What are some due diligence best practices that every investor should undertake before investing in a Qualified Opportunity Fund?

Chris Paganelli is a San Francisco Bay Area-based financial advisor at wealth management firm Stifel. He advises high net worth clients on tax strategy, wealth preservation, and portfolio management — with a recent focus on qualified opportunity fund investment strategy.

Episode Highlights

• How to assess an opportunity zone fund: what factors investors should be looking at — primarily the management team and investment pipeline.
• Risks inherent to investing in qualified opportunity funds.
• The importance of diversifying Opportunity Zones investment across multiple geographies.
• Concerns regarding blind-pool investment funds.
• Considerations regarding the different sizes of qualified opportunity funds.
• How to determine if Opportunity Zone investing is right for you.

Featured on This Episode

• Chris Paganelli, Financial Advisor
• Chris Paganelli on LinkedIn
• Stifel

Industry Spotlight: Stifel

Stifel, Nicolaus & Company, Incorporated is a Member SIPC and NYSE and is a full service wealth management firm that was established in 1890 in St. Louis. Stifel has assets under management of $270 billion as of December 31, 2018.

Stifel is the #1 California municipal bond underwriter, according to Thomson Reuters, 2017, ranked by number of issues, negotiated transactions only. Stifel and KBW combined to rank among the top stock pickers and earnings estimators in the Thomson Reuters Analyst Awards. 2018 marks our 12th consecutive top 10 finish in this prestigious analyst survey. Figures include Keefe, Bruyette & Woods (KBW), a wholly owned subsidiary of Stifel Financial Corp., and other firms acquired by Stifel.

Learn More About Stifel & Chris Paganelli

• Visit Paganelli-WM.com
• More information about the Thomson Reuters Analyst Awards
• Email Chris: [email protected]
• Call Chris: (925) 746-6569

About the Opportunity Zones Podcast

Hosted by OpportunityDb.com founder Jimmy Atkinson, the Opportunity Zones Podcast features guest interviews from fund managers, advisors, policymakers, tax professionals, and other foremost experts in opportunity zones.

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Show Transcript

Jimmy: Welcome to the “Opportunity Zones Podcast.” I am your host, Jimmy Atkinson, and today I’m speaking with Chris Paganelli from Stifel Investment Services. Chris joins us from his office in the San Francisco Bay Area. Chris, welcome to the show.

Chris: Hey, Jimmy, how you doing?

Jimmy: Great, man. It’s good to get you on the podcast finally. I’m excited about today’s episode. So let’s dive right in here. Tell me about your background first, Chris, and the work you’re doing at Stifel and who your clients are over there.

Chris: Sure. I’ve been at Stifel for about two years. I grew up in the construction and real estate world. My dad was a realtor. Grew up here in the Bay Area. Then I started my own construction company. And when I was a sophomore in high school, I started trading stocks. And eventually I started doing wealth management professionally and I’ve been doing it for about eight years and I’ve been at Stifel for, like I said, two years and prior to that I worked for a couple different international firms. And yeah, it’s been really good. I work with, you know, high net worth clients. We work on tax strategies and wealth preservation, and overall just portfolio management.

Jimmy: Could you tell me a little bit more about Stifel, the company you work for?

Chris: Yeah, sure. So Stifel is a full service wealth management firm, a member of SIPC and New York Stock Exchange. Been around since 1890. Headquartered in St. Louis, Missouri. We have about $270 billion assets under management as of December 31st, 2018. We’re the number one California municipal bond underwriter. That’s based on number of issues. We have a phenomenal research group. In fact, this year Stifel and KBW was once again ranked among the best stock pickers and earnings estimators. And that’s according to Thomson Reuters analysis board. And 2018 is the 12th consecutive year that we’ve been in the top 10. So it’s a good sized firm. It’s a regional firm. It’s not humongous like some of the other ones. And then another thing that we really like and one thing that brings me here obviously is our alternative investments desk, and we take a lot of pride in that. We do a lot of private equity in hedge funds. And most recently, we’ve been working real hard on the opportunity zone funds.

Jimmy: Yeah, so a pretty good size, regional firm, good track record of performance. And yeah, let’s talk about alternative investments. I’m sure you guys have turned your attention a lot to opportunity zones in the past year or so. So I want to get into that since this is the “Opportunity Zones Podcast.” So let me ask you when it comes to assessing an opportunity zone fund, what are some due diligence process best practices and what factors do you look at, and what factors should I be looking at as an investor?

Chris: Yeah, I know that you’ve spoken a lot about opportunity zones in the past in your podcast. So, you know, one thing that people aren’t talking about a lot yet, and I think they will be talking a lot about is the risks involved in the opportunity zones and how do you find the right opportunities zone. So, you know, there’s a lot of risk, there’s a lot of due diligence that needs to happen. And as we go along here down this path of opportunity zone funds, we’re probably going to see a huge gap between, you know, the good performing funds and the not so good performing funds. So manager selection and strategy is incredibly important for this. So I don’t know, do you want me to go over our process a little bit more?

Jimmy: Yeah. I’d love to hear what you guys are doing over there.

Chris: Okay. So the first thing we look at, I guess, is the management team. So what’s the management team of the fund? You know, is it a cohesive team? What’s the experience of the team? Do they have a consistent discipline repeatable approach? Do they have a history of outperformance over multiple cycles? These are all things that we look at, you know, not just in the qualified opportunity funds, but you know, this is exactly the same due diligence we go through for any investment to pick a mutual fund manager or an ETF or anything like that. It’s the same process, same selection process. So, you know, that’s absolutely critical. And, most importantly, with the opportunity zone funds, you know, people are using this as an asset gathering tool. So they’re changing their stripes a little bit. They’re going out there and saying, “Hey, all of a sudden we have a qualified opportunity fund.” And, you know, this should actually be, you know, an overlay of an already good investment. It’s not just, you know, the idea of it. So it needs to have a specific direction. It needs to have an investment pipeline, and, you know, in order to make it a good investment.

Jimmy: It can’t just be focused on the tax tail wagging the dog, right? The underlying investment has to be solid as well.

Chris: Yeah, exactly. That’s what a lot of the focus is right now. It’s, “Oh, great, I get to save on taxes. Let me put my money over here.” Forgetting completely that it’s got to be a good investment to make sure it really works out.

Jimmy: Yeah, in these early days, I think the educational component is pretty key. A lot of investors don’t really know what an opportunity zone is or a qualified opportunity fund is. But you know, I go to a lot of these different funds’ websites and the entirety of the website is just them pounding the tax advantages. If you invest in our fund and you get tax advantage number one, the deferral. Tax advantage number two, the reduction in basis. Tax advantage number three, the exclusion of basis on the backend without a lot of emphasis on what the funds’ underlying investments are.

So I should say that, you know, not every fund looks like that, but I’ve come across a few where I wish there was just more information on the funds’ underlying investments, not just the tax advantages. So you mentioned your due diligence process, you look at the management team, are they cohesive? What type of experience do they have? Do they have a repeatable approach? What’s their track record look like through multiple cycles? You mentioned that the fund has to have some solid fundamentals and investment pipeline. Is there anything else you’re looking at?

Chris: You know, a real important thing here is the investment pipeline And to your point previously, you know, you go and look at some of these funds are already opened on the market, and their investment strategy is as simple as we’ve identified areas in the opportunities zones that we are going to invest in once there is a proper amount of money. That’s not a very good investment strategy. So I would say do they have experience in this area? That’s definitely another thing to look at.

Jimmy: And is the area well-defined also?

Chris: Right. Is the area well-defined? And it needs to be specific. Are they doing real estate? Are they doing business acquisitions in the opportunity zones? Do they have all the pieces in place to deal with all the different regulation?

Jimmy: So you spoke a little bit about that there are some inherent risks to investing in an opportunity zone fund as there are to any type of investment. Can you tell me what some of those inherent risks are?

Chris: Yeah, so, obviously, I can go on and on about the risks and there’s all the normal risk of investment, right? You have to risk money to make money. So I’ll talk specifically about the opportunity zone funds and a couple of the risks that people aren’t really thinking about, in my opinion. And I’ve mentioned a couple times, the investment pipeline. So you have funds that are just collecting money to give people this great tax incentive. And if they don’t have an investment pipeline and if they’re are small fund and they have a few million bucks to invest and you get a huge investor steamrolling into the same opportunity zone that they were going to buy in, and then all of a sudden, they don’t have anything to invest in, that’s going to become a real problem.

And those guys are going to have to basically send checks back to their investors. And, by that time, they probably can’t do a 1031 and they’re going to be getting hammered on taxes. And it’s not gonna make the fun look very good. I think that’s probably going to happen. I mean, obviously, I hope it doesn’t but that’s definitely a huge risk. And, again, has the opportunity zone fund, have they changed their strategy to take advantage of the tax incentives? We discussed that a little bit but that type of lack of experience in real estate development and those of you who have ever been involved in real estate development, if you have any blind spot, it’s going to get exposed very quickly.

There’s permitting, there’s planning, there’s approvals. There’s so many steps that you have to go through. And obviously, I’m speaking real estate specifically here, but there’s so many approvals that you have to go through and if a manager is changing their strategy just for opportunities zones, again, that’s a huge risk. Are they going to be able to actually pull it off? I mean, just being able to pull off development in general is challenging, let alone layering it with opportunity zones and all these tax incentives and everything else. So I’d say that the third thing that people don’t talk about a lot, and I really haven’t heard anybody talk about it, it’s just a thought in my mind is the investment world is incredibly efficient.

So I’m looking at this thinking, “Okay, the underlying intention of the opportunity zones, essentially, is to create jobs, really. It’s not to create a tax incentive for rich people, it’s to create jobs in these areas.” And, theoretically, you put a tax incentive into the opportunity zones, you’re going to get growth in that area, real estate value is going to go up. However, the investment world is incredibly efficient. So if the opportunity zones, the basics of supply and demand, opportunity zones, price is going to go up, eventually it’s going to meet an equilibrium of other types of investments.

So that’s a risk. I mean, maybe that price spike happens quickly and all of a sudden it’s not quite as attractive. The other thing too that I worry about is on the flipside is in 2029, 10 years down the road, when people are trying to liquidate these properties to get the appreciated value, no cap gains, obviously, is that going to just tank the market in the area. So, obviously, that’s a risk and nobody really knows how that’s gonna play out but it’s definitely a concern of mine. Definitely something that I’m thinking about how are we going to get out of this so nobody gets hammered on it?

Jimmy: Yeah. So, you mentioned, I think if I counted correctly, four specific risks. The first one being the ability to deploy the capital within the appropriate timeframe. So you don’t waste the…I guess run out the clock, so to speak on the investor’s money. The second one was there’s a lot of non-real estate fund managers trying to get into this game. Do they have real estate experience, are they going to get exposed if they don’t have the proper experience? The third one being the tax incentive itself can cause the market to spike. And to the point where you’re not really…I guess once the low hanging fruit gets picked, so to speak. I think that’s what you were saying that the prices are going to go up in that area to the point where it kind of negates the tax incentive. And then the fourth one, exiting. Yeah, and there’s a lot of questions around exiting, especially with the regulations not being finalized yet. How do investors exit?

And, yeah, you’re not my first guest to bring up that point that 10 years plus from now, if everybody’s rushing to the exits all at once, it could tank the market. I think that is a good point. Nobody really knows what’s going to happen. It’s hard to break the future first of all and second of all we don’t have the final regulations around what it means to exit and how that can be structured.

So I wanted to ask you…want to focus on different types of opportunities on funds. So there are different types. There are, like, local opportunity zone funds that are focused specifically on one geography or even one single project. Can you compare that with buying into a national OZ Fund or a blind pool opportunity zone fund?

Chris: Sure. So I mean, obviously, if you buy something incredibly local, in my area, let’s say you buy a building in Oakland, it may be a great investment. No idea. However, this all comes back to risk, how diversified are you? It’s a 10-year holding. Again, that’s one of the obvious risks. It’s a 10-year holding. What’s going to happen in 10 years? What’s going to happen with that property in 10 years? Obviously, you think it’s going to be on the up and up because it’s an opportunity zone. But your investment risk is very, very localized. So having a fund that’s huge and invest nationally, maybe it’s got stuff in Texas and some property in New York, California, wherever, that’s going to spread out your risk a lot.

So there’s a lot of smaller investors, a lot of private investors that are going to have their own opportunity funds. And they’re going to be buying one building, and that’s going to be their opportunity fund. And that’s great. However, that’s not the best model for everybody. So there’s a ton and ton of different funds that are going to be coming out. So again, going back to risk, I personally think that having diversification in your investments, especially if it’s real estate-focused is a huge advantage. As far as blind investment pools, I’m just not a fan in general. I want everything to be relatively transparent so that I know what the fund is purchasing. Is it purchasing businesses? Is it purchasing real estate? I want to know what my investment risk is before I throw money into a blind pool.

Jimmy: You want to see their offering sheet beforehand, specifically layout. We’re going to invest in A, B, and C buildings and D, E and F businesses as opposed to we’ve identified some investment opportunities in opportunity zones in several different states throughout the country.

Chris: Yeah. I mean, I think due to just the complexity of all of this and the amount of funds that are available, going into a blind fund is not something that would make anybody too comfortable. I mean, there’s going to be a lot of competition out there as far as funds. So people are going to be able to choose a fund. They’re gonna have to weigh it. What’s the best manager out there? What’s the best firm that’s going to provide me with…hopefully the most upside and with the least amount of risk? I mean, that’s what the whole investment game’s all about, right? So if you have, “Hey, give me your money, I’m gonna buy some real estate and an opportunity zone somewhere and we’re going to do really good,” I don’t think that’s going to be a market mover.

Jimmy: Yeah, that’s a tough sell for somebody who does the due diligence for sure. What do you advise your clients in terms of diversification? Do you like them to find one big opportunity zone fund with a management team that they can trust that invests nationally or are you okay with advising clients to invest in multiple opportunity zone funds, and some of which may be local?

Chris: Well, it depends on how much they want to invest. So a lot of these funds are for accredited investors, qualified purchasers. So that people have to have enough money to invest in them, first of all. And also most of these funds have minimums, maybe it’s $100,000, maybe it’s $250,000. But also keep in mind that if somebody has a $50,000 cap gain, they could put regular money into that too. They can invest in these funds with regular money, that’s just with income money, not just cap gains money if they need to get to that minimum. So as far as diversification within the different funds, I mean, that’s a judgment call. What do I advise? I’m still looking at this.

But I can’t say it would necessarily be a bad idea to invest in a couple different. But again, it depends on what the minimum is. How big is the fund? Are you putting your money into a billion dollar fund? Or is it going to be a more nimble fund that has $250 million cap? So it depends and maybe you’re not 100% comfortable with one fund, so you want to put them in two. I mean, that’s going to be more of a judgment call on the individual investor.

Jimmy: Right. So, like the answer to many investment questions, the answer is, “It depends.” Yeah, I agree with you there. It depends on a variety of personal factors.

So you did mention just to clarify that an investor can invest cap gain money and regular money, but just to clarify the tax treatment only applies to the cap gain money. But yes, you are free to invest money beyond your cap gains in an opportunity zone fund as well.

Does it matter if I invest in a $10 million limit fund or a fund with a $5 billion limit? Like what’s the difference to me as an investor if I invest in a small single project fund versus one of these enormous funds?

Chris: So I think that’s still up for debate. I think that…so I don’t think there’s going to be a ton of huge funds. I don’t think you’re going to have, like, a $5 billion fund. I don’t see that because it’s going to be so hard to allocate that capital because there’s going to be a lot of competition here. On the flipside of that, is if you have a $10 million fund and you’re trying to invest in the same area and the same types of property as a $100 million fund, you might be left out in the cold. So to me, that’s something that’s just going to have to play out. I personally, I think the huge funds would be a little scary. How do you invest all that capital? I don’t really know how that works. And then a really small fund, again, are going to get pushed out by the big funds. So to me…

Jimmy: Maybe there’s a sweet spot in there, but it’s kind of hard to identify what that sweet spot is.

Chris: Yeah, I think there’s a sweet spot. I think something in the middle range there is probably going to be the most beneficial.

Jimmy: Yeah, that’s interesting. So, you know what? Let’s just cut to the chase right now. If I’m an investor and I’m looking for an opportunity zone fund, tell me what to do, Chris. Tell me what to do. How can I tell if an opportunity zone fund is right for me? And what factors should I concern myself with? I know we’ve already listed several of them but go into more detail on what I should be looking for.

Chris: Yeah. So if you’re just an investor and you’re coming to me and, “Hey, I’ve been hearing about opportunity zones from all my buddies at the gym. How do I know if it’s right for me?” And that’s actually been a question actually, exactly that. And first of all, do you have enough money to play in the sandbox? For some funds, you got to be a qualified purchaser, which is $5 million investable or accredited investors have to have an income of $200,000 and up and a million dollars of investable assets. So that’s obviously the first question. And then secondly, do you want to tie your money up for 10 years? A lot of people aren’t going to want to.

And again, that’s part of the risk. You’re going to have it in here for 10 years. Who knows what’s going to happen in 10 years? Who knows what’s going to happen in your life. So in my opinion, everything I do and everything we do is always we start with kind of a financial plan. What’s the outlook for you? And what’s going to make you comfortable for the next 10, 15, 20 years to get you to where you want to be? And if you can set that amount of money aside and taking advantage of the tax advantage here is going to be beneficial to you. And we all think and we’re all on the same page that the fund is going to grow and be a great investment, then it might be a good thing that’s worth looking at.

You know, with taxes, you don’t always let the tail, but I always hear people trying to let the tail wag the dog right? So when I’m dealing with somebody’s portfolio, I’ve had this happen more than once. “Hey, why don’t we sell it when the price goes down of this stock, so I pay less on capital gains taxes?” Like that doesn’t make a lot of sense. So we have to make sure that what we’re doing is going to be a great investment. And again, that’s part of the due diligence process. We want to have a phenomenal investment. And this tax incentive is just an overlay to something that’s an already good investment. So if you’re an individual investor and you meet all that criteria, and you think it’s a good investment in general, and “Hey, there’s a perk of saving some tax dollars on it,” then great, go for it. Does that make sense?

Jimmy: Yeah, it does make sense. And you don’t want to cut off your nose to spite your face as you alluded to on a previous phone call we had, in that example of that person wanting to wait until the price went down so he could have a tax loss.

Chris: Right.

Jimmy: Well, let me ask you about the IRS regulations surrounding opportunity zones. A few weeks ago the White House received the proposed second tranche of regulations from the Treasury Department, from the IRS. And we’re still waiting, as of the recording of this podcast anyway, we’re still waiting on the release of those guidelines. Is there anything in particular that you and your colleagues at Stifel are keen to receive some more clarity on?

Chris: So most of the conversation with the opportunity zones has been about real estate. And I think it’s been about real estate because it’s the easiest to kind of understand and wrap your head around. I think that the conversation is going to start to change once we get a little bit more clarity and a little bit more guidance on the business side of it. So investing in businesses, the 90% rule, you have to have 90% of the assets of the fund invested in opportunity zones. There needs to be more clarity on what those types of assets are. Like right now it’s just hard assets so if you’ve got…if you buy a billion dollars worth of intellectual property in an opportunity zone, that doesn’t count towards anything. It’s got to be hard asset.

So there needs to be some more clarity on the business side of it. And I think that’s where we’re going to see some really big multiples and people really capitalizing on this is when they start doing business infrastructure moves and purchases inside of the opportunity zones. I think real estate is going to be a very great way to get into here but I think people are going to start chasing the business opportunities as well.

Jimmy: Yeah. I think you’re right. I think, yeah, at the outside here real estate makes more sense because we know what real estate investing is within an opportunity zone. And the regulations are pretty clear on all of that. But, yeah, I am excited to see what the second tranche of regulations says about business investing. I think that is where…at least I hope that’s where a lot of the capital ends up getting placed in the years to come even though year one is looking predominantly real estate. Well, Chris, we’re getting toward the end of our conversation here. I want to ask you, what’s the most memorable investment that you’ve ever made? Is there anything in particular that stands out? I pose this question to almost all of my guests and always interested to hear their answers.

Chris: So that’s actually an easy one for me. So when I was a kid I had a good buddy and we used to look at “The Wall Street Journal” together and look at stock prices. And he kind of got me interested in it. The first stock or the first IPO I bought was Snapple and that IPO’d in 1993. And it was a huge success. I told my parents, “Hey, you gotta buy Snapple. It’s going to be great.” And they kind of looked at me like I was crazy. But we bought Snapple and it did great and I really had no idea what I was doing as far as telling my parents to buy this. But…

Jimmy: You got lucky, right?

Chris: I got totally lucky. And fortunately for me my luck was easily confused with genius. But that just gave me the confidence to continue to invest in the stock market. And that’s really where I consider the beginning of my investment career. And I started trading stocks prior to that but that was kind of my first IPO. That was like the one big exciting thing that I participated in, and then I just continued to be involved all the way through college and even when I owned my construction company I was just always involved in market. I think if I had purchased Snapple and it tanked, I probably would have just been out of the market and I’d probably be swinging a hammer somewhere.

Jimmy: Yeah, that’s a good thing you got in with Snapple in 1993 and not with some dot-com company in 1999 or 2000, right?

Chris: Right.

Jimmy: Otherwise we might not be talking today. That’s funny. Well, Chris, tell my listeners where they can go to learn more about you and Stifel Investment Services and the upcoming opportunity zone fund?

Chris: Sure. So real easy. You can just go to my website, which is paganelli-wm.com. So I’ll spell that for you. That’s paganelli-wm.com. And then if you want to get a hold of me, just hit the Contact Us button and we’ll reach out to you.

Jimmy: Excellent. So, yeah, listeners, I’ll have links to Chris’s website and any of the other resources that we discussed on today’s episode on the show notes page for this podcast episode. You can find those on the opportunity zones database website at opportunitydb.com/podcast. Chris, thanks for joining me today. This has been great. I think this has been a pretty helpful episode for a high net worth investor looking to deploy some capital into opportunities zones. You’ve given us a lot to think about in terms of what we’re looking at for in terms of due diligence and risks, what investors should think about before they write that big check. So thank you for joining us today. Appreciate it.

Chris: Yeah. My pleasure, Jimmy. Really enjoyed it.

Jimmy: All right. Thank you.

Stifel Disclosures

Alternative investments involve a high degree of risk, often engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing tax information, are not subject to the same regulatory requirements as more traditional investments, and often charge high fees, which may erode performance. An investment is appropriate only for investors who have the capacity to absorb a loss of some or all of their investment.