Partnership Perils I
by Richard
The day will come when a sleek bundle of forms will land on your desk from your friendly broker/adviser/manager…a prospectus and enrollment form inviting your participation in a public real estate/equipment leasing/oil drilling limited partnership.
Or maybe a much less formal offering for a private, exempt (from registration) partnership engaged in similar activities. For qualified (i.e. high net worth) investors.
These were called “syndications” at one time, but the term fell out of use, perhaps due to its unfortunate connotation with the organized criminal syndicates in the underworld.
Maybe that linkage is a more accurate description of the activities undertaken. Judge for yourself after we dig a little deeper…
The Limitations of a Limited Partnership
First, a working definition. We are not talking about an old fashioned general partnership, whereby all partners are jointly and individually liable for the partnership activities. Lawyers and Accountants gave up this structure ages ago, and now operate as an LLC (limited liability company) or LLP (limited liability partnership).
This was a smart, precautionary move, considering how amazingly simple it is for some entry-level junior partner to bring the whole structure down by some outrageous act of omission or commission.
What I am describing are the garden variety limited partnerships formed for investment purposes.
What was the driving impetus for this business format?
The tax code is a major factor. Many investment partnerships are structured to produce passive income or losses. As you know from my previous post on passive income, this is one of three ways income is generated. And sheltered.
No matter the ultimate purpose, any partnership is a marriage of convenience, bringing together an experienced general partner with a number of investing limited partners.
Or, as a mentor once told me: “partners with money join a partner with experience. At the conclusion of the partnership…the one with the experience ends up with the money. And the ones with money…well, they end up with an experience.”
You would think the general partner who bears all the liability exposure in these limited partnership would quake under the awesome weight of this burden.
Hardly. The general partner has simply dummied up a new stand-alone entity to serve in this role. Then….if the partnership tanks…they can jettison the damaged unit cleanly, without recourse to their core wealth.
The mega hedge fund, Carlyle Group, pulled exactly this maneuver, when they let their mortgage hedge fund crater under the weight of all its leveraged indebtedness last month. So little effect did this failure have on the parent group , Carlyle is now engaged in putting together a new vulture fund to acquire bargain priced illiquid assets.
Which is a little like the Menendez Brothers… whacking both parents, and then throwing themselves on the mercy of the court, since they are now orphans.
The whole infrastructure of hedge funds, private equity funds, and tax shelter oriented partnerships is predicated upon a rock bottom behavior patterns.
The Things We’ll Believe
Investors….the public….wants to believe these things:
- Everything in the brochure. But the brochure is not the operative document. That is the prospectus. And nobody wants to read that, because it will make your head hurt.
- They believe the investment salesman, when they say that the unconscionable fee structure is “standard in the industry”. Which it is. Just as the guillotine was the standard means of achieving societal restructuring during the French revolution.
- The investing public will do anything that might lower taxes. Even if that involves losing $5 to save $1 in taxes. This at a time when we are enjoying the lowest effective tax rate since the 1920s.
- Investors are enamored of any “hands off” investment. So long as they don’t get their hands dirty in the gritty minutiae of the venture, they will allow their pockets to be picked by the professionals.
- Most incredible of all beliefs, is that the general partner is actively working for the benefit and gain of the limited partner.
But any grifter will tell you that the con and the mark serve distinct and diverging roles…and any fleeting gain that passes to the mark is just a little fat to grease the skids.
When I was in high clover in my real estate career, I attended an industry conference of developers. Over a period of three days, not once did the discussion touch on investment valuation, property management, or any of the bread and butter skills necessary for acquiring and manging investment properties.
Every workshop was devoted to the agenda of how to extract fees from the limited partners, using multiple entities to cover your tracks. It was all perfectly legal.
And embarrassingly excessive, as we shall see in our followup post, where we will dissect a recent public offering.
