You might be considering alternative investments as a way for your non-profit to strengthen its long-term financial performance. Alternative investments can help provide higher returns than traditional investments and boost diversification. However, they also add risk and complexity, increased investment costs, and expand tax exposure. Be sure to assess the pros and cons before making any commitments.

Complexity & Risk

Alternative investments are typically defined in contrast to 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.

Such investments may provide 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 non-profits without other sources of available operating capital. The complex nature of such assets also increases risk for investors, which is why returns may be higher.

Investment Costs

Typically, alternative investment funds 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.

The fund manager is crucial. You want to choose a fund with a manager who has a proven track record and access to the best investments. Also, pay attention to management fees. In addition to a base management fee (generally about 1% 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.

Tax Exposure

Although a non-profit’s investment income (for example, from 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, income distributions 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. Non-profits can use the schedule to determine whether they’ve received UBI that must be reported. State filing obligations may also apply, particularly when a fund operates in multiple states.

Careful Consideration Is Essential

Alternative investments can potentially play a valuable role in your non-profit’s investment strategy, but they require careful consideration of the financial and tax implications. Contact us for help determining if alternative investments are right for your organization.