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Higher potential returns come bundled with illiquidity, steeper fees, and surprise tax bills.
When a nonprofit looks for ways to strengthen long-term financial performance, alternative investments often enter the conversation. They can diversify a portfolio and may outperform traditional holdings. They also bring added complexity, higher costs, real liquidity risk, and tax exposure most boards don't expect. For any organization weighing alternative investments, looking hard at both sides before committing assets is the difference between a smart diversification move and an expensive lesson.
What Counts As An Alternative Investment?
Alternative investments are defined mostly by what they aren't. Unlike stocks, bonds and mutual funds, they usually lack an easily determined fair market value. Common examples include hedge funds, private equity, real estate, venture capital and cryptocurrency.
Their appeal is access to high-growth companies and cutting-edge industries that public markets don't reach. The tradeoff is liquidity. Many of these holdings are hard to exit quickly, so you can't always cash out or rebalance when you need to. For a nonprofit without other operating reserves to lean on, that lock-up is a genuine risk. The same complexity that drives the higher return potential is what makes these investments riskier in the first place.
Watch The Cost Structure
Alternative investment funds are typically organized as partnerships or limited liability companies (LLCs). Both are pass-through entities, which means income and the related tax liability flow through to investors, who are treated as partners or members. That structure matters for taxes, as we'll cover below.
The fund manager makes or breaks the investment, so look for a proven track record and genuine access to top-tier deals. Fees deserve equal scrutiny. Beyond a base management fee, usually around 1% to 2% of capital or net asset value, managers commonly take performance-based compensation called carried interest. That cut can run 20% or more of profits, which takes a meaningful bite out of your returns.
The Tax Exposure Boards Miss
Here's where nonprofits get caught off guard. A nonprofit's ordinary investment income, such as dividends, gains, and interest, is generally excluded from taxable unrelated business income (UBI). But when you invest through a partnership or LLC, the IRS treats you as if you're conducting that entity's business directly. As a result, income distributions can become taxable, exposing your organization to unrelated business income tax.
There's a second trap: debt. UBI also captures unrelated debt-financed income from investment property, in proportion to the borrowing used to acquire it. The IRS defines debt-financed property as property held to produce income, including gain from its sale, where acquisition debt exists. So if you borrow to invest in a fund, or the fund itself borrows to buy an income-producing asset, part of the income that flows back to you may be taxable.
Pass-through entities report each investor's share of income, dividends, losses, deductions, and credits on IRS Schedule K-1. Your organization can use that schedule to figure out whether it received UBI that must be reported on Form 990-T. And don't overlook state obligations, which can multiply when a fund operates across multiple states.
Making The Call
Alternative investments can earn a valuable place in your nonprofit investment strategy, but only after a clear-eyed look at the financial and tax implications. The right answer depends on your liquidity needs, risk tolerance, and exempt purpose, and those are worth talking through before you commit. Contact GBQ, and our nonprofit advisory team can help you decide whether alternative investments fit your organization.
