Embracing the OZ Risk Register

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-facing Risks:

  • 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

Fund-facing Risks:

  • 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.

Five OZ Dynamics Coming Our Way

The mission of Opportunity Zones has remained consistent since 2017; help low-income communities access financial, human, and intellectual capital. Yet, the world is very different than it was five years ago when Opportunity Zones were born. Following is an outline of Five dynamics we at CapZone Analytics believe will take root in 2023.

1. New legislation?

There has been much buzz about the Opportunity Zones Transparency, Extension, and Improvement Act. Will it pass? When? Here is what we know: the bill is a bipartisan, bicameral bill championed by US Senators Cory Booker (D-NJ) and Tim Scott (R-SC). The legislation is aimed at adding back the elements of compliance and measurement needed to provide confidence to investors and ensure American communities receive their fair share of the tax break benefits. For more details on the proposed legislation’s components, watch this short video by Al Puchala, CEO of CapZone Impact Investments LLC.

What we don’t know is if this House will be able to get this bill—or any bill—passed. Whether it is in this session, or we have to wait another two years for a shift in power, we remain bullish that some version of this update to the OZ program will ultimately be passed.

2. Welcome institutional investors!

Equity investors have largely been riding the OZ bench, observing the gameplay, and strategizing their entry into the OZ market. In the near term, we will likely see some substantial money flow into the program from institutional investors who have been sidelined since inception, awaiting a final ruling, and riding out the wave of the post-pandemic financial downturn. 

Institutions will be looking for two foundational elements to be in place before making the leap. First, clarity around reporting and compliance. Major players are by nature risk averse, and will look for as much structure and transparency as possible before investing (FWIW, we believe this makes the case for  CapZone Analytics as a standard compliance and reporting platform, but we may be bias). Second, institutions will find attractive the ability to execute a “fund of funds” model enabled by mergers and acquisitions activity. As these two elements become more available, pay attention to the wave of super-OZ funds being formed.

3. Wait, there’s more! Expanding beyond Real Estate

Traditionally, real estate has been a natural investment vehicle because the Opportunity Zone program is location-based, and real estate represents a relatively straight-forward and predictable project in which to invest. According to UC Berkeley researchers, approximately 51% of OZ dollars are invested in real estate firms. In comparison, 9% is invested in construction firms, 9% in finance, 7% in property owned or leased directly by Opportunity Funds, 3% in professional services, and 3% in lodging and restaurants.

However, the OZ program very much applies to a wide variety of investment vehicles, including operating companies. In fact, the case for operating companies is very strong, fueled by the capacity to generate a greater acceleration of profits that can grow tax free.

4. Don’t look now … the IRS is watching 

Expect to see increased Opportunity Zone scrutiny from the IRS. In fact, it has already started happening according to the September TIGTA update which reported that 1,040 QOFs and 5,141 individual tax returns were ‘reviewed’ the previous quarter by the IRS associated to the OZ program. Before you start squirming in your seat, understand first that this is a sign of good government at work. Any agency responsible for overseeing a sizeable financial program would implement processes designed to protect investors, maintain efficient markets, and facilitate the accumulation and distribution of capital. At some level we want this. 

Everyone also wants to know that they are ‘ok’ in their situation. Anxiety sets in because the rules are at times vague, and, as yet, untested. The smart play is to pursue a rigorous approach of documentation and compliance analytics that enables an elegant and comprehensive response to the IRS should they come knocking.

5. Exiting the program early 

To achieve the greatest financial benefits as an investor in Opportunity Zones, one must hold that investment for a full ten years. The tax advantages increase the longer one is invested, allowing you to defer, reduce, and ultimately eliminate the tax burden. Investors in QOF receive a tax deferral on their initial investment. They can reduce the deferred taxes owed on their initial capital gains by 10% in year five or up to 15% in year seven. Finally, if an investor makes it to year ten, they unlock a phenomenal set of options, including eliminating 100% of the taxes owed from the initial investment. 

Here we are in year five of the program. There are thousands of QOFs that have been operating for between 3 and 5 years in the program. Some of these are surely interested in selling or exiting the program. This will pave the way for the largely untested maneuver of exiting the program and locking in tax breaks based on years of service. Again, the safe approach is to establish and maintain the necessary documentation, self-certifications, and evidence to prove compliance upon exit.


In Sum 

In many ways, the Opportunity Zone program is just getting started. With the potential for updated regulations, the influx of sophisticated investors, and significantly increased regulatory oversight, this space will continue to heat up. In the meantime, the program continues to unlock access to capital for low-income American communities. and sustainably.