How You Can Check Out a Limited Partnership

It is not unusual for investors to spot great deals that they can’t afford.

Perhaps it’s an apartment complex that promises positive cash flow to a buyer with a 20% down payment. Or maybe it’s an opportunity to lease a large piece of office equipment at a steady profit. It could even be an oil well or a horse ranch.

In instances like these, investors essentially have two choices--walk away or team up with other investors to make the purchase.

In its simplest form, investors banding together to buy something that none of them can individually afford is the basis for a limited partnership. But over the past dozen years, some partnerships have become so big and complex that they look and operate like communist bureaucracies--the only people who can make money and sense out of the system are the bureaucrats themselves.

However, some experts maintain that limited partnerships can still be a great deal for those who are willing to do their homework and accept certain risks that come with the package.

The standard limited partnership is set up in two tiers. There’s a general partner, who often serves as the manager and primary salesman. And there are limited partners who kick in the cash.

The general partner usually gets a fee for managing and selling the partnership, while the limited partners get annual statements, voting rights and, often, tax benefits based on how many partnership units they hold. (A partnership unit is roughly equivalent to one share of stock.)

Limited partnerships usually have a limited life. The partnership agreement generally will spell out when the partners plan to sell the assets and distribute the proceeds to unit holders.

The risks of investing in limited partnerships can be broken into two categories. There’s the risk of investing in whatever the partnership is buying. And there are separate risks involved in investing through the limited partnership structure.

Obviously, investors must consider both risks. But since there are virtually unlimited choices as to what partnerships can buy, it is impractical to generalize about those risks except to reiterate some basic investment tips.

Always check out the economics of the deal. Don’t invest in deals that promise only tax losses. You should be able to project with some accuracy when and how a deal will post operating profits.

Never allow yourself to be pressured into buying anything. And if something smells fishy or if the deal seems too good to be true, keep your money in your pocket. Other, less worrisome deals are sure to come along.

Now to the unique risks of the limited partnership structure:

* Management. In most of these deals, the general partner controls nearly every aspect of the business. Generals usually determine what to buy, whether or not to borrow money, whom to borrow it from, who will manage the project and how the partnership statements will be prepared. If the general is inept or dishonest, you can be sure that the limited partners will lose out.

* Fees. Limited partners usually pay hefty fees to the general and to other companies or individuals who are involved in some aspect of the partnership’s operation. It is not uncommon for these fees to amount to 20% of invested assets. The higher the fees, the lower the limited partners’ investment return.

* Illiquidity. Limited partnerships are almost always “illiquid”--investment jargon for “difficult to sell.” There is a market for second-hand partnership units, but it’s a small one.

Investors often pay dearly to sell out before the partnership sells its assets and distributes the proceeds to limited partners.

Investors should plan to do without any of the principal invested in these deals for the life of the contract.

To limit these risks, investors should look carefully at the general partner’s background and credentials. Never invest with a general partner you don’t trust. And make sure management responsibilities cannot be easily transferred.

Look at how the managers are being paid. If managers get the bulk of their profit only after limited partners get their due, then the managers will have a vested interest in ensuring the deal works out.

Finally, only use money you can speculate with and won’t need to tap for necessities when investing in limited partnerships. These are high-risk deals. Investors should feel equally prepared for a generous return or a stunning loss.