Evaluating and Buying a Limited Partnership Interest
Limited partnerships that satisfy certain tax requirements offer many benefits to investors. The limited partners receive income, tax benefits, and capital gains over a specified duration, and their liability is limited to their investment. They also have a low correlation with other securities — depending on the business — allowing diversification of a portfolio.
Limited partnerships are sold as limited partnership units that range in price from $2,500 to $20,000 or more, and cover a wide variety of businesses, such as real estate development, oil and gas exploration, and movie production. They are sold as public registered securities that are available from brokerages and in the over-the-counter market, and as restricted securities sold in private placements. Limited partnerships are, however, risky investments, because they are difficult to value and most are not publicly traded, making them illiquid investments. Indeed, the limited partnership agreement restricts the sale of limited partnership units, since they are only suitable for certain types, generally wealthy, investors. It would, therefore, behoove the investor to investigate any limited partnership and read the prospectus carefully before buying.
Tax Requirements of Limited Partnerships
In order for a limited partnership to receive preferential tax treatment, it must satisfy specific tax requirements. Specifically, it must satisfy at least 2 of the following 4 characteristics:
- liability must not be limited
- the business cannot have an indefinite lifespan
- ownership interests cannot be freely transferable
- the management of the business cannot be centralized
Although the limited partners have limited liability in the amount that they invest, the general partner assumes all liabilities for the business itself, which satisfies the 1st requirement, since at least 1 partner assumes full liability.
Since almost all limited partnerships are also limited in lifespan by contract and by objective, requirement #2 is readily satisfied. The Agreement of Limited Partnership has a termination date, or specifies events that will terminate the partnership.
Since the transfer of ownership interest is restricted by the Agreement of Limited Partnership contract, condition #3 is readily satisfied. The general partner must approve of any transfers, and usually, the general partner will have the 1st right to buy it.
Limited partnerships have centralized management, which is necessary to conduct their business, so they do not satisfy the 4th requirement, but as already stated, limited partnerships only have to satisfy 2 of the above conditions.
To ensure that the limited partnership satisfies the necessary tax requirements, the sponsor of the limited partnership will obtain a legal opinion from an independent tax attorney that will be published in the prospectus.
Limited partnerships are risky, illiquid investments. While the risk is limited to the amount invested, all the money is at risk. Furthermore, the transfer of limited partnership units is usually restricted by contract, especially for private placement units. Some registered limited partnerships can be sold in the over-the-counter market, but they are difficult to sell because of their uncertain value, the small market for them, and the large spread between bid and ask prices due to their illiquidity.
Therefore, these investments are suitable for those investors who have long-term investment goals, who will not need the money during the term of the investment, and are willing to risk the entire amount invested. Some limited partnerships may also require additional amounts later as the need arises, and so the limited partnership investor will need to be able to make the additional investments when required. Limited partnerships will also benefit those in a high tax bracket and with passive income that can be offset with tax losses and credits from the limited partnership, since passive gains can only be offset by passive losses, unless the business interest is disposed of entirely.
Because of the suitability requirements of limited partnerships, the prospectus for a limited partnership will list suitability requirements, including high income and net worth. The investor will not be accepted by the general partner unless these suitability requirements are met. The investor will have to affirm that he meets the suitability requirements when he signs the subscription agreement.
Evaluating the Limited Partnership
Prior to 1987, limited partnerships were true tax shelters that allowed investors in high tax brackets to write off much more than they invested. Many of these investors were not even concerned about whether the business was profitable, because the tax savings was profit enough. Many of these limited partnerships had little or no real economic value — their only value was that they sheltered other income earned by the wealthy from taxes—hence, the name tax shelter. Tax shelters, however, are a waste to society, creating allocative inefficiency, because the businesses were designed to maximize tax losses rather than earning a profit or providing a true economic benefit.
The Taxpayer Relief Act of 1986 eliminated limited partnerships as a tax shelter, by restricting deductions to what was actually at risk and by classifying gains and losses from limited partnerships as passive that could only be used to offset other passive gains and losses. Passive income is income from a business in which the investor does not materially participate, but does not include portfolio income from stocks, bonds, and other securities.
So while tax savings are still a consideration in evaluating limited partnerships, it is more important to determine if it is a viable business that can make good profits. The most important indicator that it will be a profitable business is the experience of the general partner in limited partnerships and in the business itself, since the general partner runs the show. The more extensive the track record of the general partner, the greater the chances that the limited partnership will be profitable.
Another factor to consider is to invest in businesses that you understand. Understanding the business will allow you to evaluate the merits of the business objective and the methods for achieving it.
Most of the information that you need to evaluate the limited partnership is contained in the prospectus, which includes financial projections of the return on investment. There are 2 methods of calculating the return on investment: cash on cash and the internal rate of return.
- The cash-on-cash rate of return is calculated by dividing the income received in a year by the amount of the investment. So if you receive $500 on a $10,000 investment, that yields a rate of 5%.
- The internal rate of return (IRR) involves a more complicated formula that includes the time value of the payments, since $500 received in the 1st year is worth more than $500 received in the last year.
Cost of Limited Partnerships
Most limited partnerships are offered as limited partnership units that usually range from a low of $2,500 for many registered limited partnerships to $20,000 or more for privately placed limited partnerships. Part of the cost — specified in the prospectus and cannot exceed 15% of the investment — is a front-end load that pays for:
- expenses in creating the limited partnership
- commissions to salespeople and underwriters
- commissions paid to acquire assets
- points and origination fees for loans.
With some limited partnerships, there could be future assessments for additional money that must be paid in order to remain a limited partner. For instance, if the limited partnership is for oil and gas exploration, the initial money is spent looking for new sources of oil or gas. If oil or gas is found, then additional money will be needed to build a well and extract the oil or gas, which will be another assessment that limited partners will have to pay.
Limited Partnership Offering
While some limited partnerships are issued as managed offerings through an underwriting syndicate, most limited partnerships are issued by the sponsor—a non-managed offering. The sponsor of the limited partnership is either the general partner or an affiliate of the general partner. In the non-managed offering, the sponsor uses wholesalers, who may be employees of the sponsor or nonaffiliated salespeople, or an independent firm. The wholesalers generally go to the different brokerages, touting the limited partnership, and why it should be offered to the broker's suitable clients.
The National Association of Securities Dealers (NASD is now the Financial Industry Regulatory Authority: FINRA) has issued guidelines as to what is fair compensation for selling limited partnerships:
- the maximum front-end load should not exceed 15% of the proceeds of the offering
- the maximum compensation to underwriters, wholesalers, brokers/dealers, and their affiliates should not exceed 10% of the proceeds
- if a FINRA member firm performs due diligence, then additional compensation for due diligence expenses should not exceed 0.5% of the proceeds
There are both public and private offerings of limited partnerships. Public offerings must be registered with the SEC, and the limited partnership units can sell for as little as $2,500, but $5,000 is more common. Most limited partnerships, however, are placed privately for wealthy individuals. They are generally riskier than public offerings, are not SEC registered, and the limited partnership units usually cost at least $10,000, with many going for $20,000 or more. Since it benefits wealthy individuals more, privately placed limited partnerships usually offer more tax savings than public offerings.