While many financial advisors find alternative investments attractive and plan to allocate more of their client’s money to alternatives, these investments come with some challenges. Among the biggest is the volume of paperwork involved, including the more complicated tax forms that often go along with these investments. A Wealth Management IQ research report last year found that 46% of advisors surveyed said the tax advantages of alternatives were "critical or "very important" factors when considering them for client portfolios. However a survey of financial advisors completed last year by consulting firm Mercer Investments and CAIS found that 55% cited high levels of administration and paperwork as the No. 1 factor that was preventing them from increasing their allocations to alternatives.
Investment management platforms, including CAIS, Capital, Opto, Altigo, Subscribe and GLASFunds, aim to help advisors solve some of these challenges through automation and digitalization. Arch, a New York City-based platform that focuses on automating operations and reporting for private investments, offers its services for any investment involving a GP or LP structure, private companies, direct real estate investments and direct start-up investments.
The firm’s services include automated tax document collection for alternative investments. As we enter the 2024 tax season, we connected with Arch co-founder Ryan Eisenman to discuss some of the pain points associated with the tax treatment of alternative assets, as well as how Arch attempts to solve those issues for financial advisors.
This Q&A has been edited for length, style and clarity.
WealthManagement.com: The commonly used forms for investing in private funds are K-1s. What issues does that create for advisors and investors? What are some pain points around that?
Ryan Eisenman: This is the hidden cost of investing in private markets. When people invest in private markets, they invest for some kind of diversification and/or access to different asset classes that they may not be getting in public markets and, a lot of times, higher expected returns. But then, as investors are investing in private markets—and this is now one of the top priorities of a lot of the large asset managers like the Blackstones and KKRs and Carlyles of the world where they want to distribute more of their products to the private wealth channel, the advisor channel and the family office channel—now you have clients and advisors that have hundreds of thousands of these investments that they are managing. And each investment in an alternative asset manager, whether it’s real estate, private equity or hedge fund, comes with a K-1.
Why is that a problem? The reason that’s a problem is all of the different funds report in different ways, report through different platforms and send their K-1s at different times of the year. If you are a client with a dozen K-1-generating investments or you are an advisor who is managing hundreds of thousands of these investments, you now need to go all across the internet and get these documents from different portals. They might arrive as early as January and as late as Oct. 14, right before the extension tax deadline. So now you are searching for these documents all throughout the year. They don’t just need to go to the investors, but the investors and their advisors need to get them to their CPAs. It creates a really painful workflow, especially when there is a lot of it, to get all the K-1s from all the different places and make sure you’ve collected them all in order to complete your tax return. And oftentimes, tax returns are delayed because of this.
WM: These investments are long-term commitments, and there are various events that happen during the lifespan of the investment, including capital calls and delayed income. What do the tax events look like during the lifespan of the investment, including at the end?
RE: A lot of the clients who are investing in alternative investments will also make estimated tax payments every quarter. In order to do that, there is a lot that goes into it. But part of it is understanding the tax implications of the underlying investments. Different types of investments have different tax considerations. You can be in a real estate investment that has really strong tax benefits, or you could be in an actively trading investment like a hedge fund that trades a lot where the tax burden is a bit higher. Tax implications are something that we think is not that well understood today. It’s something we’d love to be a part of, helping illuminate more in the future.
But if you understand both real financial return and the tax implications of an investment, that will help you understand your actual after-tax return for those types of investments as well.
WM: From what you’ve observed, do these more involved tax reporting requirements with K-1s discourage some of the investors or advisors from accessing private investments?
RE: I think it can. We definitely hear quite a bit that people will say “Yes, I stopped investing in alternative investments because I don’t want another K-1.” That is something that not everyone feels, but enough people feel that it’s a complaint we hear of with enough frequency.
Part of our mission is to make that statement irrelevant because if someone can get an extra 200 basis points of return by investing in alternatives, we as a company want to make sure that you don’t have to think about the burden of the K-1, that you don’t have to think about the burden of the capital calls and distributions and other things that are coming from all the asset managers. We want to make it easy to manage all your different investments, especially since these investments can last 8, 10, 14 years, and sometimes longer.
WM: If investors are using feeder funds instead of making a direct investment in a private fund, what kinds of tax implications does that have?
RE: Feeder funds will also likely have a K-1. And then, one thing is if you are investing in a fund of funds, the fund of funds doesn’t prepare the K-1 for you until they receive all of the K-1s upstream. Sometimes fund of funds can come a bit later. But there could be more of an industry push for a little bit more transparency that’s coming into place around how early certain asset managers send their K-1s.
It’s something that would definitely help our clients understand when they can expect to receive K-1s so that they don’t have to constantly log in and look for it. Even if it’s going to be late, just providing that level of transparency sometimes reduces stress for the advisor, client and accountant, so they can plan their workflows.
WM: We’ve seen an uptick in limited liquidity vehicles recently. Asset managers who are launching these vehicles often talk about the advantages of them requiring 1099 tax forms instead of having to file a K-1. What are the implications of that for advisors and investors?
RE: There is a lot of this that I can’t speak to because I don’t have some of the expertise on some of the tax implications. But generally, if you can get something through a brokerage account, a lot of the time, the brokerage accounts will handle a lot of the complexity. They will give you one tax document across everything that might be tradeable in a brokerage account.
There are other non-tradeable assets that might generate a 1099. I don’t know enough about what you’d lose or what you’d gain, but I would love to learn about it.
WM: Can you talk about how your platform helps solve these tax issues? Can you give us some concrete examples?
RE: Essentially, our platform makes it so people don’t have to go chase down all their different K-1s from all the different asset managers and all of those managers’ investment portals. Instead, we connect to the different portals, we put out all the K-1s on their behalf as soon as they are available. We make them simultaneously available to the investors themselves, their advisor and their accountant.
Instead of you getting a notice saying, “You have a new K-1 on XYZ platform,” and you need to get it and then download it and send it to your accountant,” we get the K-1. We share it with the accountant. You can log in to Arch and see: “Okay, I’m expecting 50 K-1s this year; I’ve received 47.” And Arch then automatically flags the missing K-1s that you haven’t yet received.
This dramatically reduces the time spent chasing down the K-1s and time coordinating around K-1s and gives you transparency on it.
One example of this is we have an RIA client that uses this for their 1,000 end clients and something like 6,000 or so K-1s. And then [they] will also use it for other tax documents to get them to their end clients. Every advisor has a dashboard that shows, “Okay, I have 20 clients that have 100 K-1s. Here’s what we received; here’s what we are still waiting for and still expecting. As then I don’t have to as an advisor play the coordination role. And, as a client, I don’t have to go try to find all my K-1s; Arch will do it for me and directly create a tax center for each client’s CPA where they can log in.”
It is just bringing organization to the chaos of chasing down K-1s.
WM: We are about to enter the tax season for 2024. What advice would you offer investors and RIAs? What should be on their to-do list if they are allocating to private market funds?
RE: Our advice is you should use a solution like ours so that you don’t have to chase down K-1s. We want to make April 15 and September 15 easy days for you. That’s our commitment, and that’s what we are looking to do long-term—streamline how you collect your K-1s and how you are able to invest in alternative investments.
Also, don’t let K-1s scare you. You can ask upfront when certain managers will send K-1s. They might be able to give you some transparency on that. That might give you more comfort when you are investing in certain securities.
We will work with you to push the whole industry forward make these processes more digital and hopefully reduce a lot of the friction here.
WM: Aside from the things we’ve already talked about, are there other big pain points for financial advisors and RIAs in handling tax reporting for alternatives?
RE: Kind of everything in managing alternative investments is a headache. We hear it frequently described as death by a thousand paper cuts. How do I get all the documents? How do I know when I have a capital call that needs to be completed? How do I complete that capital call? There is a lot that goes into the allocation process that’s painful.
And then all of the—where do my documents go? How do I access my documents? People end up having multiple systems that they are switching between. And for the client, sometimes even a single fund might have multiple portals, where it’s, “I am getting a document from investment fund A, but they have this portal for their crypto fund and this portal for their venture fund and this portal for their special purpose vehicles. And then I don’t even know where the document lives that estimates all of the different investments I’ve made.”
Our mission is to synchronize those processes. To have one place to go to find all your K-1s, all your capital calls and all your distributions. To know what needs to happen today, what needs to happen this week and cut down the work that you need to do. But also automating the majority of the work, so you hopefully don’t have to do a lot of ongoing work to manage alternative investments.
WM: How aware are advisors of the tax reporting issues they can run into if they allocate to alternative investments?
RE: I think a lot of people when they are new to allocating to alternative investments, don’t understand and don’t realize how much work is involved.
But it’s something that is manageable, and there are tools you can use to manage this. Historically, I think advisors have struggled with some of the tools. What we and other software companies that are actively building investment management systems prove is that you can invest in alternatives without running into a lot of pain points.
Alternatives are great for advisors and for their clients in a lot of ways. You can find investment opportunities. You can potentially get higher returns. It’s a really interesting way to differentiate. It does seem like advisors and clients are often interested in allocating to the right alternative investments. We just need to make the process easier so it doesn’t become a barrier to making that investment.
WM: You’ve mentioned that alternative investment taxation can often be very opaque. Some of the challenges we’ve talked about. But can you elaborate on that point a bit more?
RE: When you get a K-1, it’s not just one page with perfectly formatted boxes and easily understandable information. Depending on the complexity of the investment, some of these forms can be over 100 pages, where there are all sorts of different specialized tax treatments because of the nature of the underlying investments. And each of those footnotes or each of those supplements has something that is relevant to the tax processing of that K-1. And then you can expect that for the CPA to process these K-1s would increase your tax bill, in essence.
Also, they need to be well understood in order to make sure that one, you are paying the right amount of taxes and two, you are benefitting from the right tax deductions or losses or depreciation that’s in a K-1. That’s something that may not be as well understood—there is a lot of nuance to some of these K-1s depending on the asset class, and a lot of complexity.