The suitability of a limited partnership can vary depending on its business, setup, and structure. For example, you may recall learning about oil & gas programs if you’ve previously prepared for the Series 7*, where the risk and benefit profile of each is unique. Regardless, there are a few common traits that apply to most direct participation programs.
*The specifics of oil and gas programs are unlikely to be tested on the Series 65.
Liquidity risk applies, especially to non-public limited partnerships. Investing in a limited partnership requires a lengthy process and a subscription agreement. Getting out of a limited partnership can require the approval of the general partners and/or finding a suitable investor as a replacement. You don’t need to know the specifics, but cashing out of a limited partnership is not nearly as easy as selling stocks or bonds.
The pass through of losses is another staple of direct participation programs. While losing money isn’t fun, the ability to get a tax write-off due to business expenses or losses is not something afforded to other investments. For example, the only way to obtain a tax benefit from a stock investment is to sell it at a loss, which creates a potentially deductible capital loss (discussed later). With a limited partnership, losses can be attained and used for deductions without selling the investment, which is a big advantage.
Beyond liquidity risk and the pass through of losses, DPPs can offer a variety of risks and benefits. Investors should always do enough research to understand the business and the risks it presents. Even if a DPP seems low-risk, liquidity risk and the pass through of losses make them especially suitable for wealthy investors seeking tax benefits. Regardless, investors should not seek out DPP investments purely for tax benefits. If the business is not successful at some point, the investor can lose large amounts of money. Tax benefits only go so far!
Limited partners are only liable for losing their basis (amount contributed). The higher the basis, the more money is at risk.
Hedge fund investors are typically wealthy and sophisticated. This primarily relates to how investors gain access to these investments. Hedge funds are typically offered through private placements (usually Regulation D), which results in accredited investors being their stereotypical investor. There are several ways to qualify as accredited, but most of these investors meet the financial requirements.
Beyond the qualifications to invest, there are other reasons why the wealthy are most suitable for these investments. Many hedge funds implement lock up periods, which disallow the investor from withdrawing funds for some period of time. For example, some hedge funds do not allow withdrawals for one full year from the initial purchase. Investors subject to these restrictions face a significant amount of liquidity risk. It’s important an investor has enough cash on hand if an emergency pops up out of nowhere, and wealthier investors are most likely to afford to lack of liquidity.
As we learned in the hedge funds chapter, these portfolios tend to invest in high-risk securities in hopes of a significant return. Due to the risk involved, investors should be very comfortable with the possibility of loss. Only the most aggressive investors should allocate large sums of capital (money) to hedge fund investments.
Investors in structured products must be tolerant of certain risks and complexities related to these financial instruments. As we discussed in the previous chapter, structured products are subject to credit (default) risk (on the debt component) and liquidity risk (except for ETNs). Therefore, investors in need of liquid cash and/or concerned about losing money due to a default should avoid these securities.
Structured products tend to be complex and difficult to understand. Most retail investors have little-to-no knowledge of derivatives or debt securities, much less a product that combines the two. Due to their lack of simplicity, only sophisticated or institutional investors with broad knowledge of securities should consider these products.
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