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Tony Novak, CPA, MBA, MT
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What you should know about private placement limited partnership investments
by Tony Novak, CPA, MBA, MT
, revised 11/16/11
Every accountant and financial adviser is faced from time to time with the proposition: ” My broker (substitute: attorney, financial planner, barber, brother-in-law) let me in on an investment deal that really sounds great. I looked over the prospectus and heard what they have to say and it sounds great. What do you think?” There are varieties of the same question “You should also consider it for yourself” and “You probably have other clients who would love to hear about this”. These investments take the form of limited partnerships, private placement stocks, limited liability company shares, IPOs and other designations. Regardless of the legal format, these deals tend to have some things in common that are presented in this article.
Few people, regardless of their role in relation to the investment being offered, consider the position of the independent accountant1. Brokers and promoters often do not understand how an accountant can be so unmotivated by something that is, from their own perspective, so exciting and financially rewarding. An accountant cannot offer any meaningful advice to the discussion as to whether these are good investments. A wise accountant or adviser2 should not be “for” or “against” one of these deals. A good accountant can offer information about private placement partnerships in general, that may serve to counterbalance the information from the investment sponsors.
Everyone working with private placement partnerships (abbreviated hereafter as “LP”) whether as a sponsor, investor, promoter or broker, should be aware of the following items that tend be overlooked in the sales process:
Every LP offered is promoted as an “exceptional” investment opportunity
Never was an LP investment deal offered as an “average opportunity” or “likely to achieve mediocre returns”. In fact, some turned out to be great investments; most turned out to be OK; some turned out to be disappointing and some turned out to be true disasters. Promoters, sponsors and brokers must believe the LP will achieve outstanding rates of return in order to attract interest in an already overcrowded investment arena. Yet this belief is not correlated with the actual financial performance that will be achieved. No one knows in advance how any of the thousands of LPs issued each year will actually perform.
The primary source of information on LPs comes from those who are paid to promote them
In the legal and investment community this is called a “conflict of interest”. In other words, the people who are relied upon for information and advice have a motivation to present that information in a positive light. There is little in the way of independent third party information available on new LPs prior to issue and only limited third party information available after issuance. A conflict of interest does not mean that the information presented is wrong, but rather that it is not independent and free from bias.
Past performance is not an indication of future performance
Some LP companies promote their track record but past performance is not a predictor of future performance so the implication that an impressive history makes an investment more attractive is misleading. One famous LP promoter in the 1980s boasted their track record of dozens of successful real estate deals until one went bust. No one saw it coming and the track record only made it more shocking to investors.
The accountant’s report is not an endorsement
The prospectus for an LP includes a letter from an independent certified public accounting firm. This letter gives an opinion on the accuracy of the financial statements included in the prospectus but does not give an opinion on the performance of the LP investment. Some investors likely misunderstand the purpose of the accountant’s report and although it is illegal to do so, some promoters or brokers may facilitate this misunderstanding by making statements like “the deal has been reviewed by ABC Certified Public Accountants”.
Fees are high
When you buy a newly issued LP, a significant amount of your purchase price goes to pay the attorney, accountant, promoter, broker, marketing personnel, etc. This does not make it a bad deal, just an expensive one. Contrast this to purchasing a stock investment on the New York Stock Exchange, where almost all of your purchase price is for the investment and only a tiny portion (maybe about $15) for the trading firms.
Sales commissions are high
Brokers are well-paid to endorse LPs. Commissions and referral fees are significantly higher than for other types of investments. Some investors are under the belief that their broker is “doing them a favor” by letting them know about an LP instead of offering the more common investment choices. Compensation is higher because it takes more work and effort to sell an LP. LPs do not “sell themselves” in the same way that a no-load mutual fund, for example, is offered to investors.
LPs are illiquid
It is difficult and expensive to sell an LP. Compare it to buying a new car. Sure you can find a buyer but it may take awhile and the price may be less than you expect
LPs can be difficult to value
If you must produce audited financial statements for a bank or other entity then the cost of valuing LPs may increase your cost of preparing those statements. As a result, some investors are even motivated to leave the LP off of their financial statement, thereby lowering their audited net worth.
LPs are exempt from filing and compliance requirements
State and federal securities laws are more lenient for investments that are offered only to limited numbers of investors, to “qualified investors”, or not offered across state lines. What this means to investors is that the regulatory oversight that they may consider to be operating in their interest may in fact not exist. Most investors may have only a vague notion about securities regulation and may assume that the same standards apply to LPs.
Accountants are biased against LPs
Accountants are far more likely to hear complaints about LPs than praise about good ones. We tend to hear the horror stories about what can go wrong with LPs. No one has ever called me to say “My private placement is working out better as I had hoped and I want your opinion on it”. Virtually very call to an accountant about an LPS is about a deal gone wrong. This creates an inherent bias. In addition, we have a lot to lose if we endorse an investment and it goes bad. On the other hand, we have nothing to gain by endorsing an investment that does well. The best position an accountant can take is to offer no opinion on the investment.
The return on an “average” LPs is “average”
On average, LPs taken as an entire investment asset class perform about the same as other investment asset classes; not significantly better; not significantly worse. Some do well, some do not. Few perform exactly “as projected”. So if returns are the same and risks are higher, why would anyone want an LP? This leads to the next point:
Most LP investment decisions are based partly on emotional reasons
Investors love to own part of high profile real estate, a race horse, luxurious ships, oil rigs, movie productions, etc. and other industries that tend to rely on private placement financing. Investors often have some business or personal relationship with the sponsor or may be in the same line of work that makes the investment more attractive. LPs must have a “great story” that attracts investors. LPs can be fun to own and some offer non-financial perks that appeal to investors. LPs make for great discussion at cocktail parties.
LPs exist to provide financing
LPs exist for the sole purpose of turning the business asset of emotional appeal into lower priced financing for that business. This enables the firms to acquire financing at more favorable terms than would be available from other financing sources like banks. If the sponsor could get a loan at a bank for a lower price than they are paying, there would be no need for LPs. It is important to realize that the LP sponsor could not obtain financing under the same terms through a bank or in the securities market.
Why so negative?
This article may sound overwhelmingly negative. It is not meant to be. The fact is that there are already plenty of good reasons to invest in LPs flooding the investment media so a reiteration is not necessary here. This article is simply meant to provide “the other side” of the investment story that is not commonly discussed in the LP industry.
The author offers no opinion as to the merits of any specific offering, does not endorse them for clients or his own account.
1 To further complicate this issue, some “Independent Certified Public Accountants” now accept commissions and fees from the sponsors of investments. If an adviser is a “Registered Representative” then this means that compensation is accepted from investment sources other than a client. This destroys the impartiality implied by the professional designation and some investors are not aware of the distinction.
2The author does not receive commissions or fees from an investment sponsor for referring, endorsing or promoting an investment but does occasionally publish editorial pieces about these investments.
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