To date, Opportunity Zone Funds have been operating largely within a low-oversight environment marked by self-certifications. A wave of change is upon us, as the IRS is becoming more active in their inspection of funds and QOZBs, and as regulatory updates are being seriously discussed. In anticipation of more stringent reporting and transparency requirements, savvy Fund Managers are taking a page out of the established corporate playbook and embracing an OZ Risk Register.
A little background. A Risk Register is a tool used to identify, analyze, and communicate potential setbacks of an initiative before they become full-blown problems. When a Risk Register is generated and shared with the entire ecosystem of stakeholders, it is a powerful way to ensure focus is placed in the right areas, resources are allocated in a smart manner, and the impacts of risks are minimized or eliminated. Corporate boards have used Risk Registers for decades to prioritize top risks, as have cybersecurity and program management organizations.
Why do you need a risk register for Opportunity Zone investments?
As Fund Managers work to optimize OZ Funds, part of that job is managing risk. Like all investments, OZ’s has several associated risks that can significantly impact fund performance:
- Market Risk: The possibility that the value of the investment will decline due to changes in market conditions, such as supply and demand, competition, and regulation
- Liquidity Risk: The possibility that the investment will be difficult to sell or exit due to lack of buyers, legal restrictions, contractual obligations, or OZ program restrictions
- Societal Risk: The possibility that the investment will have negative impacts on the local community, such as displacement, gentrification, political disfavor, or environmental degradation
- Business Risk: The possibility that the investment will perform poorly due to operational issues, management problems, or financial difficulties
- Regulatory Risk: The possibility that the investment will lose its tax benefits or face penalties due to non-compliance with OZ rules and regulations
These risks are not new—they have existed since the launch of the OZ program in 2017. However, little attention has been paid to these risks within OZ funds, and even less thought and conversation has been spent on managing these risks. We could dedicate an entire blog post to exploring how we got here. The more important step now is to admit we have a problem: we are not actively managing OZ risk.
This problem is about to catch up to the market, which CapZone estimates at $180 billion in invested equity over 20,000 active Funds. The sheer size of the tax incentive explains why the IRS has increased audit activity, why the SEC will start asking questions about actively traded OZ funds, and why Investors will increasingly compare fund performance. OZ Funds need an OZ Risk Register to identify the risks that most OZ Fund Managers are not managing for their investors.
What is an OZ Risk Register?
There is no need to reinvent the wheel. The Risk Register is designed to keep track of risks and plan for their mitigation. A Risk Register structures the steps of risk management. It:
- Identifies the possible risks that could affect your Opportunity Zone Fund operation, such as legal challenges, community opposition, environmental hazards, etc.
- Assesses the likelihood of each risk occurring and its impact, using qualitative and quantitative methods
- Prioritizes risks based on their severity and urgency
- Develops appropriate response plans for each risk
- Assigns roles and responsibilities for managing the risks and implementing the response plans
- Monitors and reviews the risks throughout the Fund lifecycle and updates the risk register accordingly
At CapZone Analytics we have started rolling out OZ Risk Registers for our Fund clients, and the early feedback is encouraging. Some of the early benefits Funds are claiming include:
- Making the work visible. One client remarked, “There was no new information when we generated our first Risk Register. Having it all in one place, however, was a great comfort and jolted us into action on the top issues.”
- Enhancing communication and efficiency. Issues often span internal teams and stakeholders. A central tool for communicating planning and status increases visibility into progress and reduced the swirl of ad hoc questions and concerns.
- Boosting returns and performance. It is too early to quantify the impact of OZ Risk Register programs. However, savvy Funds are investing in their Risk Register with the explicit goal of improving performance and reducing cost.
- Protecting reputation and credibility. OZ fundraising is more competitive than ever. If history within other financial sectors repeats itself, OZ winners will be determined not just by performance, but also by reputation through compliance and risk management.
Coming Up Next
In our next blog, we will lay out the steps for creating an OZ Risk Register. We will pull from our still-unfolding experiences working with live OZ Funds to create the template, populate it with top risk issues, prioritize issues, and then show how to use the Risk Register as an active management tool.