Direct participation programs (DPPs)

Direct participation programs (DPPs) are investments in businesses that allow the investor to “directly” participate in the profits and losses of the business. A DPP investment could be connected to anything from a grocery store to an oil drilling operation. Just like any other investment, investors make money if the business venture is profitable. What makes a DPP unique is its business structure and that it provides a way for investors to become directly connected to their investment. Unlike a normal stock investment, which provides limited ownership to their stockholders, investors in DPPs share in all of the finances of their issuer. The defining feature of a DPP is its ability to pass through losses to its owners.

Passing through losses doesn’t sound great. Who would want a loss? When DPPs pass through losses to their investors, they’re actually providing a tax deduction. The more tax-reportable losses an investor has, the fewer taxes they pay. When a DPP spends substantial amounts of money or has a business loss, it passes through the loss to its investors, providing them with a tax deduction. Typical investments, like a mutual fund, can only pass through income and gains to their investors. DPPs pass through income, gains, and losses in the form of tax deductions to their investors.

In a future chapter, you’ll learn about several different forms of DPPs, including general partnerships, limited liability companies (LLCs), and S corporations. We’ll specifically focus on limited partnerships (another type of DPP) in this chapter.

Limited partnerships

Limited partnerships are a common type of DPP. This type of business entity includes one or more general partners, plus one or more limited partners. General partners are responsible for running the business, while limited partners fund the business. Think of the general partners as the business managers, while the limited partners are the investors. When investing in this type of DPP, investors take on the role of the limited partner.

The term ‘limited’ refers to liability for investors. As a limited partner, the risk is limited to their investment. If a limited partner contributes $100,000 to a partnership investment, their maximum potential loss is $100,000. General partners assume unlimited liability as the managers of the business venture. It’s a risky position; a general partner’s personal assets are fair game in legal proceedings.

In general, limited partnership investments come with a considerable amount of liquidity risk. Typically, there is no secondary market that trades limited partnership units, therefore liquidating them can be difficult. Investors should not consider investing in DPPs if they need quick access to their funds.

Organization

To create a limited partnership, paperwork must be filed with the state where the limited partnership will primarily operate. This information includes the name of the business, address, and information on the partners (general and limited partners). When this is filed with the state, the partnership will receive a certificate of limited partnership from the state. Once this document is in possession of the limited partnership, it’s a legitimate business.

Each state has unique requirements and protocols for establishing limited partnerships. For a real-world look into the information requested by a state to legally form a limited partnership, here are the protocols from the state of Colorado (my home state).

An agreement between the general and limited partners must also be put in writing. Known as the agreement of limited partnership, this document details the rights, duties, and restrictions imposed on each type of partner. Additionally, it establishes how revenues and losses are allocated. If you’re interested, here’s a boilerplate version of an agreement of limited partnership provided by a law firm in California.

It’s important to understand the overall roles of the general and limited partners. General partners must act in a fiduciary capacity when managing the business, which prevents them from competing with, borrowing from, or working against the business in any way. As a fiduciary, they must always act in the best interest of the business.

Limited partners can be summed up as “the investors.” While they do not have management authority, limited partners have similar voting rights to common stockholders. They have the right to vote on changes to the overall objectives and large financial moves of the business, while also having access to the books and records of the partnership.

Unlike traditional equity and debt offerings, there are several steps investors must go through in order to become limited partners. A subscription agreement, which is basically an application to invest, establishes the potential investor’s suitability in regards to the partnership. General partners prefer to have wealthy investors that are not concerned with liquidity, which will allow them to obtain large amounts of capital without worrying about making payouts.

In addition to suitability, the subscription agreement requires the investor to explicitly state they are aware of the risks involved. Registered representatives (like you) typically help their clients build the necessary knowledge to judge the merits of the potential investment. If a registered representative wants to recommend a limited partnership, they should do a thorough suitability determination. This is accomplished by obtaining their client’s investment objectives, risk tolerance, tax status, net worth, annual income, personal liabilities, and investment goals. Some subscription agreements require registered representatives to certify their client understands the necessary facts and is suitable for the investment.

In order to solicit interest from potential investors, limited partnerships utilize investment banking services. If offered privately, limited partnerships are typically sold through Regulation D private placements, where unlimited numbers of accredited investors can participate. Limited partnerships can be sold through public offerings as well. When this occurs, registration with the SEC and/or the state administrator must occur (depending on if offering is intra or interstate) and a prospectus must be offered to investors.

One defining characteristic of limited partnerships is their limited lifespans. Unlike corporations, which can last in perpetuity (forever), limited partnerships are always dissolved at some point. Whether the dissolution is voluntary or required (typically because of bankruptcy), limited partnerships are always liquidated in the same way. All of the business debts are paid off, the leftover assets are liquidated, and cash is distributed in this order:

Secured creditors
Unsecured creditors
Limited partners
General partners

Sidenote

Real estate limited partnerships (RELPs)

Real estate limited partnerships (RELPs) are very similar to real estate investment trusts (REITs), which we discussed in a previous chapter. The big difference between the two is the structure of the investment itself. REITs are structured as trusts, are typically liquid (easy to buy and sell), and cannot pass through losses to investors. RELPs are structured as limited partnerships, are typically illiquid (difficult to buy and sell), and can pass through losses to investors.

Beyond the structure, both RELPs and REITs operate similarly. Both invest in commercial real estate. Some RELPs and REITs invest for capital appreciation, which occurs when property values rise. Others collect income from mortgages or tenants paying rent.

Key points

Direct participation programs (DPPs)

Pass through business returns and losses to investors
Investor suitability:
- Seeking tax benefits
- Comfortable with liquidity risk

Limited partnerships

Most common form of DPP
Must contain:
- At least one general partner
- At least one limited partner

General partners

Manage and run the business
Have unlimited liability

Limited partners

Provide funding for business
Have limited liability

Certificate of limited partnership

Makes the business official
LP must file partnership documents with the state
Received from the state when LP is officially formed

Agreement of limited partnership

Agreement between general and limited partners
Establishes rights, duties, and restrictions
General partners must act in a fiduciary capacity
Limited partners cannot manage

Subscription agreement

Application to invest in LP
Establishes an investor’s suitability
May require certification of investor’s knowledge

Liquidation priority of LP

Secured creditors
Unsecured creditors
Limited partners
General partners

Real estate limited partnerships (RELPs)

Invest in commercial properties
Various investment goals:
- Capital appreciation
- Income
- Tax benefits