Alternative investment limited partnerships have never been more popular. I think investors should think twice before committing funds to alternative investment limited partnerships, especially if the investment is being sold by a broker (aka financial advisor).
There are many reasons to avoid alternative investment limited partnerships. Here are seven of the most common:
- The Low Volatility Myth
- Huge Fees
- No Transparency
- Tax Complexity
- No Performance Reporting
- No Liquidity
- Debt
Low Volatility Myth
Many distributors of alternative investment limited partnerships, whether it is real estate, growth equity, private credit, VC, or buyouts, will focus on the supposedly low volatility of alternative investment limited partnerships. But this low volatility is a myth. The volatility is there; you just do not see it. Alternative investment limited partnerships do not mark-to-market on a daily basis. Instead, the general partners typically perform quarterly valuations which are sent to limited partner investors. These valuations should be taken with a grain of salt. Unlike the stock market, where real-time valuations are available whenever the stock market is open, alternative investment limited partnership valuations can be very subjective. Methods for valuation such as the price from a new round of financing, transaction multiples or comparable multiples from publicly traded companies are just guesses and not a reliable indicator of investment value. Because valuation is generally done just a handful of times per year based on subjective methods, volatility appears to be low. In reality, the underlying fund investments are moving up and down much more than limited partners realize.
Huge Fees
Most investors know, or should know, that alternative investment limited partnerships have substantial fees. General partners will receive a management fee, which is often two percent of the fund assets and a carried interest fee which is generally twenty percent of fund profits. But In addition to the management and carried interest fees, many alternative funds, especially real estate funds, have other ways to enrich themselves. If you carefully read the private placement memorandum (ppm) for your limited partnership investment, you may find that the general partners of your fund are getting paid on things like debt placement, acquisition and disposition fees, refinancing fees, construction and property management fees, on and on. Often these fees are a form of double-dipping where the fund is charging investors a fund-level fee and an additional property-level fee, for the same service. Unfortunately, too many investors do not read the fine print and challenge the general partners on these exorbitant fees. They just pay them and never know.
If you buy your alternative investment limited partnership from a financial advisor, they need to get paid too so be aware that alternative investments sold by brokers usually carry significant under the table commissions paid to the broker.
No Transparency
Unlike a fiduciary, lawyer or accountant, who will show you their fees, all the fees in your alternative investment limited partnership will be hidden from you. Do not expect any transparency here.
Tax Complexity
Alternative investment limited partnerships distribute a schedule K-1 instead of form 1099. The schedule K-1 is necessary for you to report your share of partnership gains, losses, deductions and credits, to the IRS.
Because partnerships must finish their own tax return before they can issue K-1s to investors, the investors often receive their K-1s very close to the April 15th tax deadline. Many limited partnerships are so complex that more time is needed to prepare their tax return and as a result, the partnership will file for an extension. Due to the extension, limited partners will receive their K-1 after April 15th and will not be able to comply with the April 15th tax filing deadline. The more limited partnerships you invest in, the more significant this problem becomes.
When you receive form K-1, your tax return automatically becomes more complicated and requires more time and effort from your accountant. If you invest in many alternative investment limited partnerships and receive a dozen K-1s or more, your tax return could easily cost $5,000 or higher, just to prepare.
No Performance Reporting
In twenty-five years of working in wealth management I have yet to see a performance report from an alternative investment limited partnership. I am talking about a time-weighted, net-of-fees, return calculation comparing the performance of the partnership investment to a common benchmark like the S&P 500, Dow Jones Industrial Average or Bloomberg Aggregate Bond Index.
In my experience, most general partners will get their limited partners excited about a return of capital multiple or hype up their IRR. But what I have discovered is that nearly always, if the investor had simply put their money in the S&P 500, they would have come out ahead and with less tax issues. Warren Buffett is known for stating that private investments can rarely beat the S&P 500 and he is right.
No Liquidity
Once you invest in an alternative investment limited partnership, you may not be able to access your funds for many years. Under stressful market conditions, such as a recession, alternative investment general partners often gate their funds eliminating any liquidity options. Before you commit capital to an alternative investment limited partnership, be sure you understand the liquidity options. If the fund manager tells you they expect to return capital in three to five years, those projections are usually best-case scenarios. Add a few more years to that timeline to account for unforeseen economic events.
Debt
Alternative investment limited partnerships often use debt to enhance returns. Debt can help get you there faster, but it can also wipe you out. Just look at what is happening in every downtown area in America right now. Beautiful office towers are selling for pennies on the dollar everywhere these days. The debt against the buildings is the number one problem for the investors who are losing everything. If these investors had bought the buildings for cash, they would have no problems. Instead, in a period where vacancy rates have moved up and cash flow is down, many cannot service their debt and they are defaulting on their loans.
When you invest in an alternative investment limited partnership, make sure you understand how the general partners plan to use debt.
Ethan S. Braid, CFA
President
HighPass Asset Management
Denver, Colorado