Pros and Cons of Alternative Investments for Nonprofits

Quick answer: Alternative investments like real estate and private equity can boost a nonprofit’s financial returns and diversify its portfolio. However, these assets carry higher risks, lack easy liquidity, incur significant management fees (up to 20%), and may trigger unexpected tax liabilities such as unrelated business income (UBI).

Nonprofits constantly seek new ways to strengthen their long-term financial performance. Traditional securities like stocks, bonds, and mutual funds form the foundation of most portfolios. Yet, some organizations look toward alternative investments to generate higher returns and improve diversification.

These non-traditional assets include hedge funds, private equity, venture capital, cryptocurrency, and real estate. While they offer access to high-growth opportunities, they also introduce complex risks, high fees, and potential tax complications. Understanding exactly how these assets impact your organization is crucial before you commit any operating capital.

What are the risks of alternative investments for nonprofits?

Alternative investments usually lack an easily ascertained fair market value. Unlike publicly traded stocks, assets like private equity and real estate are highly illiquid. An investor cannot simply cash out or shift allocations on a whim.

This illiquidity poses a substantial risk for nonprofits that rely on readily available operating capital to fund their programs. Choose alternative investments only if your nonprofit maintains a strong cash reserve to cover short-term operational costs. The complex nature of these non-traditional assets increases the risk for investors, which is exactly why the potential returns may be higher.

How much do alternative investments cost to manage?

Alternative investment funds typically operate as partnerships or limited liability companies (LLCs). Because these are pass-through entities, the tax liability passes directly to the investors, who are considered partners or members.

The fund manager plays a critical role in the success of these investments. When evaluating a fund, nonprofits must scrutinize the management fees and ensure the manager has a proven track record. Managers typically charge a base fee of 1% to 2% of the fund’s capital or net asset value. Furthermore, managers often charge performance-based fees called carried interest. Carried interest can reach as high as 20% or more of an alternative investment’s profits.

Do alternative investments create tax liabilities for nonprofits?

Generally, the IRS excludes a nonprofit’s investment income—such as dividends and standard interest—from taxable unrelated business income (UBI). However, investing in partnerships or LLCs changes the equation. The IRS treats the investors as though they are directly conducting the entity’s business. Consequently, income distributions from these alternative funds may be classified as taxable UBI.

Additionally, UBI encompasses debt-financed income. The IRS defines debt-financed property as any property held to produce income where an acquisition debt exists. If a fund finances the purchase of an income-producing asset, the associated income becomes partially taxable.

Pass-through entities report this financial activity on IRS Schedule K-1. Nonprofits use Schedule K-1 to identify reportable UBI and determine multi-state filing obligations.

Make informed investment decisions for your nonprofit

Alternative investments can play a valuable role in a nonprofit’s overall financial strategy. They provide unique growth opportunities, but require a thorough assessment of the associated financial and tax implications.

At SD Mayer, we help organizations navigate complex financial challenges with clear, actionable strategies. Contact SD Mayer today to determine if alternative investments align with your nonprofit's financial goals.

Frequently asked questions about nonprofit investments

What qualifies as an alternative investment?

Alternative investments encompass assets outside traditional stocks and bonds. Common examples include hedge funds, private equity, real estate, venture capital, and cryptocurrency.

Why do alternative investments carry higher management fees?

Alternative investments require specialized expertise to manage complex, illiquid assets. Managers typically charge a 1% to 2% base fee plus up to 20% in performance-based carried interest to compensate for this active management.

How does Schedule K-1 impact a nonprofit?

Pass-through entities issue a Schedule K-1 to report a partner's share of income, losses, and deductions. Nonprofits must review this form to determine if they have generated taxable unrelated business income (UBI) that requires reporting to the IRS.