Retailization of Private Markets: Audit, Tax & Operations Considerations

As private markets have gained more traction from retail investors over the last few years who desire access to private equity, private credit and real estate, there are a handful of considerations that funds need to take into account from a tax, audit, and operations perspective all while managing the associated risks involved with a new and bigger pool of investors who demand greater transparency, faster reporting and more.

Key takeaways:

• Private market funds should consider leveraging AI and automation to streamline tax reporting to cater to the larger investor base.
• Private market funds should also consider utilizing automated processes for investor onboarding due to the larger number of allocators to accommodate.
• With different types of structures such as interval funds, business development companies (BDCs), and more, auditors will rely on heightened valuation controls, increased reporting transparency, and complex regulatory compliance.

Tax Considerations:  

Tax can no longer be a back-office afterthought; it should be integrated into product design, valuation, and liquidity management to prevent surprise tax events. In addition, leveraging AI and automation to manage tax reporting will be key to accommodating an increased investor pool.

Below are some tax considerations across the investor and fund lifecycle.

Reporting Shift: Instead of issuing complex Schedule K-1s, private funds must issue various Forms 1099 to retail investors, including Forms 1099-DIV, 1099-B, 1099-INT, and 1099-MISC.  

Navigating Multi-State Tax Exposure: Private funds are obligated to manage withholding requirements based on investor residency and address multistate tax exposure.

Product Structuring: Although the use of corporate structures over pass-through entities may expedite the reporting, funds should be aware of possible tax inefficiencies.

Gain & Loss Recognition: To manage gain & loss recognition effectively, firms need robust, modern tracking systems to replace manual workflows and ensure accurate data across multiple jurisdictions.

Audit Considerations:

As retail investors access private assets through structures such as interval funds, BDCs, and more, auditors will require heightened valuation controls, greater reporting transparency, and more complex regulatory compliance.

Below are some audit considerations.

Enhanced Valuation Scrutiny for Illiquid Assets: Because investments are held in semi-liquid structures, auditors are encouraged to rigorously verify valuation policies and methodologies in accordance with guidelines, including Rule 2a-5 of the Investment Company Act of 1940.

Rigorous KYC & AML Compliance: With traditional manual onboarding insufficient for retail investors, auditors should evaluate the technology and internal controls for automated investor identification (KYC), anti-money laundering (AML), tax reporting, and more to ensure operational scalability.

Increased Regulatory Compliance and Transparency: With an increased demand for transparency, auditors will adhere to stricter standards for financial reporting, including liquidity exposure, fee transparency, and investor education disclosures.

Liquidity & Risk Management: Auditors must ensure cash management policies are robust and that the different structures, such as interval funds and BDCs, can handle redemption requests.

Tax Reporting Complexity: The rise of regulated investment company (RIC) qualifications has required thorough auditing of investor-facing tax reporting.

Operations Considerations:

As the retailization of private markets has transformed the industry from relationship-driven to high-volume, tech-enabled operations, driven by an increased investor base, on the operations side, managers will have to adopt daily/monthly Net Asset Value (NAV) reporting and manage liquidity.

Robust Technology & Infrastructure: With more investors, private market funds will have to shift away from manual processes to leveraging technology for investor onboarding, compliance checks, and more to handle thousands of retail clients.  

Valuation Frequency: Private market funds are encouraged to leverage third-party automated valuation partners to accommodate the shift from quarterly/annual to monthly or daily NAV calculations.

Regulatory Compliance & Reporting: Private market funds will have to conduct scalable reporting to meet SEC guidelines regarding investor protection, disclosure, and, potentially, new requirements regarding “accredited investor” standards.

Investor Servicing: Private markets managers will have to invest significant resources in investor relations, including automated CRM systems and educational sessions to inform new investors about the associated benefits and risks.

Distribution: Funds must comply with distribution policies, earnings and profits calculations, and potential exposure to ECI and UBTI for certain investors.

Exit Stage: At the exit or redemption stage, funds should manage gain or loss recognition, distributions, and the correct allocation of tax attributes. 

The Future of Retailization of Private Markets

Retail investment in private markets is expected to increase with dedicated vehicles and is anticipated to more than double in assets under management in the next few years. Although there are many considerations funds need to take into account from an audit, tax, and operations perspective, when managers keep these in mind, they can create products that scale more efficiently and foster an investor-friendly experience. EisnerAmper is here to help you answer the difficult questions about private markets and deliver tailored solutions to navigate with confidence. Contact us to learn more.