Weighing Potential Risks and Returns of Alternative Investments

by | Jun 4, 2024 | Insight-Post, Not-for-Profit

Key Points

  1. Alternative investments offer potentially higher long-term performance but come with greater risk and tax liabilities.
  2. These investments, often illiquid, can pose substantial risks for nonprofits without other sources of operating capital.
  3. Management fees for alternative investments can be significant, and income from these investments may be treated as taxable unrelated business income (UBI).

Alternative investments may appeal to your not-for-profit because they often offer higher long-term performance than traditional securities do. But these investments can come with tax liabilities. They also typically are riskier, which may not be appropriate for your organization. Here’s what you need to know.

No easily ascertained value

Alternative investments generally are defined in contrast to more traditional securities, such as stocks, bonds and mutual funds. They generally don’t have an easily ascertained fair market value. Examples include hedge funds, private equity, real estate, venture capital and cryptocurrency investments.

Alternative investments may provide investors with access to high-growth companies in cutting-edge industries. However, because alternative investments may be illiquid, investors typically can’t easily cash out or shift their allocations. This can be a substantial risk to nonprofits without other sources of available operating capital. The complex nature of such assets also increases risk to the investor, which is why returns may be higher.

Pay attention to fees

Alternative investment funds generally are formed as partnerships or limited liability companies (LLCs). Both are types of pass-through entities, meaning the income and the tax liability pass through to investors, who are considered partners or members.

Manager selection is crucial — you want someone with a proven track record and access to the best investments. Pay attention to management fees. In addition to a base management fee (generally about 1.5% to 2% of the fund’s capital or net asset value), managers generally charge performance-based fees known as carried interest. These fees can reach as high as 20% or more of an alternative investment’s profits.

Unrelated business income

Although investment income (for example, dividends, gains and interest) typically is excluded from taxable unrelated business income (UBI), investors in partnerships or LLCs are treated as though they’re conducting that entity’s business. As a result, distributions of income may be treated as taxable UBI.

In addition, 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 an acquisition indebtedness. If you use financing to invest in a fund — or, if the fund has financed 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 the schedule to determine if they’ve received UBI income that must be reported. State taxes may also apply.

Right for your organization?

We can help you decide whether alternative investments might be right for your organization. If you choose to adopt this investment strategy, we can also help you determine any tax liability.

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