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Limited Partnerships - Rising From the Ashes

By Stu Wells         July, 2002 

"A retail building boom is occurring in Greater Vancouver as a growing number of private investors and institutional buyers continue to develop a voracious appetite for investment opportunities." (Colliers In the News July 2, 2002)

Sound familiar? In good times and bad, investors want to participate in real estate. For those seeking to invest discrete amounts to participate in larger opportunities, and for those seeking to raise capital from investors for the same purpose, some form of syndication is necessary. Passive/aggressive (not really a contradiction in terms) and active/aggressive investors can work together, spreading the risk and getting a piece of something larger, hopefully with a larger return as well.

Most of the publicly traded real estate companies in Canada have been gobbled up in recent years by the big players. Many passive investors, including institutional investors, have turned to investment in publicly traded REITs. Several Canadian REITs afford investors a chance at decent returns and excellent liquidity, something many other forms of real estate investment do not. On the other hand, REITs are necessarily risk adverse and do not offer the upside that more aggressive investors might be looking for. Many such investors feel that REITs distribute moneys that might be better used for reinvestment and that REITs unnecessarily limit opportunities for effective leverage. By their nature, REITs tend to have cumbersome governance as well as high management, administrative, compliance and reporting costs. Most REITs avoid or are prohibited from becoming involved in development activities. While the risk may be reduced on the sidelines, so too is the potential for higher returns.

Many attractive acquisition or development opportunities (such as smaller office buildings, strip centres or residential rental projects) fail to meet REIT or major player investment criteria. Many seemingly attractive opportunities are considered to be inappropriate by reason of being the wrong type, too small, in the wrong geographic market or the time horizon isnít right. Some are avoided because they have a particular tenant, donít have a particular tenant or are perceived to have the wrong type of tenants. Many attractive assets presently held by the larger players are actually being divested for similar reasons. As a result, many viable opportunities are below the radar of larger players, leaving an opportunity for smaller players, banded together in a syndication vehicle.

Syndication can take many forms, as discussed in Syndication Ė A Useful Tool for Raising Real Estate Capital, a recent article on this site.

For very good reason, limited partnerships were the vehicle of choice for many years. Developers and promoters looking to raise equity for the development or acquisition of projects of all sorts, found that limited partnerships were the perfect vehicle. However, too often in past cycles, limited partnership offerings were based upon overly optimistic (in some cases outrageously optimistic) projections or were extremely over-leveraged. Investors were attracted in droves by the promise (and, ultimately, the false comfort) of deferred cash calls, cash flow guarantees, rental guarantees, "limitless" cash flow loans, disproportionately huge tax deductions and deferrals and "guaranteed" returns. Many such projects fell victim to hype, and ultimately general collapse in the markets. Economics were often ignored for the sake of perceived tax advantages or the expectation of huge appreciation. Many were doomed from the outset. Some served to attract unwitting investors to bail developers out of failing, or failed projects. In the worst of all cases, some failed to protect limited partners with limited liability. When the smoke cleared (and, figuratively speaking, even before the blood had dried in the streets) investors and many advisors had taken up the mantra "donít touch limited partnerships". A classic case of shooting the horse rather than the rider.

Many opportunities which are being overlooked by the big players, or which in some cases are being dumped by the big players, are being identified by knowledgeable developers and entrepreneurs. These opportunities offer excellent returns, but often not enough to support extremely high leverage or mezzanine debt rates. Many entrepreneurs lack sufficient capital to seize the opportunities on their own and need to attract investors prepared to take a little higher risk for the potential of substantially higher returns. Once again, circumstances certainly warrant a look at limited partnerships as a vehicle of choice.

For someone wanting to "test the waters", setting up a limited partnership can be fast and easy. Limited partnerships need not be complex, although they can be tailored to suit almost any objective. All that is required in order to form a limited partnership in British Columbia is for a founding general partner (thatís a nicer term than "promoter"), together with at least one limited partner (who is usually related to the founding general partner), to file a certificate under the Partnership Act, Section 51. The limited partnership exists from that point on and can carry on business and be marketed. A formal limited partnership agreement can be finalized at a later date. After the soundness of the opportunity has been explored and any necessary modifications to the structure are made, the certificate is amended accordingly and the investors are admitted as additional limited partners. Simple enough?

The limited partnership vehicle is well suited for a project specific opportunity which is limited in scope and duration (to address the issue of liquidity). Units can be of virtually any denomination and may include a huge variety of features, designed to suit the particular investment objectives. Different classes of units can be subscribed for, depending upon the circumstances, and may include preferential return, conversion features and other special rights or options which can be created to suit even the most sophisticated passive investor. The founding general partner is obliged to report material matters to the limited partners and keep them generally informed, but otherwise has its hands free to carry out the mandate of the limited partnership. The general partner will arrange appropriate financing and do what it does best to try and make the venture profitable for all. These days, the founding general partner is often willing to take a good portion of its "promote" or special return at the back end.

British Columbia and Alberta significantly changed the private placement prospectus exemptions in the Spring of 2002. The changes greatly facilitate "private issuer" offerings. Several new and expanded exemptions are now available from the registration and prospectus filing requirements and make it much easier to put groups together and at greatly reduced cost.

Not surprisingly, many developers, entrepreneurs and investors, scarred from old burns but now wiser, are overcoming their prejudice against limited partnerships. They are once again discovering that limited partnerships do work, and work very well if utilized responsibly.

The limited partnership vehicle enables a diverse group of passive investors to rely on a trusted personís expertise, while enjoying the benefits of limited liability, some tax shelter and participation in the potentially significant upsides of development. Development or acquisition of revenue producing projects enables the investors to share in the benefits of enhanced cash flow and income tax deferral produced by the deduction of capital cost allowance. Limited partnerships can be used not only to pool equity for acquisition or for development, but also for lending, including at the mezzanine level.

For sensibly evaluated opportunities, and especially higher risk, higher return investments, the limited partnership vehicle still presents one of the most attractive, cost effective, tax effective, management efficient means there is to bring a group of investors together to pool passive capital and active expertise for specific projects. At present, nothing else seems to fill the bill so nicely.

 

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