FundFire quotes Tiedemann in Opportunity Zones article

CIO Kent Insley and Investment Analyst Anisa Dougherty are quoted about the potential conflicts of interest when it comes to Opportunity Zone investments in FundFire's "Advisors Spot Red Flags in Opportunity Zones" article.

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FundFire
Advisors Spot Red Flags in Opportunity Zones
By Tom Stabile
May 29, 2019

Fund managers bounding into opportunity zone funds have yet to see big capital inflows – and one reason is that advisors are flagging for potential flaws or are holding out for products that have clear deals in place.

Among the intricate risks coming into focus are misaligned incentives that could see a manager sell assets to secure higher performance fees, but in doing so sacrifice possible tax breaks for investors. Another is the potential for investors to lose tax benefits if private funds managers take too long to call capital.

Only a handful of managers have raised significant capital thus far, such as Related Cos., which has brought in $200 million for a fund targeting $250 million. But many other managers are in limbo as advisors and consultants have begun honing new skills to vet these vehicles, which can provide up to 300 basis points in returns through a series of capital gains tax breaks for investors who put money into economically disadvantaged census tracts.

There are multiple layers of risk in the new funds, says Nick Veronis, head of research and due diligence at iCapital Network, an alts product platform for advisors. The platform is looking primarily at offerings from real estate fund managers and recently added its first opportunity zone product.

“There’s pricing risk, development risk, lease-up risk, and now duration risk, because you have to hold that property for 10 years to gain the tax benefit,” he says. “It can be an extreme risk if you don’t choose the right manager.”

Many of the risks stem from pressures to ensure that funds meet the program’s specific rules, which both managers and advisors are still learning. But managers generally are not adding extra provisions and terms to their contracts in order to participate in the program, says Richard Shamos, counsel at Sadis & Goldberg.

“Managers are interested in using this regime, but aren’t going out that far on a limb to raise capital for it,” he says. “We’re not seeing much in terms of items being added to [standard investment] contracts. There’s a delicate balance to meet that fiduciary responsibility for an investment as well as accommodate certain aspects of this regime.”

The potential for mismatched incentives between managers and investors emerged as an early focus in the due diligence process for Tiedemann Advisors, which began vetting funds last year, says Anisa Dougherty, an investment analyst at the $19 billion independent advisor firm.

The issue arises because the program’s main benefit – the ability to pay no capital gains tax on new assets held at least 10 years in opportunity zone funds – flows not to fund managers but rather to investors, she says. A provision in the program that lets fund managers stay in compliance if they sell assets before the 10-year mark but reinvest the proceeds back into the opportunity zone vehicle doesn’t prevent investors in the fund from having to pay capital gains on the disposed assets, she says.

“We’re worried that this may create incentive misalignment,” Dougherty says.

The incentive for managers to sell individual investments before investors get their full 10-year tax benefits on each asset will increase over time, says Kent Insley, CIO at Tiedemann. That’s in part because the funds will largely invest in new projects where the value gains will be most rapid in early years, and then taper off into more core-style returns as the fully built asset generates more stable revenues, he says.

“So the longer the hold, the lower the internal rate of return, and the lower the incentive fee for the manager,” he says. “In those later years, [managers] are at risk of seeing their incentive fees decline.”

That dynamic especially changes for managers after a fund itself approaches the 10 year mark, but potentially has not owned all of its individual assets for 10 years, Insley says. “Then, the temptation to liquidate to crystallize the incentive fee becomes stronger,” he says.

Tiedemann has discussed with managers the possibility to add provisions to their investment contracts that would prevent funds from selling assets before their individual 10-year hold periods, but none have agreed to the request, Dougherty says. “They say because they have their own capital in the funds, they have an incentive to remain in the assets,” she says. “But the incentive fee could dwarf the tax benefit.”

As a result, Tiedemann is expecting to create its own opportunity zone fund and hire a subadvisor to manage it to the optimal benefit of the underlying investors, Insley says.

Another potential snag for individual investors is around the timing of their commitment into private funds, says Kunal Shah, head of private equity due diligence at iCapital. To get tax benefits from the program, investors must sell an asset that has capital gains and then reinvest it into qualified investments within 180 days. But limited partners in a private fund will only meet the 180-day timeframe when a manager has called their capital to invest in an asset, rather than simply when they have committed money, he says.

That means investors face a tricky and potentially tight timeline in which they have to sell their original assets and get it into a fund that is ready to deploy capital, Shah says.

“For that reason, we’re only investing in funds where we know they are ready to call capital right after the commitment,” he says. “If the capital call date is unknown, then the investors don’t know when exactly to sell their assets with capital gains.”

For iCapital, that also means zeroing in on managers that have a clear set of targeted investments that have fundamental, long-term investment return prospects, rather than simply having a zone that they have identified as promising, Veronis says. “We want to take the mystery out of it,” he says.

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