Evaluating the Risks and Rewards of Alternative Investments

Alternative investments can be appealing to nonprofits due to their potential for higher long-term performance compared to traditional securities. However, these investments often come with significant risks and tax implications that may not be suitable for every organization. Here’s what you need to know to make an informed decision.

Understanding Alternative Investments

Alternative investments differ from traditional securities like stocks, bonds, and mutual funds. They often lack easily ascertainable fair market values. Common examples include hedge funds, private equity, real estate, venture capital, and cryptocurrency.

These investments can offer access to high-growth companies and innovative industries. However, they are usually illiquid, meaning investors can’t easily cash out or adjust their allocations. This illiquidity can pose a significant risk for nonprofits without other sources of available operating capital. The complex nature of these assets also increases risk, which is why they may offer higher returns.

Considering the Costs

Alternative investment funds are typically structured as partnerships or limited liability companies (LLCs), both of which are pass-through entities. This means that income and tax liabilities pass through to investors, who are considered partners or members.

Manager selection is critical. Choose managers with proven track records and access to top-tier investments. Be mindful of management fees, which generally include a base fee (typically 1.5% to 2% of the fund’s capital or net asset value) and performance-based fees known as carried interest, which can be as high as 20% or more of the investment’s profits.

Understanding Tax Implications

While investment income (such as dividends, gains, and interest) is generally excluded from taxable unrelated business income (UBI), investors in partnerships or LLCs are treated as though they’re conducting that entity’s business. This means that distributions of income could be considered taxable UBI.

Additionally, UBI includes unrelated debt-financed income from investment property in proportion to the debt acquired to purchase it. The IRS defines debt-financed property as any property held to produce income (including gain from its disposition) for which there’s acquisition indebtedness. Therefore, if you finance your investment in a fund—or if the fund finances the purchase of an income-producing asset—some of the associated income may be taxable.

Pass-through entities report each partner’s or member’s share of income, dividends, losses, deductions, and credits on IRS Schedule K-1. Nonprofits can use this schedule to determine if they’ve received UBI that must be reported. State taxes may also apply.

Is This Right for Your Organization?

Determining whether alternative investments are suitable for your nonprofit requires careful consideration of potential risks, returns, and tax implications. We can help you evaluate whether this investment strategy aligns with your organization’s financial goals and risk tolerance. If you decide to proceed, we can assist you in managing any associated tax liabilities.

By weighing the potential risks and returns, your nonprofit can make informed decisions about incorporating alternative investments into your portfolio.

How HoganTaylor Can Help

The HoganTaylor Nonprofit team of business advisors and CPAs is comprised of former CFOs, controllers, and industry experts with extensive experience providing the guidance organizations need to lean forward again in their leadership. If you have any questions about this content, or if you would like more information about HoganTaylor’s Nonprofit practice, please contact Jack Murray, CPA, Nonprofit Practice Lead.

INFORMATIONAL PURPOSE ONLY. This content is for informational purposes only. This content does not constitute professional advice and should not be relied upon by you or any third party, including to operate or promote your business, secure financing or capital in any form, obtain any regulatory or governmental approvals, or otherwise be used in connection with procuring services or other benefits from any entity. Before making any decision or taking any action, you should consult with professional advisors.