Opportunity Zone Fund Admin: Can Blockchain Do the Trick?

Blockchain is finding a new opportunity in middle and back-office operations for opportunity zone (OZ) fund managers, but can it outperform the current alternative fund administrators?

One Arizona entrepreneur certainly thinks so. Co-founded and part-owned by Nico Willis, chief executive of cost-basis technology provider Networth Services, new fund administrator Agora AltX uses Hyperledger Fabric’s permission-based distributed ledger technology (DLT) for recordkeeping and fund accounting functions.

Agora AltX’s front-end investor relations interface will connect investors, fund sponsors, the sponsor’s related businesses and the sponsor’s bank. This front layer digitizes the initiation and submission of subscription agreements and tracks and confirms the investor’s deposit from its account to the fund manager’s escrow account. The second layer of the platform, called Pathchain, keeps an immutable record of the investments to a given sponsor at different times and with different dollar amounts. It also automatically records all of the transactions of the fund manager in opportunity zones and tracks distributions back to the investor such as return of capital and interest payments.

The two services not offered by Phoenix-based Agora AltX are asset valuation and know-your customer/anti-money laundering screening. OZ managers, like many private equity fund managers, hire a specialist third-party valuation firm to do the analysis. The fund administrator then allocates the value of the investment to each investor. Agora AltX is also relying on another undisclosed anti-money laundering firm to do the investor onboarding work to comply with regulatory requirements.

Agora AltX won’t charge fund managers any fees which they would need to pass along to investors. Instead, the firm will be paid by the bank which holds the investor’s funds in escrow until its investment is made. So far, Agora AltX has nabbed regional bank Western Alliance as its bank partner and will waive fees as long as the fund manager keeps a minimum monthly average of US$1.5 million in its bank account. If the fund drops below that level, the monthly charge will be US$1,500 a month until the minimum level is reached.

Opportunity zones represent a new market for fund managers who are promoting the tax incentives and social benefits to accredited high-net worth individuals, family offices, pension plans and endowments. Established as part of the Tax Cuts and Jobs Act of 2017, OZs are low-income areas the US government has designated in need of real-estate investment. Until 2026, investors can benefit from deferred and lower capital gains taxes as long as they invest in the fund within 180 days of redeeming their monies from another investment.

More than 8,700 tracts have been designated as opportunity zones. A directory published by the National Council of State Housing Agencies, a non-profit Washington, DC organization representing state housing agencies lists 183 sponsors for multi-project opportunity funds alone. The OZ funds, so far run mostly by money management firms and real-estate developers, range in size from US$1 million to US$10 million with an average size of US$242 million.

Given the growing size of the OZ fund market, Agora AltX has ample territory to market. However, it will face some competition from brand name players and niche firms all trying to nab a piece of the new OZ fund pie as fund managers turn to third-party service providers to do their middle and back-office work. The range of services is wide representing basic investor recordkeeping all the way to compliance testing and tax calculations.

Bank-owned fund administrators, such as BNY Mellon and State Street Bank are leveraging their experience in with other alternative funds to enter the OZ market. So are independent non-bank owned players — San Jose, California-based NES Financial, Windsor, Connecticut headquartered SS&C Technologies and New York-based Gen II Fund Services. SS&C has adapted its real estate administration platform to handle the OZ fund work and nabbed 10 clients with four in the pipeline. “Fund administration for opportunity zones is similar to that for closed-end private equity real estate funds,” explains Bhagesh Malde, global head of real assets for SS&C in New York. “So far, opportunity zone managers have invested in real estate development and the funds have a shelf life of only ten years.”

BNY Mellon has also adjusted its real estate administration platform for the work. As one of the world’ largest fund administrators and custodian banks, BNY Mellon services close to 80 real estate funds with more than 20 clients representing over US$130 billion in assets. The bank doesn’t break out the number of OZ fund sponsors, but a recent press release cites SkyBridge Opportunity Zone Real Estate Investment Trust as a client. Comparable information was not available from State Street at press time. Gen II Fund Services, a large private equity fund administrator, does not disclose the number of OZ funds or size of the book of business.

Of all the players in the OZ fund administration space, , NES Financial appears to have nabbed the biggest market share based on public information. The company points to its customized platform for OZ funds and track record in other specialty funds with heavy recordkeeping and compliance requirements, such as 1031 exchange funds and EB-5 funds, as key differentiators in winning 50 fund sponsors as clients. They include Arcis Real Estate Capital, Gateway Opportunity Funds, Griffin Capital Company, Hotbed Entertainment Group, Oregon Community Capital and Urban Catalyst.

Although Agora AltX has no experience in alternative fund administration, Willis has twenty three years of work in tax operations– a critical component of Agora DLX’s service and a benefit for OZ fund investors. Agora AltX will use NetWorth Services’ cost-basis technology, which already calculates the adjusted cost-basis of investors’ securities accounts. Another of Agora AltX’s investors, Kyle Walker, provides subject matter expertise as the chief executive of New Gen Worldwide, a Phoenix-based alternative investment firm specializing in the hospitality industry. Agora AltX service is operated as a separate independent firm with Willis and Walker serving as co- managing directors.

“Only investors with realized capital gains are able to invest in opportunity zone funds and the ability to determine the correct cost basis of these tax lots needed to fund the OZ investments is key,” says WIllis. “The second important cost-basis functionality is in determining, adjusting and tracking the OZ project’s cost-basis for each investor.” The cost-basis adjustment kicks in during the sixth year of an investor’s investment.

If an investor keeps its funds in the opporunity zone fund for at least five years, it can exclude 10 percent of the capital gain from taxation. The percentage increases to 15 percent of the reinvested capital gain if the funds are held in the fund for seven years. Any gains achieved after the investment is made are tax fee if held in the fund for at least 10 years.

Correct tracking the exact timing and value of the investments made by the fund managers in distressed zones is also critical to ensuring investors can keep their tax benefits and be comforted that their dollars are being invested correctly. That’s what Agora AltX offers, says Willis. “Investors know exactly when the fund sponsors receive their executed subscription agreements, when their money is deposited in the sponsor’s bank account and when their money is invested in the project through the permissioned DLT which instantaneously records all transactions,” he explains.

As is the case with all fund managers, OZ fund managers need to review track record, technology and fees when hiring a fund administrator. However, OZ fund managers might also want to go the extra mile and consider how well their fund administrator can help with meeting the Internal Revenue Service’s intricate requirements to retain the fund’s eligibility as an OZ fund. No eligibility, no tax benefits for investors.

Among the IRS’ numerous litmus tests are biannual tests on a fund’s assets. OZ fund managers can invest in either properties or businesses. The IRS requires that a qualified OZ fund must hold at least 90 percent of its assets in a qualified OZ property. When a fund sponsor operates a business through a subsidiary, the business must pass a separate asset test that 70 percent of the tangible property “owned or leased” by the business must be a qualified OZ property for the business to be considered an OZ business.

OZ fund managers can’t afford any operational snafus regardless of who is to blame. The fund administrator or even the real estate developer could be at fault for the fund manager failing to meet the IRS’ criteria for its fund’s eligibility as an OZ fund. A fund administrator could easily record the wrong data anywhere in the lifecycle of the OZ fund project from the time the fund sponsor is onboarded. Mishaps include the timing of investments by the fund sponsor, subscriptions and redemptions by investors and the composition of the fund’s assets could also lead to its failing the IRS’ asset tests.

At a minimum, the fund manager will face reputational risk. Investors could gripe about incorrect cost-basis reporting, payments or statements. In a worse case scenario, depending on the type of error, the fund could incur a monthly penalty allocated to investors directly until the mistake is corrected or investors could lose all of their tax percs. Unhappy investors won’t hesitate to sue the fund manager. Whether the fund manager can successfully sue the fund administrator for damages depends on whether it can prove it was at fault, the range of services it agreed to offer, and level of liability it agreed to assume.

Making life even harder for fund managers is that some of the IRS’ current rules aren’t written in black and white language. “The rules on OZ funds are still evolving and some are in a gray area, subject to interpretation such as whether a manager’s investment made a substantial contribution to a community,” says Ronald Fieldstone, a partner with the law firm of Saul Ewing Arnstein & Lehr in Miami. The good news, as he notes, is that the IRS will be issuing final clarifications by year end.

Selecting a qualified fund administrator won’t be a panacea considering the multitude of unforseen problems that could occur during the life of an OZ fund. However, it could help the fund manager breathe more easily. “Agora AltX’s platform helps the OZ fund manager manage the OZ project with accounting assignment of assets and fiat transactions to meet the IRS’ strict compliance guidelines,” says Willis, who insists that the permissioned-based DLT platform can easily beat the level of accuracy of even the best designed platforms originally intended for other alternative investment funds, such as private equity.

Given that DLT is a new development, Agora AltX faces some understandable skepticism. “Agora AltX’s no-fee approach is an incentive, but fund managers who are unfamiliar with blockchain technology may still be hesitant of its merits,” says Chris Meader, director of the North American Fund Administrators Association, a Boston-based trade group representing alternative fund administrators. “Fund managers may also question whether Agora AltX can successfully provide the full range of fund administration services using DLT, including the critical IRS compliance element.”

While not commenting directly about Agora AltX, NES Financial’s executive vice president Reid Thomas suggests that blockchain and artificial intelligence are over-hyped. Fund managers and investors, he believes, are more interested in whether the technology platform will deliver automated and accurate results. “There are other value-added services fund managers should consider, such as reporting on the benefits of the investment on the community which NES Financial provides,”adds Thomas.”Investors are increasingly concerned about the social benefits as well as the tax incentives.”

However, Willis argues that OZ fund managers should worry about the potential for processing errors that other paper-based fund administrators can experience over the decade of the OZ project’s life cycle. “Agora AltX can provide the exact transaction in which the parties were involved, the digital copy of the associated documents to the transactions and the time stamp with approval conditions within seconds,” he says. “This is the only way full accountability and transparency can be accomplished during the 10-year project timeline.”

Willis says that Agora AltX’s platform can also help fund managers issue job impact and other impact reports to determine how effective the OZ program is in improving local economies. It has been designed future-proof to accommodate more complicated OZ deals where fund raising tranches are combined with other tax credit programs and debt deals are combined with equity deals. Other platforms might not be up to the task, claims Willis.

So far, Agora AltX is off to a good start, nabbing seven OZ fund managers as clients. Willis expects interest in its permissioned DLT-based service will increase as the IRS clarifies its operating requirements for OZ fund sponsors and business startups enter the market. It’s just a matter of fund sponsors understanding the merits of permissioned-based DLT, he says. If Willis’ claims about Agora AltX’s ability to execute flawless middle and back-office operations are proven right, its fund sponsor clients can sleep a lot easier knowing they might avoid either a call from an upset investor, an unpleasant letter from the IRS, or even worse an irate investor’s attorney.