Bridging the GAAP – The Emerging Sector of Nonprofit Investment Vehicles

It may even allow outside investors to participate. And it may be responsible for a structure where other investors are relying on its judgment, governance reporting and conflicts process. So that's the shift. So what has changed is not necessarily the concept of alternatives. What has changed is access, scale, sophistication, visibility, and the willingness of some tax-exempt organizations to consider whether a dedicated structure can better support their financial mission or strategic objectives. We're also seeing organizations think differently about capital. So historically, an investment portfolio was often viewed as their primary source of income, growth, or preservation of purchasing power. And so today some organizations are asking whether a structure that can do more than just investments. Can it support the mission? Can it support economic development? Can it support long-term financial sustainability? And can it create a common platform for related entities or outside investors? So that's really something that's newer and it's becoming more of a thing that's happening.

And when it does that, can it create a better governance around a particular strategy? So it's not really a brand new trend, but it's more like an evolution from simply participating in alternative investments to, in some cases, and what we're going to talk about today, creating and governing the vehicle through which those investments are made.

Candice Meth:Excellent. Thanks, Bill. And Jeff, I actually think you have a couple of examples to give us. Jeff might've frozen. So we'll get back to that. But Bill, what do you think is the business reason? Oh, I got

Jeff Chazen:It. I think I got it. I got it. Sorry. So sorry about that. Over the last number of years, I've seen different things. The two things I've seen is I once had a state where they were trying to get technology for their state. And so they worked with a sponsor creating a separate fund. And the sponsor for their fund would only invest in, these were venture capital funds for technology within their state to try to build jobs, to try to build that technology to be the cornerstone for their state. I've seen another situation where we've had a not-for-profit that was for a specific item, let's say for eyes, and they had a limited amount of cash. So they actually became a sponsor of a fund. And by becoming the sponsor, they had 5X of the amount of money to invest, which allowed them to invest in substantially more types of solutions as well as getting a return on their money.

Candice Meth:Great. Thanks so much. So Bill, what would you say is the business reason a nonprofit would be motivated to do this?

William Epstein:And Jeff Graves gives excellent examples. So the business case is not simply better returns. It's really whether a dedicated structure helps the organization manage capital more effectively. So in my experience, the business reason usually comes down to four things. Access, scale, control, and efficiency. But I would define these things a little bit differently in the context of what we're talking about. So access is not just access to investments. It may be access to a strategy, a pool of outside capital, or a structure that the organization could not replicate through the traditional investment sort of avenues. Scale really means pooling capital in a way that makes the strategy more viable, more efficient, more attractive to other participants. And control means that the organization may have more influence over governance, reporting, investment parameters and mission alignment and investor communications, which is a little bit more of a responsibility, but that is a good thing in this case.

And efficiency means creating a dedicated structure rather than having multiple affiliates, related organizations, outside donors, other donors, outside investors, everybody trying to solve the same thing, but separately. So I would think that the business case really isn't purely a return enhancement conversation. The question is not simply, would this produce better returns? The question really is, does creating this structure help the organization manage capital more effectively in support of its exempt purpose?

Candice Meth:Great. And we've seen so many clients come to us because we have that perfect intersection of not-for-profit and financial services backgrounds. Bill, with the clients that you're working with, are you seeing the trend being driven more by the mission, i.e. That the clients are trying to do impact investing or by the economics themselves? The yield, the diversification, the control, for example?

William Epstein:So mission and economics, they can really exist together. I've seen it both where it's either one or the other or a combination of both. So some organizations may create a sponsor or structure because they're trying to advance a mission-related policy objective. That could be the examples that Jeff was just talking about. It could be really doing something for housing, state-related jobs, buildings and things like that. But then others may just really be motivated by the economics, the scale, the yield, long-term sustainability. Neither is inherently wrong. The concern that I would always have when I see these structures start to appear is when the economics starts to become detached from the purpose. If the structure exists to support the mission and long-term sustainability, that can be very appropriate. If the structure starts to exist mainly to attract capital, generate fees, or behave like a commercial investment manager, and the exempt purpose really starts to become secondary or even a footnote, then the organization needs to pull back a little bit while we're thinking through that.

Candice Meth:Great. And we know there's a lot of complexity to doing this properly. And so based on the clients that you've worked with, do you see that the boards and the investment committees are actually equipped to oversee these structures? Are we seeing any governance gaps?

William Epstein:Yeah. I've seen both sides of this. So some boards and investment committees are super, super, very sophisticated. The board members volunteer their time on some of these organizations because that is what they do in their personal lives. They devote that element and they give that expertise to some of these organizations. And so they understand alternative investments, they understand private fund structures, they understand due diligence, the liquidity concerns, tax reporting, all those things. On the other side, we do have boards that are comfortable reviewing investments, but maybe they don't have all they need. They haven't really put the time into evaluating the structures. What does a capital call mean? What happens if these investments are locked up? If they're investing in private businesses, what kind of valuation issues are they hitting on? Again, later on, we're going to be talking about foreign filing exposure. There's all kinds of things that happens in the governance gap.

And so really have seen it both. So that is really the governance gap. And the gap gets wider when the not-for-profit isn't just the investor, it's when they're sponsoring or structuring the organization. So when the organization is a limited partner in someone else's fund, it's valuating someone else's structure. And it matters, but it doesn't matter as much as when an organization sponsors the vehicle. It is responsible for the structure. And so those are very different governance positions to be in. And the issue usually isn't any type of bad intent, it just becomes that these organizations become very complex. And so the structures in this situation evolve faster than the governance process that supports it.

Candice Meth:Great. And what would you say are the advantages to the nonprofits about being able to tap into private equity?

William Epstein:Lots. It becomes complicated. And a lot of this is not for the faint of heart, but private equity can provide access to opportunities that just really aren't available in the public markets. It can provide a long-term growth potential diversification, exposure to different businesses that align with the mission. But in the context we're talking about today, the not-for-profit may not simply be investing in private equity, but it may be using private equity fund style structure. So that means that they're sort of like the venture capital provider. And that is a different level of responsibility. So for organizations with a long-term horizon, that can be very attractive. But I always remind the boards that I work with here that private equity is not a free return. Really, you were accepting more likely than not illiquid positions, evaluation complexities. You're dealing with capital calls, you're dealing with all kinds of different tax considerations.

And so if the not-for-profit sponsors or governs the vehicle, you're accepting additional fiduciary governance, investor communications, audit readiness, which is a big one. So the conversation isn't about rate of return or whether we should get into private equity, things like that. It's really about whether the entire structure makes sense for the organization.

Candice Meth:Great. So we've laid the groundwork. So now let's really get into the nuts and bolts. So Bill, how do we get this right?

William Epstein:So I just brought up this slide and it's called the Golden Rule Mission Before Structure. And when I look at this slide, it really comes down to four words. And just honestly, repeat anyone who's going into this type of structure for a not-for-profit should just repeat these four words over and over again. Exempt purpose before structure. So honestly, to me, as a not-for-profit guy, this is probably the most important slide in the entire deck. And before I really get into it, I just want to broaden the conversation just a little bit. So a lot of the conversation today is framed around 501 organizations because that's primarily what people think about when they first hear the word not-for-profit. They think charities, foundations, religious organization, educational institutions, things like that. But the idea of what we're talking about here applies across the entire tax exempt set. So it could be a 501 entity, it could be a C4, it could be a C6.

Other exempt organizations may have different purposes. So the code section, the 501 section may change, but the discipline behind what those four words really mean does not. So whatever type of exempt organization we're talking about, the structure has to support the reason that the organization is exempt. So that is why when I look at this slide, I think of those four words, exempt purpose before structure. And if you look at the slide itself, it's really kind of giving us the roadmap here. So the first question should be not what entity we should create, but the first question is what are we trying to accomplish? So once we understand that objective, then we can start to evaluate the investment strategy. And then we evaluate governance. And then do we have the right oversight? Do we have the right expertise? Do we have the right controls? Then we can start to also think about the tax implications about how this all works.

Then we can start to evaluate who is participating in the fund itself, how they're participating, whether the economics are aligned with the exempt purpose. So only after we've worked through those questions, should we be talking about entities, fund structures, block reports, management arrangements, all the things that. All the cool terminology relating to fund structures that people want to talk about. But really because if we start with the structure, we're solving the wrong problem. And there's another reason this matters. So for a tax exempt organization, the exemption itself is the most valuable asset. The investment portfolio isn't the asset. The fund structure isn't the asset. The exemption is the asset. So once an organization starts creating structures that primarily benefit insiders or they create a private benefit or private inurement concerns or cause the organization to drift away from the reason that it was granted exemption in the first place, we're no longer simply talking about investment strategy.

We're talking about protecting an organization's exempt status. So a well-run fund can be a tool, a separate vehicle can be a tool, but the tool cannot be the purpose. The structure exists to serve the exempt purpose. And so the exempt purpose was never intended to serve the structure.

Here's a good way to think about it, and I would use this simple test. And this is something that I think people should take away from if you go down this road. If someone asked the board two years from now why this structure exists, could the board clearly explain how it supports the organization's exempt purpose? If the answer is yes, then you're probably on the right track. If the answer is no, you probably have a structure, but you don't yet have a strategy here.

Candice Meth:Next slide.

William Epstein:Oh, a poll.

Candice Meth:So what category best describes your role? And we'll give everybody 60 seconds to respond. And Bill, I think after this, we're going to move into what a typical structure looks like. So a picture's worth a thousand words.

William Epstein:Yep. I have a good slide next. We should all say the mantra again. Exempt purpose before structure. I keep saying it over and over again.

Candice Meth:Okay. And these are the results. Okay. Bill.

William Epstein:Okay, here we go. So what you see here is in the most simple form of a slide that sort of diagrams how these structures are really set up. And then they get very, very complicated, but this is just a very simple diagram to show how it works. And so the most important thing to recognize is that when you're thinking about these things, that the not-for-profit is no longer simply making investment decisions for itself. The moment outside capital structure, the not-for-profit's responsibilities change. And that's really a key distinction here. So when we're talking about a not-for-profit sponsor and governing, facilitating, we're creating opportunities, but we're also creating a lot of responsibilities. So let's walk through this slide. So from top to bottom. So at the top here you have the not-for-profit sponsor. That is the organization or exempt entity driving the strategy. Alongside the sponsor, you have outside investors.

It could be other not-for-profit organizations, it could be foundations, it could be individuals, it could be however your structure is set up to allow whatever investors particularly in there. So in the middle, you have the manager or the general partner. And this is important to note because the manager or the general partner may have its own governance, its own economics, its own duties, its own potential conflicts. And in many cases, this is where the governance conversation becomes really real. So who controls the general partner? Who appoints the decision maker? Who approves conflicts, things like that. Because whoever effectively controls that general partner or that management company is often controlling the investment decisions as well. So then across from the management company, then you have the fund itself. And then underneath that, the underlying portfolio. And the underlying portfolio could be anything. It could be private equity, credit, real estate, hedge funds, other alternative investments.

It could be all kinds of different things. So the shift is this, investing your own balance sheet is one exercise. Selecting for a fund where others are relying on your judgments is another. At that point, the organization has to think about governance, reporting, valuation, conflicts, tax reporting, all the things that, especially audit readiness. As being an auditor myself, audit readiness is right at the top for me.

Jeff Chazen:Great. Bill, can I add one thing?

William Epstein:Absolutely.

Jeff Chazen:I just want to add one thing. Just for everyone on the thing, historically, if you look at the nonprofit sponsor on the left, historically it's on the right-hand side with the outside investor. The trend we're seeing and what we're talking about is now you're moving to the left side of the slide, which is a very key point.

William Epstein:Thanks, Jeff.

Candice Meth:Exactly. And Jeff, actually, over to you. I'm curious, a lot of times we hear this term carry, a financial services term, but in this nonprofit context, what do we mean by carry it and how does it jive with this structure?

Jeff Chazen:So this is a typical fund structure in the private equity hedge credit world. It's all very, very similar. Manager DP will be two vehicles versus one. Other than very similar. And many of you are familiar probably with the two in 20 term. 2% management fee, 20% carry, which is generally structured as reallocation. So the 2% management is a fee paid to the manager. And to the extent it goes to a not-for-profit, it's basically UBTI. The carry, the 20 can be structured as two ways. It could be structured as a fee, which is very rare. Again, causing a problem for both the tax-exempt sponsor, because it would be UBTI, as well as the ultimate limited partner investor. It's a portfolio deduction. And if they're individuals, et cetera, they can't use it. So it's structured as a reallocation. So instead of coming in as fee income, it comes in as the character of income that's earned at the fund level, which is usually interest, dividends, and mostly capital gain.

Candice Meth:Great. Thank you so much. So Bill, how do organizations decide between keeping the investments inside that not-for-profit versus creating a separate legal investment vehicle?

William Epstein:Yeah. Honestly, the easiest answer there is a separate vehicle should solve a problem. It shouldn't exist because it just sounds cool or it seems interesting to do. So the first question I would ask is whether the not-for-profit is simply investing its own capital or whether it's creating a platform to which capital is managed. So that distinction matters. If the not-for-profit is investing its own assets, then keeping investments inside the organization may be totally fine. If the organization is pooling capital, bringing in outside investors, creating a dedicated strategy, then a separate legal entity makes sense. And so I would go back to the five things here. So scale, liability, outside investor participation, governance capacity, reporting capacity. So scale matters because the strategy may only make sense if the capital is pulled. Liability matters because the organization may not want the particular activity that they're going down getting into.

They may not want that activity sitting directly on the not-for-profit's own balance sheet. And liability isn't just an abstract concern. It's in the traditional fund structure. The fund itself usually sits below the general partner. And if the not-for-profit itself were serving as the general partner, the not-for-profit's own balance sheet may be exposed to claims arising from operations of the fund. So that could be a big deal. And the operations of the fund could include investor disputes, litigation, things like that. And so they don't want that coming back on the not-for-profit and to be able to take resources that are for a charitable mission.

There's also a tax reason to create that sort of middle entity there. And so the structure also creates a clearer contractual relationship. So the board can see who is being compensated, what services are being provided, what the fee arrangements are. And honestly, the reason that we see these structures in the not-for-profit space is because sophisticated investors expect to see something like that. So most institutional investors would say we would require that or look for that. And if they don't see that, maybe they would say, "What's going on here? We're not going to particularly invest in this particular fund." And so it's an operating structure that parties really rely on. Governance, capacity matters, and reporting complexity matters. Now you have separate agreements, books. So there's a lot of decision-making that goes into whether or not your investments sit on the not-for-profit itself or create these. And so the structure really is driven by a real.

Candice Meth:It's interesting. We've had clients that we've worked with that have housed this inside a disregarded entity, an LLC, and that certainly creates legal protection, but obviously all the activities then get reported in the 990 of the nonprofit. And so in some instances, that's a good structure. And in some instances, if you just want to see how the fund is performing, you don't get that level of detail when you look at the 990, you just see little pieces of it in Schedule R. So thinking through what feels right for your particular situation I think is critical here.

William Epstein:Absolutely.

Candice Meth:Yep. And speaking of which, can the nonprofit allow outside investors to get into their fund? And moreover, can they guarantee their investors a certain return and still remain tax exempt?

William Epstein:We'll tackle that second one. We'll talk about second part separately. So depending on how the fund is structured, generally, outside investors may be able to participate. It just really depends on how it's structured. But remember, outside investors, so if you're opening this up to outside investors, I That really changes the profile. I mean, outside investors are not just more capital. Thinking about what that really means to allow that is now you have additional reporting obligations, you have fiduciary obligations, you have valuation expectations, conflict procedures, and they bring a much higher level of governance, required governance discipline. So when a not-for-profit is investing its own assets, the board is focused on whether the investment is appropriate for the organization. But when a not-for-profit is sponsoring the vehicle that allows other in it, others, outside people in it, the board has to think about whether the structure is being operated fairly, transparently within the organization's exact purpose.

Now, for the point on the guaranteed return, I would caution anybody who's going down this road to be very careful with that and probably stay pretty far away from it. A targeted return or a preferred return is maybe one thing when you're doing your perspective. Guaranteed return is something very different. In the not-for-profit sense, you could probably equate a guaranteed return to something like a charitable gift annuity. That would be a good example of a guaranteed return. But a charitable gift annuity, it's not an investment. It's not an investment vehicle where outside investors are contributing capital and expecting a not-for-profit to guaranteed investment returns. So that distinction matters. And if we're going down that guarantee, I would make sure you have every lawyer on the planet involved and to ensure that that's something you can do. But preferred return, targeted return, define that. Guaranteed return, I would stop and talk to all the lawyers.

Candice Meth:Perfect. So then just kind of thinking about what can go wrong, what kind of guardrails do we need and how do we think through so we can avoid those?

William Epstein:So these structures are not easy. And as we've been talking about, they're very complex. And what can go wrong is usually not one dramatic technical mistake. What happens is usually what we see is that there's a series of governance misses. And that could be the mission or exempt purpose is not documented. The board approves a general idea, but not the structure. There's an insider affiliate who was compensated, but the fees weren't benchmarked. The fund uses leverage, but no one ever discussed UBEIT. The first audit starts and the valuation support is not ready. So there's lots of guardrails that need to be practical and sort of done in the front. So the guardrails really are, get your documentation in order, make sure you have your written investment policies, conflict of interest have been reviewed, arm's length fee benchmarking, investor reporting protocols, your valuations are done. So guardrails are there to make the strategy defensible and not slow the process down.

You muted.

Candice Meth:Sorry about that. What should nonprofits understand about capital calls, distributions, lockup periods before they get involved?

William Epstein:The fee question, it's not just what's the percentage. It is who gets paid for what, by whom, and is it defensible? So fees can include management fees, as Jeff mentioned before, carried interest, incentive allocation, organizational costs, transaction fees, monitoring fees, the fees, the fees on top of the fees, all the fees. Where organizations I think get tripped up is really they focus on the headline, just management fee. And that's pretty narrow. The better question to ask is really who is getting paid for what service, by who, under what authority, and was that the benchmark? And so is the manager related to the not-for-profit? Is the general partner controlled by the not-for-profit insiders or affiliates? Is there a board member involved? Is there an officer involved? Are the fees being allocated consistently? Or are fees being charged at the fund level, the manager level directly?

I mean, there's lots of levels here in relating to how these fees can go. And also the board needs to make sure that they understand the full economic arrangement, not just that there's a fee. And in the not-for-profit contents market isn't enough as a verbal conclusion, the board needs documentation. So especially when the not-for-profit is effectively controlling both sides of the structure, meaning that it's connected to the sponsor, the GP, the manager, or the governing body approving the arrangement.

Candice Meth:Perfect. And then just touching upon capital calls, distributions, lockup periods, what should nonprofits know?

William Epstein:So are we actually on a different slide?

Candice Meth:Yep. I advanced it to the getting investor ready.

William Epstein:Oh, sorry about that. That's okay.

So capital calls, distribution, lockups, all the fancy fund operational words. I mean, they're not just investment terms. They affect liquidity, cashflow planning, budgeting, all those things. So capital calls really means that the organization may commit capital today, but funded over time, and that sounds convenient, but it's a legally binding obligation. And if the not-for-profit is sponsoring the structure, it may also be relying on other investors to honor those commitments. So for instance, if the organization is going into a deal with a private company and that private company is X millions of dollars of a stock purchase and they're relying on outside capital, well, that outside capital call needs to come in before they sign that deal. So managing capital calls, commitments, and we're managing liquidity. And those things don't always arrive on a predictable schedule. Lockup periods are equally important. Most likely the underlying investments are going to be illiquid, and so the fund structure needs to reflect that reality.

So before creating the structure, management needs to understand that it's not just investments, but the operational obligations that the structure creates.

Candice Meth:Perfect. Okay. So then I think we are moving to our next polling question. Which category best describes your role?

Candice Meth:Okay. So before we move into the next slide, just really quickly, a couple of questions we're just going to touch on. In terms of what types of nonprofits we see having an interest in using these vehicles, we see a lot of scientific research nonprofits that are looking to invest in early stage research, things that pharmaceutical companies aren't ready to invest in yet because it hasn't been proven out yet. So they want to be first dollars in to try to move the research ahead aligned with their mission. As Jeff mentioned earlier, some states have set up funds for the purpose of job creation to help the economy of the state. So those are the types of examples where we're seeing a lot more traction on this. So in terms of preparing for the first audit, Bill, you touched on this earlier, but can we just talk a little bit about getting ready for the audit and thinking through valuation, et cetera?

William Epstein:And I'll be quick because I know I'm meeting into Brett's though. So the best time to build the audit trail, and very simple answer, the best time to build the audit trail is when the fund is formed, not when fieldwork starts. So you want to have all that information ready to go before the auditor starts to mass that information. So you don't want the auditor for showing up and then you have 10 different people trying to find all of this information. You want to start to do that as the actual fund is being structured and have those things ready to go. The other important thing here is that you assign the organization when they go into these structures should assign people who are responsible for the particular documentation. So who maintains the investor records? Who's got the board approvals? Who's got the conflict documentation? All those things should be sorted out before the auditors step foot.

Candice Meth:Perfect. All right, so I think we're going to dive into tax. And so Brett, we want to kick it off with what types of things should the organizations be on the lookout for? And of course, UBIT is top of mind.

Brett Cornell:Great. Thanks, Candace. Yeah, we have quite a bit of tax to get through in the next 20 minutes, so I'll try to give everybody the highlights. When tax exempts are thinking about getting involved with alternatives and alternative investing, really the things to look out for are going to be driven by what types of investments the taxes are getting involved in, and then how they're getting involved in those investments, meaning what vehicles are they entering into to make those investments. Different types of investments produce different types of income. Some of, as we've mentioned a lot already, UBTI is bad for tax exempts. And then depending on what vehicle you're using to make those investments, there could be certain foreign filings, so certain tax compliance forms that aren't necessarily an actual tax, but do carry major penalties if you're not in compliant with those forms. So those are two main areas you want to be aware of.

And of course, you also need to consider those areas in the context of the tax exempt purpose. We'll reiterate the mantra again, exempt purpose for structure. So let's dive into UBIT first. I think that's really top of mind for everybody. So let's give a quick definition UBIT. That's unrelated business income tax. It's a tax that an exempt organization owes on income from a trader business that's regularly carried on and not substantially related to the organization's exempt purpose. So that's basically it's income generated from a real trader business. So think of making investments in an operating partnership. Think of, as Jeff mentioned, management fees that you're earning. These are all things that could be viewed as a trader business and generate UBTI, which would have a negative impact for our tax-exempt investors. The other second bucket that UBTI generally presents itself is debt finance investing. So if you're using a lot of leverage, that's where we see UBTI coming in as well.

Think of acquisition and debtedness in real estate, or think of hedge fund investments that are trading, hedge fund strategies trading on margin, things of that nature. So why is UBTI of consequence to our tax exempts? Well, in short, it's an actual tax on that specific type of income. So it's a 21% tax on corporate rate entities. And in addition to filing your typical 990 that a not-for-profit would have to file, you're now falling into requirements to file a Form 990

And to actually compute and pay the UBIT tax on your unrelated business taxable income. And there's obviously a lot of compliance that goes around with that, gathering all of the tax documents, putting the calculations. There's some interesting rules around if you're invested in multiple different streams of income generating UBTI that losses from one can't offset income from another. So a lot of additional compliance on top of the tax itself. So why this matters is when we're going into alternative investments, it's not just the return that you're expecting from your particular trading strategy or investing strategy. It's the after tax, after compliance cost of return you really want to be focused on.

Yep. And I think one of the main things, and we can go into a little bit more of what income we're going to see. There's certain types of alternative investments that generate different, or you could expect maybe UBTI to be present either from debt finance investments or from, as I mentioned, operating businesses as well. So we have a few here up on the slide when you're thinking about your investment strategy as a not-for-profit. If you're investing in hedge funds, that type of income is generally going to be exempt from UBTI. You're talking more interest, dividends, capital gains, et cetera. Generally not too many issues there. However, if you're getting into a fund strategy that uses a lot of leverage or trades a lot on margin, you could end up with some UBTI generated. So you need to be a little bit careful there. Private equity, that's really the main culprit we see in the alternative investment space.

A lot of those returns are coming from direct investments in operating businesses. Those can be structured a lot of times as partnership, investing in an underlying partnership, which will generate K-1s out to you that basically give you a distributive share of the company's tax character, which would also include UBTI in general. So you got to be a little bit, just understand the profiles of different type of asset classes and whether or not they may or may not produce UBTI. And we'll go into some structures in a little bit to help you figure out where can we mitigate this and where we could potentially structure around some of this. I'll mention private credit. Private credit has been pretty big as well as of late. If you're getting involved in some loan origination or investing in loan origination funds, that could be deemed a trade or business and shoot off some UBTI.

And then I'll go back to real estate. We see that a lot with the acquisition and debt and as you're using debt to finance the purchases, and that could be really a hotbed for UBTI as well.

Candice Meth:Perfect. So the distinction we're making is rather than let's say an independent school or a college or university just managing their own endowment and just including in that endowment alternative investments, this is a situation where a nonprofit has decided to create an investment fund and typically allow outside investors into that fund. Those investors might be individuals, they might be for-profit entities, they might be nonprofit entities. In that case, is the nonprofit still filing a 990? What types of filings get triggered?

Brett Cornell:I mean, the types of filings that generally would get triggered for the nonprofit itself, then usually they're going to be filing their 990. And if they're generating UBTI, there'll be a 990T where the UBTI is going to actually get reported and calculated and pay the tax on the 990T. So that's generally what you see for the nonprofit. Perfect.

Candice Meth:And how does fund level leverage change the tax profile of an investment for a tax-exempt investor?

Brett Cornell:Yeah. As I mentioned, it can turn really otherwise exempt or passive type income, interest, dividends, cap gains, et cetera, which ordinarily wouldn't be subject to UVTI or considered UBTI. Using that leverage could now essentially taint it and make it an exposure item for EBIT. So some funds obviously are using leverage as a matter of their strategy to get the returns that they're looking for. So you just need to go in eyes wide open to understand that, okay, this might still be part of our mission, further our mission, further our investment strategy, further our returns, et cetera. We're okay with some of this UTI risk, but you just want to go in eyes wide open when you're dealing with leverage and make sure that you're adequately structuring. Perfect.

Jeff Chazen:Oh, I just would like to add the keywords that Brett just added. It's about structuring. While a fund may use leverage, in most cases you can structure, which Brett will talk later about, to avoid that issue.

Candice Meth:So Jeff, thank you for setting this up perfectly. So we're going to start talking about blocker corporations and then we'll move into foreign filing. So in plain English, Brett, what is a blocker corporation and why is it commonly used for tax-exempt investors?

Brett Cornell:Yeah, so as simple as the explanation can get, a blocker corporation essentially is just a taxable corporation that sits in between the tax-exempt investors and the investments that are generating UBTI itself. So when we're just talking about the types of investments that might shoot off UBI, trader business income or debt finance investing, very, very common for tax exempts getting involved in those types of investments to look to go through a blocker corp structure. And the reason why we see that happen a lot is kind of threefold. One, when you put the blocker, the corporation in between the taxes and the investments, all of that UBTI income is blocked, quote unquote, because we're no longer as a corporation, that's the ultimate beneficial owner from a tax standpoint. It's not a flow through that's then a partnership that would flow all that character down to the ultimate owners.

That corporation in between is going to block all of that UBTI, and the tax then would be paid at the blocker corp level as opposed to at the actual corporate level as opposed to investor itself. So it's really just shifting that tax up. And then when the payments come from the blocker, the corporation to the tax exempt, it comes in the way of a dividend generally, which would not be subject to UBTI. So very, very common for that reason. Also, you completely avoid the 990T filing as well. So if that UBTI is blocked at the corporate level and never actually hits the tax-exempt investor directly, that's going to keep it off its own return, which above all is going to also to preserve the tax-exempt status because those investment activities that might otherwise generate UBTI are now basically investments in the blocker corporate itself.

Candice Meth:Perfect. And so essentially what I'm hearing you talk about is acknowledging the trade-off. So you can use the blocker and pay the corporate tax rate, then you avoid surprises, then you avoid additional filings of the 990T or perhaps some state UBIT forms, but it might actually cost you more money at the end of the day. Or you cannot go through that structure and potentially have a surprise year where now you're suddenly in the situation of having to file the 990T and potentially some state UBIT forums. So I think we'll move into the polling question. And while we're giving people a chance to talk through that, I have one other question for you, Brett, that I want to go to. So let's move to the polling question. Okay. And so what is your approach towards investments that generate UBIT? Our policy is to avoid any such investments.

We are not worried about triggering UBIT for our investors or we offer each investor the option of structuring through a blocker corp. And while we're giving people 60 seconds to go through that, Brett, do you see funds not setting up the corporate structure or do you typically see them going through a blocker corp?

Brett Cornell:It really depends on a couple of different things. We certainly do see managers passing on the corporate structure as it relates to considerations such as cost. It could be very costly to set up some of these additional entities, whether they're foreign entities, US entities, et cetera. There's annual audits, annual tax, there's legal fees associated with it. So if your investment profile is of such that you may not have a lot of UBTI exposure, you might not think you're going to be generating a lot of it, or if your taxable base is, sorry, your LP base is mostly taxable investors or there's not a lot of tax exempts, for example, then it might be a decision where you decide to pass from a cost perspective or really just from a need perspective. And then quickly what I would add is you also see a lot of funds that are just starting out.

They might want a simplified structure, try to keep things a little bit more efficient and cost-efficient, and then maybe add a block or a corporate structure as you move further on in the life cycle and make certain types of investments or of difference when investors come in.

Candice Meth:Perfect. And so the response to the polling, the most common was that the policy is to avoid any investments that trigger UBIT. And thinking through this type of structure, you have to know your investors as well. So if you have investors, for example, that are religious entities that don't typically have any tax filings, then you as the fund sponsor want to make sure you are selecting portfolio investments that aren't going to suddenly trigger a filing for your investors. Okay. So when a fund manager says that the UBIT is blocked. Sorry, when a fund manager says that there is a UBIT blocked share class or feeder, what should the investor confirm before signing those subscription documents?

Brett Cornell:Yeah, so first things first, just like what's on the screen here, you're going to want a structure chart. You're going to want to figure out what vehicle we're actually subscribing to. Are we going to go through a blocker fund? Are we going to go direct and have exposure if we don't go through a foreign feeder with a blocker situation? So just getting the structure chart and getting the mapping and the details of what are the entities that are set up and which entity are tax-exempt investors actually going into.

Candice Meth:Okay, great. Go ahead.

Brett Cornell:Yeah, I want to mention just quickly, we're just showing two different structure charts. One here is a very basic structure chart with going into a US operating partnership. So you see your UBI folks, your tax-sensitive exempt investors at the top right. They might go through a parallel fund, maybe it's foreign, maybe it's US, that could be a partnership and going into a US blocker or it could be a foreign blocker. It really depends on what you're investing in and who are the folks that what you're trying to achieve with that structure. So we just wanted to give you a quick illustration of what that looks like. But again, really want to, as part of the diligence, understand which vehicles you're getting into and what those vehicles are investing in. And we have a second one here. This is a little illustration just of a typical master feeder in a hedge fund structure.

Again, tax exempts off to the top right. A lot of times when there's a mixed investor base, so for example, you have non-US folks and tax-exempt folks, they can actually go through the same. More often than not, it's going to be a foreign corp, a foreign offshore feeder. We see that out of the Cayman Islands, we'll see that in Luxembourg, we'll see that in certain different jurisdictions. That's where we see some risk. And I think we'll be able to get into that next on the foreign filing exposures where if you're getting involved in some foreign feeder corporate, if you're going right into the foreign feeder, there's certain considerations and things you need to be aware of from a foreign filing component as well.

Candice Meth:Perfect. You teed me up beautifully. So moving into foreign filings, which foreign information returns tend to surprise nonprofit investors most often and why?

Brett Cornell:Great. Thanks.

So I think that polling question is actually a great question because it says which foreign filings gives you the most headaches? And I would say probably all of the foreign filings tend to give our tax-exempt folks some headaches. Not something that a lot of folks are necessarily thinking when they're getting into some alternative investment vehicles or investments. So just quickly, we wanted to list out a few of the highlights here. I'll focus I think on just two or three just in the interest in time. But on the last slide, we actually talked about the tax exempts going into an offshore feeder. And that offshore feeder is very often structured as a foreign corporation. For example, a Cayman Corp, as we mentioned. So whenever there's certain foreign filing obligations with form 5471, for example, if you are a US person, a US tax exempt that owns over 10% of a foreign corporation, you would have a 5471 filing requirement.

These are pretty arduous forms to fill out. There's a lot of data you need. It's basically a mini tax return. So certainly something you're going to want to be on the lookout for and make sure that you're able to get the appropriate information either from that corporation itself or the administrator or whomever you're going to be to get the info from. There's also the, skip to the 926 where that can be as routine as making a capital call into the foreign corp. So if you're making a capital call to the investment, it goes into the foreign feeder first before it matriculates into the actual investment.

That obligation can occur with cash contributions of $100,000. So again, another filing that you may not have been aware that as a tax exempt you would need to file could pop up with a very routine transaction. 8621s, that's PFIX. You may have heard of those. Those don't typically apply for tax exempts unless there's leverage involved, but wanted to highlight that for you here. And really the takeaway here on the foreign filings, and it's very important to understand your structure and what vehicles you're getting into and what investments you're getting into. I There may not be tax due with these forms. They're more informational. However, there's stiff penalties for missing these filings and they could range generally for $10,000 per form per year. And on top of that penalty, it actually keeps the statute running on your tax return itself, which is an open-ended liability that you certainly would like to avoid.

So very, very important to have these types of questions in your diligence questionnaires, to be focused on that from an investment committee standpoint and really come up with a game plan for timelines of reporting and making sure that you have a compliance calendar and a filing list kind of buttoned up before you get into these investments.

Candice Meth:Perfect. And before we move on to protecting the tax exempt status, I just want to ask a quick question, which is how should the nonprofit as a manager of a fund make the foreign reporting obligations more transparent for their tax exempt investors?

Brett Cornell:Yeah, so a lot of the same things, you're going to want to provide structure charts if possible. Maybe as part of the subscription docs or the offering docs that you're having to your investors, you're going to want to be committed to the extent that you can on information reporting, K-1 delivery, PFIC information delivery, any type of information that they would need, not just necessarily saying it, but maybe memorialize it in some of your documents. And then obviously giving them some tips to what's for, "Hey, here's the expectation. If you're investing with us, these are the types of vehicles we go in the tax profile, and this is what you could expect at year end." So obviously the transparency around it and the communication around it is something that tax exempts who are actually running the fund should and should be able to provide to their LPs to make it more of a seamless relationship.

Candice Meth:Okay, great. So we are just slightly over time, but we're going to bring it home now and just kind of in summation talk about the most important thing, which is protecting the tax-exempt status.

Brett Cornell:Yeah, I think the last kind of thing I would say to just button it all up is too much exposure to UBTI potentially could have a negative impact on your tax-exempt status. So really want to build those safeguards into your investment policies, making sure that you've done diligence as part of your diligence questionnaires for investment selection on structures and blockers and reporting, and really being able to plan ahead for any type of UBTI exposure or foreign filing exposure, and just make sure that that is kind of a formal piece of what you're doing from an investment policy. Shouldn't be an afterthought, it should be done upfront and that will save a lot of heartache on the back end.

Candice Meth:Fabulous. And Bill, the final question is to you. How should an investment policy statement be updated to address tax exempt investor risks associated with alternative investments?

William Epstein:Yeah, so the investment policy should not just simply govern the investments, obviously. It should govern the full decision as to what you're really doing here and creating this type of structure, I guess is the easiest, simplest way to answer that. But I would also just add one little piece to that is that the policy should really just also be updated to ensure that the board is doing a periodic review of the structure itself. They sort of need to gauge themselves as to how they're doing and whether or not this still makes sense for the organization.

Candice Meth:Great. So really want to thank everybody for hanging in there. I know we went slightly over time. We have your questions. We will follow up with you individually if we weren't able to answer your questions in real time. And thank you so much for joining us today. I'm going to pass it back to Bella.

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