Overview:
Tax-exempt investors often face unanticipated tax issues when they choose to invest in alternative investment strategies. Hedge funds and private equity funds offer a variety of investment opportunities, but there are some tax traps for tax-exempt investors that can get in the way.
Unrelated Business Income Tax (UBIT):
Hedge fund and private equity fund partnerships pass all items of income and deductions to their limited partners. The typical hedge fund partnership uses leverage to enhance returns. However, borrowing to purchase investments triggers UBIT for IRAs, pension and profit-sharing plans and private foundations. Dividends, interest, and capital gains that are ordinarily income tax free are subject to UBIT to the extent they have been debt-financed through the use of leverage. The percentage of debt-financing can be exceedingly high. For example, a hedge fund that traditionally uses margin borrowing and other leverage techniques can easily have a debt-financed percentage of 50% or more. Thus, 50% or more of the dividends and capital gains attributable to those investments would be taxable income subject to UBIT. The UBIT rates are the same tax rates that apply to all taxpayers.
In the case of private equity funds, private equity investments in other business operating partnerships can result in business income passing through to tax-exempt investors and that income will be subject to UBIT. A tax-exempt investor would never expect to run a fast-food franchise without incurring an income tax on the profits. Investing through a partnership will not change that result.
Alternative Investments that Avoid the Unrelated Business Income Tax:
Regulated investment Companies (RICs) and Real Estate Investment Trusts (REITs) are good solutions to the unrelated business income tax dilemma. A RIC or a REIT is a corporation for tax purposes. Unlike partnerships, any debt-financed income or any business income is trapped inside the corporation and does not pass through to tax-exempt investors. The income from RICs and REITs are dividends that are entirely free of UBIT. Similarly, gains on the disposition of RIC and REIT shares are also exempt from UBIT.
RICS AND REITS OFFER A VARIETY OF INVESTMENT CHOICES THAT PERMIT TAX-EXEMPT INVESTORS TO DIVERSIFY THEIR INVESTMENT PORTFOLIOS WITH PRIVATE DEBT, MORTGAGE LOANS, AND REAL ESTATE.
Disclosures
Past Performance is not indicative of future results
Institutional Use Only
Prospect Capital Management L.P. (“Prospect”) is an SEC registered investment adviser that was founded in 1988 (along with its predecessors). Prospect invests across the United States in diversified portfolios by industry, company, and situation, and its proprietary underwriting process and metrics have been developed over more than 30 years and through multiple economic cycles. Prospect has over 150 employees and $9.4 billion** of assets under management as of March 31, 2026. With a buy-and-hold mentality, Prospect’s objectives are to preserve capital by making credit and equity-focused investments at reasonable multiples of recurring cash flow, earn attractive current cash yields and long-term capital appreciation while achieving consistent low-volatility returns. For more information, call 212.448.0702 or visit prospectcap.com
**The $9.4 billion of Assets Under Management (“AUM”) refers to the assets managed by Prospect and its affiliated registered investment advisors. AUM equals the sum of: (i) the gross assets of (a) Prospect Capital Corporation (“PSEC”), Priority Income Fund, Inc. (“PRIS”), Prospect Floating Rate and Alternative Income Fund, Inc. (“PFLOAT”), Prospect Credit REIT, LLC (“PCRED”), and Prospect Enhanced Yield Fund (“PENF”), and (b) pooled investment vehicles with respect to discrete assets for which Prospect has non-discretionary authority, (ii) any amounts available to be borrowed under certain credit facilities of the investment companies, (iii) total managed assets for real estate and structured credit investments, and (iv) uncalled capital commitments. Prospect’s AUM measure includes assets under management for which Prospect charges either nominal or zero fees. Prospect’s definition of AUM is not based on any definition of assets under management contained in any management agreements of the investment companies Prospect manages. Given the differences in the investment strategies and structures among other investment advisors, Prospect’s calculation of AUM may differ from the calculations employed by other investment managers and, as a result, this measure may not be directly comparable to similar measures presented by other investment managers. Prospect’s calculation also differs from the manner in which Prospect and its affiliates registered with the SEC report “Regulatory Assets Under Management” ($6.9 billion) on Form ADV.
This information is educational in nature and does not constitute an offer to sell or the solicitation of an offer to buy any securities. Prospect is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. All investing is subject to risk, including the possible loss of principal. Prospect cannot guarantee that the information herein is accurate, complete or timely. We make no representation or warranty in respect of any information derived from the third-party sources which has not been independently verified. Prospect and its affiliates do not provide tax, legal or accounting advice. This material is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
