Investing in crowdfunded ventures can be a great way to put your self-directed retirement plan to work. As we discussed in prior articles on the topic, these opportunities have many benefits — including the ability to invest with smaller amounts of capital, risk mitigation through diversification, and being easy to manage.
However, choosing the right crowdfunds to invest in can be a complicated matter. A thorough and educated evaluation of such investments is key to ensuring the best possible results for your self-directed IRA or Solo 401(k) plan.
Best Types of Funds for IRA Investors
Before diving into the details of how a particular fund is run, it makes sense to start by choosing funds that are well suited for retirement plan investors.
Not all crowdfunds are appropriate, such as those that may create exposure to taxation on Unrelated Business Taxable Income (UBTI). Following are a few of the main issues you should be aware of.
Accredited Investor Requirements
Some funds are only open to accredited investors. Accreditation requires that you have a certain combination of income and net worth, and is meant to ensure a certain level of sophistication when it comes to investing.
Your self-directed retirement plan inherits your accreditation status. If you’re not accredited, then there’s no sense spending time evaluating these types of ventures.
Unrelated Business Taxable Income Generating Funds
When in receipt of income produced by participation in a trade or business conducted on a regular or repeated basis, tax exempt retirement plans are subject to tax on Unrelated Business Taxable Income (UBTI). The top end tax on UBTI can be 37%, so it’s generally best to avoid such ventures.
Funds that produce income from rents, interest or dividends will not generate UBTI, as these are all forms of passive income. However, real estate related funds that engage in new construction of properties for sale or property flipping will likely create UBTI.
Funds that hold an equity stake in an operating business providing a product or service will also likely generate UBTI if the underlying business entity is a pass through for taxation such as a LLC or LLP. Ownership of shares in a corporation paying dividends to investors will not have tax exposure.
Unrelated Debt-Financed Income Generating Funds
Income produced via the use of debt-financing can also produce tax liability for retirement plan investors.
Tax exempt entities are exposed to Unrelated Debt-Financed Income (UDFI) when leverage is used. In this case, the portion of income that the plan receives via access to the non-plan (borrowed) capital is what is taxed.
The tax implications of UDFI are not always a deal-killer. The impact of this type of taxation may be relatively minimal, and such investments can still produce a quality return even after subtracting the tax cost.
That said, if there are two reasonably equal opportunities and one generates UDFI while the other does not, it would make sense to look more closely at the venture without UDFI exposure. UDFI can be common in many real estate funds, where income properties are being acquired with a combination of investor capital and mortgage financing.
Other types of funds may also use a combination of investor equity and debt, and UDFI will be generated as a result. An IRA investor would be exposed to UDFI in all such leveraged investments.
A Solo 401(k) has a narrow exemption for debt-financed income where the debt is associated with the acquisition or improvement of real property.
Once you have identified one or more funds that you find suitable for your IRA, it’s time to move on to performing diligence on the investment itself.
Vet the Platform
Quality and experience of leadership is one of the most important factors to consider when evaluating a crowdfund. You’ll want to know who the key team members are, and what kind of experience they have in managing the asset class or project type the fund is investing in.
You should be able to learn what level of success the fund principals have achieved in the past, and what kind of relevant licensing or certifications they may hold.
With funds that have been around for some time, there will be a track record of performance on prior ventures or funding rounds. Depending on the nature of the fund investment, it may be necessary to delve deeper into the operations of a venture, most notably when investing in a startup or business as opposed to an asset-based fund such as real estate equity or debt.
In a business venture, you’ll want to understand important factors such as the business plan, management succession plans, how principals are compensated, and the like.
What Diligence Processes is the Provider Using?
In many types of crowdfunds, the fund operator is aggregating a multiple of underlying assets such as properties or notes. A venture or angel fund may be acquiring interests in several underlying businesses.
One way to judge the quality of a platform is to understand the steps they take in performing diligence on the investments they are making.
Some funds are much more thorough and transparent about how they evaluate opportunities. The more you understand about how the fund operator selects suitable assets or ventures, the more confidence you can have with the fund itself.
The type of underlying diligence will vary based on the asset class. The more important consideration here is that you have insight to what the diligence process is and how it is conducted.
Some key things to look for include: background checks on significant counterparties, evaluating creditworthiness of borrowers, thorough title searches, and the like.
Asset Selection Control
Some funds are very narrow in scope, and may give investors a clear picture of exactly what is being held by the fund. Other funds — especially in the real estate and note spaces — operate more broadly and only let you know the type of deal being invested in, but not the specifics of individual deals or assets.
A fund that acquires one or a small number of large commercial properties would generally give you an opportunity to look specifically into the assets, the funding structure and business plan. A fund that invests in a broad portfolio of notes or single-family rental properties may be less transparent.
The more you know about underlying assets and the process of acquisition and funding, the more control you have over risk assessment. Otherwise, you’re essentially trusting the fund manager to get it right.
What is the Underlying Security?
Just because a fund invests in properties or notes doesn’t necessarily mean that your investment in the fund is directly secured by those assets. Understanding the configuration of a fund and how your investment is secured is critical.
Some arrangements such as Borrower Payment Dependent Notes, are not actually secured by the underlying asset and are really just a contract between the investor and the platform. If borrowers fail to pay or the platform itself goes out of business, individual investors will be pretty much at the back of the line when it comes to claims against the platform.
Exit Strategies and Liquidity
Getting into an investment is one thing — getting back out again is also a very important consideration.
Many funds may have a set time frame of existence, with little or no opportunity to exit prior to fund termination. In other cases, you may be able to exit early, but with some kind of penalty.
Be sure to ask questions about both normal and early termination options. With retirement funds, you’re generally looking at the long term anyway, but there can be life events that may require access to liquidity.
It’s always important to know what happens if things don’t go as planned. Not all funds will be transparent about failure plans, but you need to think about this topic before investing.
Knowing what your investment is actually secured by is the first step in this evaluation. Equity in a fund vehicle may not be worth much if you do not have a clear claim on the underlying assets of the vehicle. The fund prospectus should illustrate what rights you may have in the event of a fund going bankrupt.
Take your Time and get it Right
There are several layers of diligence required to evaluate crowdfund opportunities. Taking your time, digging as deeply as you can, and enlisting the help of trusted associates or advisors are all important parts of mitigating risk and identifying the best possible investment opportunities for your retirement savings.