September 12, 2006

Commercial Real Estate Financing and Limited Partnerships

The Limited Partners Cannot Be Held Liable for the Debts of the Partnership

In our last post, Commercial Mortgage Financing and General Partnerships, we discussed how each partner in a general partnership is personally liable for the debts of the partnership.

Personal liability is pretty scary for the average investor. Investors are typically older folks who are too old to go back and earn their dough all over again. They cannot afford the risk of being personally liable for the debts of a failed company.

Today we will discuss limited partnerships. A limited partnership is a form of partnership where there is at least one partner who serves as the general partner and who therefore remains personally liable for the debts of the partnership. The rest of the partners are called limited partners. A limited partner is at risk of losing all of his initial investment, but he cannot be held responsible for the unpaid debts of the partnership.

Suppose again that Bob and Steve want to form an energy company. They want to build an ethanol plant, and they will therefore need to raise $50 million. When they approach their first few investors with the idea of forming a general partnership to build the ethanol plant, every investor tells them the same thing, "No way! If the energy company fails, not only could I lose my $300,000 initial investment, but I could also be held liable the millions of dollars of unpaid bills to suppliers and subcontractors. I like the idea of investing in an ethanol plant, but not if the structure of the business entity is going to be a general partnership." (Think of term general partnership as meaning just a garden-variety, everyday partnership.)

Instead of a general partnership, Bob and Steve could form a limited partnership. Bob and Steve would be the general partners (there must always be at least one general partner but there can be many general partners), and the rest of the 40 investors would be limited partners. Their liability would be limited to the amount of their initial investments.

Limited partnerships are dinosaurs. Nobody uses them anymore. One reason is because tens of thousands of elderly investors lost on the order of several billion dollars by investing in limited partnerships in the mid-1980's. They had intentionally invested in real estate with a negative cash flow in the early 1980's. They used the negative cash flow to shelter their earned income from taxation. Then the government got smart and closed this loophole. Suddenly the investors were stuck feeding an alligator, a property with a painful negative cash flow. Most investors just walked from the property and lost their entire investments. To this day, limited partnerships still carry the stigma of flim-flam investments, even though the structure of a limited partnership is fine.

The other reason why limited partnerships are seldom used anymore is because someone has to serve as the general partner. Yikes! What if you invest in a commercial property that is contaminated and has a $2 million clean-up bill? If you're the general partner, you're toast.

Nevertheless, many limited partnerhips still exist. If you intend to lend to a limited partnership, be sure to gather the limited partnerhip agreement and Certificate of Limited Partnership, which is updated annually and shows the identity of the current general partner. Be sure to read the limited partnership agreement to make sure the general partner has the authority to encumber the property with a loan. If he doesn't, your collateral could be deemed legally worthless because your mortgage is invalid.