The recently introduced Investing in Opportunity Act (IIOA) has the potential to be the most transformative economic development program in the history of the United States — and it’s coming along at just the right time.
Like a rising tide, the US economy has continually improved since the Great Recession; however, unlike prior economic recoveries, this tide has not lifted all boats. In fact, the economic recovery has been extremely concentrated into relatively few geographic areas. Despite record growth in some markets, others are approaching historic levels of distress. The Opportunity Zone program, which was created as part of the IIOA, contains all the right incentives to help these distressed communities turn the tide in their favor.
The basics of the Opportunity Zone (OZ) program are refreshingly simple: individuals who reinvest realized capital gains into Opportunity Zone Funds are able to temporarily defer, and eventually reduce (at five- and seven-year milestones), their tax burden on those capital gains. After 10 years, any capital gains realized from the appreciation of the investment in the OZ Fund are tax free.
The areas defined as Opportunity Zones have been agreed upon, at least for the next decade, and the straightforward benefits associated with the program are already beginning to create a flow of capital into distressed areas around the country.
While all of this sounds great, unfortunately, the fact remains that there have been far too many well-intentioned (and in some cases well-designed) investment-motivated economic development programs that have failed to do the good they intended. The programs end up with too many reports of fraud and abuse, as well as endless debates about their effectiveness, which ultimately lead to their demise. Left unchecked, the Opportunity Zone program may suffer the same fate.
Stakeholders in the Opportunity Zone industry have an unprecedented chance to establish a regimen of standards and best practices to prevent fraud and abuse in this burgeoning industry, and to guard against misconceptions that could ultimately harm public perception of the program. To achieve this, we see the need to establish best practices in three key areas: security, transparency and compliance.
Security: Use an Independent, Third-Party Administrator
Whether it be through third-party record keeping, third-party controls, or even independent board memberships, the notion of having an independent third party involved in complex investment arrangements is well understood by sophisticated investors in the post–Bernie Madoff era. As a best practice in the Opportunity Zone industry, fund managers should utilize — and investors should insist upon — the services of an independent firm to ensure that investment monies are directed as intended, and that all books and records are current and accurate.
Transparency: Make All Material Information Accessible
The Opportunity Zone program is more than just an investment program. It combines a typical private equity investment fund structure with a tax program and a community development program. As a best practice, fund managers should implement a policy of transparency in all three areas, regardless of what is technically required under the law. Investors (i.e., taxpayers) are obviously interested in the returns their investments generate, but in addition, they will be equally motivated to ensure that they achieve the tax benefits and social impact benefits they are looking for. Moreover, the long-term sustainability of the program will be dependent upon whether or not it achieves the good that it was intended to. Tracking the social impact of OZ funds’ investments will help to ensure that community benefits, where they are realized, are properly acknowledged.
Compliance: Develop a Compliance Platform that Exceeds the Minimum Standard
The Opportunity Zone program has been developed with few regulatory requirements and a minimum in initial oversight, with the hope that this will encourage the flow of capital. However, implementing compliance standards to the lowest bar leaves open the potential for abuses. A high-bar compliance program is not that much more expensive to implement at the outset, but it can become very expensive to retrofit an existing program down the road — as is often required to meet new standards imposed as the result of early, high-profile abuses. Fund managers in OZ should embrace the rigorous compliance best practices of other, more established industries (such as private equity) from the beginning.
The Opportunity Zone program holds tremendous promise. But this promise will only be realized if stakeholders truly embrace the intention of the program — positive social impact — and take steps to protect the young industry from common pitfalls. To this end, establishing best practices in security, transparency and compliance at the fund level is paramount.