The suitability of a limited partnership depends on the partnership’s business, how it’s set up, and how it’s structured. For example, you may remember oil & gas programs from Series 7 preparation, where each program can have a different mix of risks and potential benefits. Even so, most direct participation programs (DPPs) share a few common traits.
*The specifics of oil and gas programs are unlikely to be tested on the Series 65.
Liquidity risk is a key concern, especially with non-public limited partnerships. Buying into a limited partnership typically involves a lengthy process and a subscription agreement. Exiting can be difficult because it may require approval from the general partners and/or finding a suitable replacement investor. You don’t need the procedural details here - just remember that cashing out of a limited partnership is usually much harder than selling stocks or bonds.
Another common feature of DPPs is the pass-through of losses. While losses are never desirable, they can create tax benefits through deductible business expenses or losses - something many other investments don’t provide in the same way. For example, with a stock investment, the typical way to generate a tax benefit from a loss is to sell the stock at a loss, creating a potentially deductible capital loss (discussed later). With a limited partnership, losses may be passed through and used for deductions without selling the investment, which can be an advantage.
Beyond liquidity risk and pass-through losses, DPPs can have a wide range of risk/return profiles depending on the underlying business. Investors should research the business and understand the specific risks involved. Even when the business itself appears relatively low-risk, the combination of liquidity risk and pass-through losses often makes DPPs most suitable for wealthier investors who can tolerate illiquidity and who may benefit from tax deductions.
At the same time, investors shouldn’t pursue DPPs solely for tax benefits. If the business performs poorly, the investor can still lose substantial amounts of money. Tax benefits can help, but they don’t eliminate investment risk.
Limited partners are only liable up to their basis (the amount contributed). The higher the basis, the more money is at risk.
Hedge fund investors are typically wealthy and sophisticated. A major reason is access: hedge funds are usually offered through private placements (often under Regulation D), so accredited investors are the most common participants. There are several ways to qualify as accredited, but many investors qualify by meeting the financial requirements.
Wealthy investors are also often the best fit because many hedge funds impose lock up periods, which prevent withdrawals for a set period of time. For example, a fund might prohibit withdrawals for one full year after the initial purchase. These restrictions create significant liquidity risk. An investor needs enough cash reserves to handle unexpected expenses while their hedge fund investment is inaccessible.
As covered in the hedge funds chapter, hedge funds often pursue higher-risk strategies in search of higher returns. Because of that risk, investors should be comfortable with the possibility of substantial losses. Typically, only aggressive investors should allocate large sums of capital (money) to hedge fund investments.
Investors in structured products need to be comfortable with both the risks and the complexity of these instruments. As discussed in the previous chapter, structured products are subject to credit (default) risk (on the debt component) and liquidity risk (except for ETNs). That means investors who need ready access to cash and/or who are concerned about issuer default generally should avoid these securities.
Structured products can also be difficult to evaluate. Many retail investors have limited familiarity with derivatives or debt securities, and structured products combine features of both. Because of this complexity, these products are generally most appropriate for sophisticated or institutional investors with broad knowledge of securities.
Venture capital funds are high-risk, illiquid private investment vehicles offered to accredited investors, usually through private placements. If successful, venture capital funds can offer the potential for a substantial return. Advisors to these funds are exempt reporting advisors who do not have to register with the SEC but have to file financials, regardless of their Assets Under Management (AUM).
Commodity pools are alternative investments used for speculation or hedging in the commodity markets. They operate under a different regulatory framework than traditional securities, combining investable capital to trade in commodity interests, such as commodities, futures, and options on futures. Commodity pools are managed by a commodity pool operator (CPO), and sometimes a commodity trading advisor (CTA) is involved to direct the trading strategy. Commodity pools are often structured as private offerings and are usually only available to accredited or institutional investors because of their complexity and risk. They are regulated by the Commodity Futures Trading Commission (CFTC), and they must comply with rules enforced by the National Futures Association (NFA).
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