defaults and its recovery rate is above par. “A lot of that has been because we've gone in and operated the company. We definitely have the resources of Blackstone to fix the company if things go sideways,” he says.
Klehr agrees that defaults and bankruptcies are not necessarily a bad sign. “Maybe because people grew up playing monopoly, they think bankruptcy is this bad thing. And bankruptcy can be an awful thing if you are an equity holder, but if you're a creditor, bankruptcy is a second bite of the apple. You get to exercise your rights in a bankruptcy,” he says.
As the fall in the price of oil and the danger that poses to independent US producers, GSO's head of energy Dwight Scott has been leading education sessions for investors. Scott used to be based in Houston and still spends a lot of time there, working directly with borrowers and sitting on several boards of energy firms.
He admits that the returns from GSO's and Franklin Square's energy portfolios have been challenged and the firm has been cautious on making new loans, but he's confident in the future of this strategy. “Energy has always been a big part of what we do and it will continue to be a big part of what we do. These companies will need our capital more in a recovery than they do now,” he tells PDI. “The timing of that recovery is hard to predict, but we believe that, over time, we're investing under the theory that prices will recover and these companies will be able to make returns.”
Now coming up on 10 years, neither Franklin Square nor GSO are looking to pull out of their collaboration, but there are questions about how it will play out: a buyout or break-up?
Forman is the chairman of the board of the publicly-traded FSIC, while the other 10 members are independent corporate and financial industry executives and the advisor and sub-advisor could be fired by the board with 60 days' notice.
Neither side, of course, has any interest in breaking up right now.
The Franklin Square executives speak highly of GSO's origination capabilities and breadth of coverage, while the GSO executives are pleased with the scale that Franklin Square helped them achieve. The large asset base helps GSO make large loans and hold them in their entirety, justifying their strategy, which few can replicate.
Franklin Square's asset base is wholly in alternative credit investments with GSO. There is no doubt that both the success on the investment side coupled with cash-rich fee model has driven the growth of the vehicles.
Franklin Square plans to hire about 50 people this year, adding senior roles and expanding its product set into private equity, liquid alternatives and real estate.
Mike Kelly joined a year ago to oversee product development, including expanding the corporate credit line-up, as well as forming new sub-advisory relationships on other strategies.
“We hope to continue to build capabilities to expand our relationship with GSO. We've been built from day-one to be a multi sub-advisor firm,” says Kelly.
“We have been looking very closely at real estate and speaking to many potential partners.”
The firm also moved into a new office last year in the Philadelphia Navy Yard that's roughly twice the size of its old office in Cira Center. The new site was built for Franklin Square to accommodate the firm's expanding staff.
With $17 billion under management, the platform already has scale, though Marshall says the scope of the opportunity means the vehicles' asset base could double over time. All with Franklin Square's administrative support, of course.
“Just like a CEO would never be criticised for hiring Goldman Sachs as its M&A banker, I don't think these RIAs or broker-dealers would be criticised for underwriting GSO/Blackstone,” says Goodman.
“GSO has $75 billion in non-investment grade assets. We're a ubiquitous presence in this $1.5 trillion marketplace. If you're a sponsor, we probably touch you in one way or another.”
Goodman, it seems, is well aware of how the right relationship can amplify the influence of each.