DPPs, Hedge Funds and Private Vehicles

The limited partnership structure

Most DPPs are limited partnerships, and the two roles are sharply distinguished.

The general partner manages the program, makes all business decisions, and has unlimited personal liability for partnership obligations. The GP owes a fiduciary duty to the limited partners and may not compete with the partnership, borrow from it, or use partnership assets for personal purposes.

Limited partners contribute capital, have no management role, and enjoy limited liability — their exposure is confined to their investment plus any amount they have contracted to contribute. That protection is conditional on staying out of management. A limited partner who takes an active role in running the business risks being treated as a general partner and losing limited liability, which is the exam's favourite consequence in this area.

Limited partners do retain certain non-management rights: to inspect the books, to vote on the sale of substantially all assets, to sue the general partner, and to vote to remove the general partner.

An investor subscribes by signing a subscription agreement stating their net worth and income, acknowledging the risks, and granting power of attorney to the general partner to execute the partnership agreement. The investment is not complete until the general partner signs and accepts the subscription — a point the exam tests directly.

The certificate of limited partnership is filed with the state and contains the partnership's basic terms. Other pass-through structures the outline names include limited liability companies and corporations that have obtained pass-through treatment.

Flow-through taxation and its limits

A partnership pays no entity-level tax. Income, gains, losses, deductions and credits flow through to the partners in proportion to their interests, reported to each partner on a Schedule K-1 and included on their own return. This is the whole appeal: a corporation's losses die inside the corporation, while a partnership's reach the investor.

The limit is the passive activity rule. A limited partnership interest is a passive activity, and passive losses may generally be deducted only against passive income — income from other passive activities, including other DPPs. They cannot be used against wages, interest, dividends or capital gains. Unused passive losses are suspended and carried forward, and are generally released when the investor disposes of the entire interest.

That rule reshaped the market. Programs designed around generating deductions for high earners with no passive income no longer work as advertised, and a representative recommending a DPP on the strength of its tax losses to a customer with no passive income is misrepresenting what the customer will get.

A partner's basis, which limits how much loss can be recognised, is their capital contribution plus their share of recourse debt plus income allocated, less distributions and losses. Non-recourse debt generally does not add to basis outside real estate, where qualified non-recourse financing does.

And there is a standing principle FINRA Rule 2310 rests on: economic soundness comes first. A program must make sense as a business before its tax treatment matters. A representative evaluating a program should look at the objectives, the expertise and track record of the general partner, the start-up costs and how much of each dollar reaches the actual investment, the leverage employed, the projected cash flow, and the exit — before considering any tax benefit.

The program types

Real estate programs are the largest category. Raw land programs seek appreciation and generate no income and no depreciation. New construction programs carry development risk. Existing property programs generate rental income and depreciation deductions immediately. Government-assisted housing programs historically generated tax credits alongside modest income. Depreciation is the characteristic real estate deduction: it produces a paper loss without a cash outlay, which is why real estate DPPs generate deductions in excess of cash losses.

Oil and gas programs come in three flavours with different risk-and-deduction profiles. Exploratory or wildcat programs drill in unproven areas — highest risk, highest potential return. Developmental programs drill near proven reserves. Income programs buy producing wells, so they generate revenue immediately with the least drilling risk and the fewest deductions. The characteristic deductions are intangible drilling costs — the non-salvageable costs of drilling, deductible in the year incurred, which front-loads deductions into an exploratory program — and depletion allowances, which recognize that the reserve is being consumed.

Equipment leasing programs buy equipment and lease it out, generating income and depreciation. Their risk is residual value and obsolescence rather than geology.

Other DPP types the outline names include small-cap debt and equity programs and business development companies.

Dissolution

On liquidation of a limited partnership, claims are satisfied in a set order and the exam asks for it directly.

Secured lenders first. Then general creditors, which includes unsecured lenders and trade creditors. Then limited partners — their claims for distributions owed and then their capital. Then general partners.

The general partner is last, which is the counterpart of their control and their unlimited liability. Note that limited partners rank ahead of general partners but behind every creditor, which is the ordinary position of an equity holder.

Hedge funds and funds of funds

A hedge fund is a privately offered pooled vehicle that relies on an exclusion from the definition of investment company under the 1940 Act — typically the exclusions for funds with a limited number of beneficial owners or for funds owned entirely by qualified purchasers. Because it is not a registered investment company, it is not bound by the Act's restrictions on leverage, short selling, concentration or liquidity, and it can pursue strategies a mutual fund cannot.

The consequences the exam wants named: interests are sold in a private placement, generally to accredited investors and often to a higher standard than that; there is limited or no liquidity, with lock-up periods and restricted redemption windows; information is limited, and there is no standardized prospectus; charges are high, typically a management fee plus a performance allocation; and strategies vary enormously, so 'hedge fund' describes a legal structure rather than a risk profile.

A fund of funds invests in other hedge funds, adding diversification across managers and a second layer of fees. Registered funds of hedge funds exist and are sold with a prospectus, but they retain limited liquidity, often offering repurchase only on a periodic tender.

Blind pool or blank check offerings — where the specific investments are not identified in advance — raise the same set of issues in a sharper form: the investor is buying the sponsor's judgement rather than an identified asset.

Distributions from these vehicles are taxed according to their character as it flows through, which for a partnership-structured fund means a Schedule K-1 and often a late one — a practical detail customers should be warned about before they file.