Limited partnerships can be a great addition to a diversified portfolio. They are complex investments and not suitable for every investor. But many investors can benefit from these investments, if they are prudent in their decisions.
The heyday of limited partnerships came to an end with the Tax Reform Act of 1986. Before this point, many limited partnerships were structured primarily as tax shelters for the wealthy. The underlying business purpose was often weak — and secondary to their primary objective as a tax shelter.
The Act ended this seemingly inappropriate use of limited partnerships, and today’s limited partnership investments are not the dubious tax vehicles of the past.
The structure of a limited partnership requires that there be at least one general partner and at least one limited partner. The general partner operates the business and has no limits on their liability.
The limited partners cannot participate in running the operation and have liability limited to the amount they have invested.
This structure lends itself to concentrated investment in a particular business or type of business. The most common include commercial real estate, films, venture capital, and oil and gas exploration.
Some people set up limited partnerships to manage small pools of investments. These are not commercially available. Commercially available limited partnerships include both public offerings and private placements.
Public offerings are the partnerships most investors would consider. They are required to be registered with the SEC and costs are bound by FINRA regulations.
Why Consider Limited Partnerships?
We hear the endless beating of the drum of diversification. But buying more similar things isn’t really diversification. To improve diversification, we need to add assets that are either negatively correlated with our existing assets or at least not correlated with our existing assets. Limited partnerships tend to have low correlation with your mainstay asset classes.
Limited partnerships allow an investor to benefit from the upside of direct business ownership with protection on the downside: They cannot lose more than they have invested. This is the primary benefit of investing in limited partnerships.
You have significant upside potential. Your downside is limited to the amount of your investment.
Some partnerships do offer tax advantages. Investors who have existing passive income may find the opportunity to offset passive income with passive losses.
The Downsides of Limited Partnerships
The downsides of limited partnerships are significant. The potential to lose money is limited to your investment but it is possible to lose your investment. The chances of loss are higher than with most mainstream investments.
Costs tend to be high. While FINRA has capped the sales expenses of publicly offered limited partnerships, the costs are still higher than nearly that of any other investment. While in the end it is what you keep that matters most, the partnership still has to make enough gains to overcome these high costs before you even begin to accrue any benefit.
Limited partnerships are illiquid investments.
There is no secondary market with regular trading activity like there is with stocks. The holding period for the investments are long, generally over 10 years. If you need to sell prior to the end of the partnership, you will find it difficult and you will most likely incur a significant loss. It is common to see partnerships sold prematurely for pennies on the dollar.
Many partnership investments have a speculative component to them. Potential investors need to make certain they understand the risks involved. Businesses such as movies and oil and gas exploration have greater risks than the average business. Risks may be mitigated by multiple projects within a partnership but will often still be risky.
Not all partnerships are in highly speculative industries; commercial real estate and other businesses can offer upside potential without as high of potential for loss.
The business case for the business of the partnership is the key. Most partnership investors choose to invest in something they know or believe in. They look forward to a chance of making a greater return, tempered by a higher chance of losing money.
Investors often connect more with investments directly into a business, either through ownership of individual stocks or through partnerships, limited partnerships in particular.
Investing, for many, has become abstract. They put their money into index funds and periodically note that they have gains or losses. There’s no excitement, often not a lot of interest. Limited partnerships are often something investors can connect with.
They can help generate interest in what has become the fairly mundane world of investing.
The needs for investor due diligence are great. You should never invest in anything you haven’t researched yourself or don’t understand.
Brokers and financial advisors can help you navigate this more complex investing world and find potentially suitable investments. Most partnerships have income and net worth requirements. They are there for a reason.
Limited partnership investing isn’t for everyone. It can, however, be fun and interesting where appropriate for you and your portfolio.