Nonprofit Insights Fall 2013
Risk & Reward:
The Challenge of Alternative Investments
Nonprofit investment committees are like any other investor: They want returns. Today, this increasingly means moving into alternative investments — everything from hedge funds and private equity funds to real estate, timber, oil & gas, LBOs and commodities.
Alternative investments can make sense for some nonprofits. But, by their very nature, alternative investments operate in less-regulated — or even un-regulated — markets. Moving beyond the tried-and-true can present a number of unique challenges to nonprofits.
- Valuation — Alternative investments are usually classified as level 3 investments, which require some expanded disclosures. Yet, establishing an accurate value for alternative investments is by far the biggest challenge for a nonprofit’s investment committee. Unlike stocks, bonds and mutual funds, there isn’t always a readily available “market price” for an alternative investment. A private equity fund is just that — private. You won’t find its share price listed in The Wall Street Journal.
- Liquidity — Investing in alternatives often entails illiquid holdings, especially when compared to stocks, bonds and mutual funds. An organization must carefully consider the “lock-up” periods required, as well as its overall tolerance for illiquidity. Capital requests also come into play: Some alternative investments require additional phased-in investments, which the nonprofit must be adequately prepared to meet.
- Tax Implications — Alternative investments can carry substantial tax implications — primarily unrelated business taxable income (UBTI). For instance, a real estate fund could generate UBTI if it generated income with debt financing (e.g., purchasing real estate with a non-recourse loan). UBTI can likewise result from operations in flow-through entities (such as limited partnerships) that are unrelated to the nonprofit’s exempt purpose and do not meet any of the exceptions for passive activities. Alternative investments can also trigger the need for foreign filings.
Are They Worth It?
While not appropriate for every organization, alternative investments do have their place. They can help with diversification and reduce the volatility of investment performance. But nonprofits need to think hard about the added complexity and obligations, as well as the core investment risks presented by these alternative opportunities.
Here are a few tips to help you succeed with alternative investments:
- Utilize a “prudent expert.” When it comes to oversight of a nonprofit’s investment portfolio, the primary role of the board/investment committee is to prudently evaluate, hire and monitor the investment professionals whose roles are to manage the organization’s investments. Follow sound due diligence and clearly establish the standard of care and even ethical expectations you expect your investment managers to follow.
- Establish a comprehensive investment policy. Your board should also establish an investment policy that clearly outlines the organization’s investment objectives, cash flow expectations and risk tolerance. Be sure to include requirements to periodically rebalance portfolios back to original policy targets.
- Use your board/investment committee. Once a prudent expert has been retained, ensure that your board provides oversight and monitoring and maintains a level of understanding sufficient to verify the valuation of any alternative investments. Consider establishing mechanisms for regular portfolio reviews as well as a periodic review of the services offered by your outside investment managers and/or brokerage firms.
Good Governance Is the Key
Ultimately, the key to success for nonprofits exploring alternative investments is good governance — clear policies, proper due diligence and thorough oversight.
Our experienced professionals can pro-vide valuable guidance on establishing a sound investment policy for your organization, including the use of alternative investments, if appropriate.