Potential conflicts of interest between fund managers and investors could dampen enthusiasm for the Opportunity Zone tax sheltering program.
The tax benefits of OZ investments typically accrue only to investors, not to the funds’ managers. And, if OZ fund managers who control the assets fail to comply with the U.S. Treasury’s requirements for the most generous tax benefits of the program — specifically, holding assets for 10 years — they nonetheless still may receive contractually set performance fees.
Bottom line: fund managers will sometimes receive performance fees even when investors forfeit the OZ program’s lucrative tax shelters, according to several advisory firm representatives who have helped conduct due diligence on multiple offerings on the market.
Kent Insley has found no Opportunity Zone funds that have adopted legally binding language to guarantee investors’ tax benefits, says the chief investment officer for New York-based Tiedemann Advisors, which manages $13 billion.
Management also failed to find such guarantees at Wells Fargo’s high net worth unit, Abbot Downing. Among the OZ funds Carol Schleif has reviewed, there has not been language holding fund managers accountable to comply with the OZ program’s detailed rules to secure tax benefits for investors, says Abbot Downing’s deputy chief investment officer. “I’ve double checked with our due diligence folks,” she says.
But Schleif stresses that OZ fund managers have other incentives to get tax compliance right. “[T]heir reputations are at stake for ever raising additional funds if they don’t adhere to the rules,” she says.
OZ funds, which FA-IQ has written about extensively, became possible after President Donald Trump signed the Tax Cuts and Jobs Act of 2017.
With that legislation, Congress identified capital gains tax relief as a carrot to lead investors to buy stakes in economically-neglected U.S. neighborhoods. The Treasury then approved some 8,700 census tracts located in all 50 states as economically disadvantaged enough to become Opportunity Zones.
Under the program, investors can defer capital gains taxes — and even avoid some entirely — if they deploy their recently-realized capital gains to buy stakes for the long haul in the designated tracts. To achieve the maximum tax benefits, investors are required to make a 10-year commitment.
“Thorough due diligence is always on the shoulders of the investor … and in addition to standard private capital protocols, the due diligence on OZ funds requires an extra layer (or two or three) of conversation around legal and accounting expertise of the fund manager, experience managing properties and/or investments in the area the fund intends to invest in, presence of projects, activities, ownership already in hand and a host of other things,” Schleif says. “We probe deeply into the return expectations the proposed managers are proffering and what assumptions underlie them. Investing in private capital is higher risk by definition and when you layer tax consequences on top it can be that much more complex.”
“[T]here’s zero incentive for a manager to mess up this process. But it’s incumbent on potential investors and their representatives to thoroughly diligence and ask all sorts of detailed questions to insure the investment and the manager fits their unique situation,” she says.
“Investors always pay the ‘price’ or consequences for non-compliance,” according to Paul Saint-Pierre, a principal advisor for PSP Advisors, which provides alternative investment due diligence research and other fund advisory services.
Historically, that dictum has held true for REITs and investment companies. Now it holds true for OZ funds, Saint-Pierre says.
If they lose out on the tax shelters OZ funds potentially offer, investors may try filing legal claims against fund managers and rely on their Errors & Omissions insurance coverage for payment. “As part of fund due diligence, it is always important to assess insurance coverage,” Saint-Pierre says.
OZ funds worth considering will have resources dedicated to tax compliance, Saint-Pierre says.
“The significant complexities of the OZ tax compliance program require a ‘line of sight’ in the entirety of the tax compliance starting with investors, into the funds, and ending with all of the investees who receive OZ capital,” Saint-Pierre notes.
If they take compliance seriously, fund managers will staff up “and this will be a significant additional operating cost that investors will bear. If there is inadequate attention to the entire compliance architecture, then investors should avoid those funds,” he warns.
Tiedemann’s Insley has yet to encounter an OZ fund with adequate assurances about such tax compliance.
“We have not yet been able to get comfortable with any of the offerings,” he says.
The potential for conflicts appears particularly acute with real estate-focused OZ funds — the bulk of the presently available offerings, Insley says. Funds with real estate assets typically calculate managers’ performance fees based on internal rate of returns (IRRs), or the percentage of interest earned on each invested dollar over the entire holding period. The IRR is highest typically in the third or fourth year of ownership for funds that own newly- or re-developed real-estate assets. Therefore, fund managers will often be likely to net the highest performance fees if they sell during that shorter time period, rather than waiting for the 10-year clock set by the U.S. Treasury for OZ investments’ tax benefits to accrue, Insley says.
Investors should wait for “the right partner and be patient rather than work with some of the early movers” in the OZ fund space, Insley says. He expects some managers “who have much longer time horizons” to offer vertically integrated, multiple asset funds in the near future.
“It’s just taking some of them longer,” Insley says about those managers.
Investors should demand veto power over fund managers’ decisions to sell assets if they seek to avoid losing out on the potential tax-sheltering benefits of an OZ fund, without getting a high enough return on an asset sale to make the loss worthwhile, Insley says.
Since he has not found such terms among the OZ funds presently offered, Insley had told his clients to wait and they have followed his advice.
“They have been patient for the last several quarters, despite the fact that they read about OZ funds all the time in the press,” he says about his clients.