Limited partnerships

Barney Hearnden looks at the reasons why limited partnerships are still so popular within the property industry

The popularity of limited partnerships with property investors shows no sign of diminishing. Indeed the number of limited partnerships being formed is increasing dramatically. Traditionally a vehicle used for property funds, the limited partnership is also displacing the trust for land as the vehicle for more routine joint ventures.

Towards the end of last year, research published by DTZ Debenham Thorpe indicated that in two years since 1997, investors had committed £5.2 billion to limited partnerships – more than property unit trusts had attracted in 25 years. Limited partnerships have been used as the cornerstone of the Bluewater development, as well as the redevelopment of the Birmingham Bullring.

What are the benefits?

The main virtues of limited partnerships have become fairly well-known. The most important is tax transparency – broadly speaking, investors are taxed on income and gains as if they directly owned the underlying assets. Thus offshore investors preserve their capital gains tax exemption, whilst exempt investors receive all returns gross. A second advantage is that interests in a limited partnership can be transferred. The procedure is somewhat cumbersome – see further below – but in principle liquidity is aided by the structure's suitability for a wide range of investors. In addition, the structure can accommodate different numbers of investors, and different sizes of holding, very easily. Thirdly, limited partnerships have a clear and simple structure - investors become "limited partners", enjoying the benefit of limited liability provided they adopt a passive role, whilst management is undertaken by a special purpose vehicle created to act as the "general partner", with the help of third party advisers engaged by the partnership. In circumstances where a limited partnership is to be used for a joint venture, the arrangements can usually be structured around a jointly controlled special purpose company as general partner. Fourthly, the structure allows considerable flexibility in the allocation of profits. This means that a "carried interest" for the manager - that is, a performance-related share of the profits - can be incorporated into the structure in a tax efficient way.

Limited partnerships bring other benefits too. First, the vehicle can raise external finance without affecting the transferability of the limited partners' interests – subject to any covenant restrictions which the bank may seek to impose. It is usually desirable to register the title to the underlying assets in the names of two nominees for the partnership (one of whom may be the general partner). In this way, any third party dealing with the partnership (including the bank) can be sure that it will overreach all beneficial interests. In practice, this means that all leases, licences and similar documents need to be executed by the nominees.

A second benefit, which has become increasingly significant in the light of recent budgets, relates to stamp duty. A transfer of a limited partnership interest can be effected by an assignment of that share, and does not affect the legal title. Offshore execution of that assignment may operate to avoid duty altogether, provided that the original document does not need to be produced in the UK – something which will usually be possible, unless production of the original is required by the partnership agreement. Indeed, in some circumstances, it could be possible to sell the limited partnership – that is, to sell all of the limited partnership interests, and the shares in the general partner – and reduce stamp duty significantly.

What of the disadvantages?

First of all, costs of establishment and operation are relatively high, although these are reducing as the trail becomes more familiar. This can clearly be a disadvantage for joint venture-type transactions.

Second, the UK Limited Partnerships Act prescribes a limit of 20 on the number of partners in any one partnership. This can be a nuisance for a fund, and establishment of parallel partnerships is more difficult than for an equity fund. It is therefore preferable (where necessary) to attempt to circumvent this limit by the use of "feeder funds" for certain categories of investor. Because the 20 partner limit serves no valuable purpose, it would be helpful if it was abolished - no doubt a vain hope.

A third problem area is regulation. In general, property investment falls outside the scope of the Financial Services Act 1986 (the "FS Act"), but a limited partnership falls within the definition of a "collective investment scheme" in the FS Act - and both the promotion and the operation of collective investment schemes are regulated. This is unobjectionable in the context of a true fund, marketed to a number of external investors. In practice, the promotional obligations are easily complied with, if the target investors are institutions. The main obligation is to ensure that the general partner – or a delegated third party – is authorised under the FS Act (not usually a problem for a fund management organisation). But these rules are not appropriate for a simple joint venture, and although there is an exemption from regulation which can sometimes be used, the position is complex and less than clear cut. Once again a change in legislation would be helpful. Unfortunately, the Financial Services and Markets Bill seems unlikely to address such a detailed point.

A few other practical points

As noted above, transfers of limited partnership interests are effected by assignment. Any such assignment will not be effective until it has been advertised in the London Gazette. It must also be registered at Companies House. This makes the transfer procedure inevitably rather complicated, even before pre-emption rights and possible lender consents are introduced. At a minimum, any lender to the partnership is likely to require that the limited partners agree to subordinate their claims to those of the bank, so any incoming partner will need to submit to these arrangements as part of the transfer process, even if the bank's consent to the transfer is not strictly required. Another aspect of transfers is that the transferee will become entitled to receive all subsequent distributions (in the absence of contrary agreement), but the transferor will still be liable to tax on all income and gains up to the time of transfer. This can lead to a mismatch, which both transferor and transferee need to watch out for.

Perhaps the most difficult area is the extent to which limited partners can maintain any involvement in the activities of the partnership. Caution is the watchword here, because the Limited Partnerships Act states categorically that a limited partner shall not take part in the management of the partnership business, and is permitted only to inspect the partnership's books and records and "advise with" the other partners on the state and prospects of the partnership business. It is difficult to generalise because there are many different sets of circumstances, but traditionally the view has been taken that participation in management must be construed widely, and it is dangerous (for example) for a limited partner to own shares in and nominate directors to the general partner. The resulting uncertainty is undesirable, and in this respect at least the position is better overseas. In jurisdictions such as Jersey and Bermuda, legislation has been updated to provide a sensible list of permitted activities, including (in the case of Jersey) the holding of shares in the general partner.

In conclusion

The limited partnership is a somewhat strange vehicle, rescued recently from obscurity and suffering from various imperfections because it relies on 1907 legislation. The fact that it has become the vehicle of choice for collective investment in real property could be said to reflect the absence of a better structure more than the merits of limited partnerships themselves. Nevertheless, it has the right fundamental character for tax purposes, and the other problems it throws up are all soluble – unless the Government creates a flexible REIT, limited partnerships will be here to stay.