Why accounting for alternative investments takes a bit more time…
Over the past decade or more, investors have increasingly embraced various types of alternative investments for their portfolios. From hedge funds to private equity to venture capital, investors have been willing to take on increased complexity in exchange for potentially improving portfolio returns, reducing overall risk, or both.
A major side effect of this complexity is delayed tax reporting for investors. For tax-exempt institutions such as pension plans and large charitable organizations, this is perhaps less of an issue. But for the thousands of high net worth investors and family offices with a tax filing deadline, this can be quite the hassle. Investors generally address this simple fact of life by obtaining an extension.
The recommendation for investors in alternatives: Plan to file for an extension on your taxes each year. Fortunately, filing for an extension is not a costly exercise. And the deadline for filing an extension is the same day that taxes would normally be due.
Additionally, as a Registered Investment Advisor, Altera has elected to audit its holdings so as to ensure accuracy for its investors. Not every alternative investment manager does this, but as a fiduciary (RIA’s are, by statute) Altera believes that this function is among its responsibilities. And it takes time.
At the core of the issue: Partnership Accounting for Private Equity and Real Estate
Partnerships are taxed as “pass-through entities”. This means that they do not pay taxes on their own, but instead pass any income, deductions or credits to the various partners. Partnerships file Form 1065 with the IRS and then issue a Schedule K-1 to each limited partner that details their share of the financial results. Each limited partner is required to report this tax liability on their own tax return.
Challenge #1: Complexity. Determining the results from a portfolio of private companies requires financial reporting by each of the holdings (think corporate Annual Report multiplied many times over.) Corporations are expected to report their income to the IRS by April of most tax years, but a very large number of them do not meet this deadline. This is a seldom known fact of financial reporting and directly reflects similar timing for filings by private companies held in fund portfolios.
Challenge #2: The Weakest Link. A fund’s documents are only prepared as quickly as the slowest filer in the portfolio.
Challenge #3: Other LLC’s. When a partnership (i.e., a private equity fund) invests in an entity that is also an LLC, the pass-through challenge is magnified. The filing is then about more than gains, losses and net income. It is also about tax credits, deductible expenses and other items. And as previously stated, the fund cannot file until all of the LLCs in which it invests have filed.
Challenge #4: COVID-19. Companies have experienced varying degrees of disruptions due to the COVID-19 pandemic in 2020, complicating the preparation of financial filings. For 2020, the IRS relaxed the filing date to July 15, giving companies even more time to provide this data to their investors.
Challenge #5: Fund-of-fund accounting. A partnership investment is often held within another fund as a means of gaining diversification, providing access that was previously unavailable, to gain economies of scale among many investors or to reduce risk. These attributes provide value to investors. However, this structure adds another layer of accounting that must be completed before tax documents can be generated, pushing the final K-1 to weeks after receipt of documents from their holdings. It is not uncommon for investors to see their K-1s delivered as late as September.
Challenge #6: The industry bottleneck. The accounting industry is, unfortunately, charged with providing all of the financial statements, audits and tax documents around the same time each year. Inevitably, some are completed more quickly than others.
Accounting for Credit Strategies
In a low yield environment, investors have been attracted to private credit strategies that offer premium returns from managers who provide capital to private companies. Increased banking regulation has pushed this function to credit funds who attract capital from investors that is ultimately lent to companies who cannot access the bond markets.
One might assume that credit funds are easier than private equity to account for. But this is not always the case. The value of any loan on a fund’s books is influenced by the credit worthiness of the borrower. A markdown in the value of a specific position would flow through to the investor. A fund may also receive “warrants” (equity-like investments) as part of a loan it provides, the sale of which will generate a taxable event that needs to be reported.
Accounting for Infrastructure Investments
Owing to their inherent stability and strong cash flows, infrastructure partnerships, such as renewable energy vehicles, have attracted billions of dollars from investors. Additionally, many private investments are making a direct impact on problems that investors wish to help address. These investments, however, like other private partnerships, present unique reporting challenges to their managers and investors.
Energy investments can also include tax benefits, tax credits and depreciation expenses, all of which can offset the taxability of certain income, making them even more attractive on an after-tax basis. Those same attributes make for a hearty soup of accounting issues that the financial professionals must annually deal with. Fortunately, the investor’s challenge is merely in the lateness of the reporting, not in understanding the intricacies of the accounting.
Investors are attracted to alternative investments as a means by which they can better meet their portfolio objectives. Lower correlations of returns versus public investments can possibly reduce portfolio risk. The potential for higher returns could help investors meet their growth requirements. Unique tax characteristics can add to their attractiveness. The direct, measurable social “impact” made by some private investments is arguable superior to what is available in the public markets.
The lack of liquidity, and of timely reporting, are drawbacks that investors need to consider when making a commitment to these asset classes. And while liquidity needs are unique to each investor, the simple act of filing a tax reporting extension can make late reporting less of a concern, allowing investors to access the benefits that many alternative investments can offer.