LIMITED PARTNERSHIPS
AS INVESTMENT VEHICLES
By:
Mark H. Barth
Albert Francke
New York
Investors from outside the United States have only recently been introduced to limited partnership investments, and are often unsure about the purpose and suitability of these entities. In the United States, however, limited partnerships have been in regular use as investment vehicles for the professional management of investments for a long time. Small groups of U.S. investors, such as institutional investors or wealthy individuals, often pool their capital to make investments through such partnerships. Most commonly, transactions have been in venture capital or other securities, real estate or oil and gas. Generally, limited partnership investments are suitable only for a narrow class of relatively sophisticated investors.
U.S. TAX CONSIDERATIONS
The principal reason for using partnerships rather than companies or trusts for investment vehicles in the United States is their tax treatment. If a U.S. company were used as the vehicle to pool investors' capital, the company itself would be subject to U.S. taxation on its net income. Shareholders would also be taxed upon distribution of profits. Thus, in the case of a U.S. company, there would be two levels of taxation.
An entity qualifying as a partnership pursuant to the Internal Revenue Code is transparent for federal income tax purposes (the partners are taxed currently on their allocable portions of income and gains from the partnership, but the partnership is not taxed as a separate entity). To achieve this tax transparency, the partnership must be structured to avoid having more than two of the following characteristics of a corporate entity: freely transferable interests; continuity of life; limited liability; and centralized management.
Although an investment vehicle could be structured as a general partnership, investors normally want insulation from liability and their exposure limited to the amount they have invested. Accordingly, investment partnerships are normally organized as limited partnerships, with the investors as limited partners and the investment manager, or an affiliate of the investment manager, as the general partner. To assure limited liability, investors should not participate in the management of the partnership, except as specifically allowed by the partnership law under which the partnership is organized.
The fact that the partnership is a limited partnership does not mean that the corporate criterion of limited liability is met for tax purposes. If the general partner is either an individual or a corporation meeting certain levels of net worth, and investment and profit participation in the partnership, then the unlimited liability of the general partner will suffice for purposes of meeting this partnership criterion.
U.S. SECURITIES LAW CONSIDERATIONS
Organization of an investment limited partnership and the sale of interests to investors in the United States engage many of the U.S. securities laws. Limited partnership interests are considered securities. Accordingly, unless exempt, their offer and sale must be registered under the Securities Act of 1933 (the "Securities Act"), which is costly and time-consuming and is undertaken only for retail investment vehicles sold to the public. Issuances by private investment vehicles are exempt from registration under the Securities Act if sold in transactions not involving a public offering (i.e., private placements). Most private placements are made in accordance with the safe harbor provisions of Regulation D under the Securities Act. Such provisions require that no general solicitation be made. For instance, there must be no public advertising or seminars called by public advertising, but instead there can be discreet approaches to relatively limited numbers of institutional and other investors whom the sponsors have reason to believe would be appropriate investors for the partnership. It is preferable (particularly in the case of individual investors) that the sponsor have some pre-existing relationship with the investors.
Private placements under Regulation D are normally made only to accredited investors. These are institutional investors and wealthy individuals meeting the criteria set forth in Regulation D. Although Regulation D permits sales to up to 35 persons who do not fall within the definition of accredited investor, sales to such persons engage certain mandatory information disclosure requirements in the offering documents. Thus, offerings are normally confined to accredited investors. Securities acquired in a private placement are subject to restrictions on transfer (in addition to those imposed to assure proper characterization as a partnership for tax purposes as described above). However, they may be freely transferred (for securities law purposes) among certain substantial institutional investors defined as qualified institutional buyers under the provisions of Rule 144A issued under the Securities Act.
An entity organized under U.S. law that falls within the definition of an investment company must register as such under the Investment Company Act of 1940. By the nature of its assets and activities, a pooled investment limited partnership would generally be considered an investment company. It is excluded from the definition, however, if it does not make a public offering in the United States and does not have more than 100 investors. If a corporation or other entity is a limited partner and owns more than 10% of the limited partnership interest, the shareholders of the corporation might have to be counted as part of the 100 investors permitted. Accordingly, an investment limited partnership should limit itself to fewer than 100 investors, including those by attribution through a corporate or other entity.
The general partner or other person giving advice or managing the limited partnership investing in securities is likely to be considered an investment adviser for purposes of the Investment Advisers Act of 1940 (the IAA). Investment advisers normally are required to register with the Securities and Exchange Commission, but are exempt from registration if they have fewer than 15 clients in any 12-month period and do not hold themselves out to the public as investment advisers.
In the case of an investment adviser based outside of the United States, the adviser is exempt if it has fewer than 15 U.S. clients in any 12-month period and does not hold itself out to the public in the United States as an investment adviser. Generally, the investment limited partnership itself and not the limited partners will be considered investment advisory clients of the general partner or other person rendering advice or management to the limited partnership, so the registration requirement under the IAA can often be avoided.
Finally, those persons engaged in selling the limited partnership interests in the United States may be considered engaged in the business of effecting transactions in securities and subject to registration as broker-dealers under the Securities and Exchange Act of 1934 (the "Exchange Act"). There are certain exemptions for persons associated with the general partner of the partnership, so long as those persons do not receive compensation tied to the amount raised for investment, are not affiliated with a broker-dealer and meet certain other requirements. Foreign brokers who organize and sell interests in investment vehicles in the United States may be exempted from registration by Rule 15(a)-6 under the Exchange Act if they solicit only certain U.S. institutional investors and a U.S.- registered broker-dealer participates in the transaction.
