Limited partnerships seem to be growing in popularity. The Limited Partnerships Act was passed in 2008, so the structure is no longer something new. There are now over 500 registered, and they seem to be increasingly used as a business vehicle. There are a number of advantages to limited partnerships (as well as disadvantages), and they can usefully be used in a range of situations. But they must be used critically. As the use of a limited partnership structure becomes more common, further issues – what we could call ‘second generation issues’ – are likely to arise. This article briefly outlines what limited partnerships are, before considering when they are most useful, when they are not useful, and the key issues that need attention for those forming or considering a limited partnership structure.
Each limited partnership (properly abbreviated as ‘LP’ not ‘LLP’) is governed by the Limited Partnerships Act 2008. An LP consists of a general partner, and at least one limited partner. The general partner is essentially the manager of the partnership, while the limited partners are the investors in the partnership. The limited partners cannot be involved in the management of the partnership, though the Act contains various “safe harbours” which make it relatively easy to structure arrangements so that the limited partners can do so in a permissible way – for example, by making the general partner a company, and the limited partners (or their associates) directors of that company. Because of potential liabilities on the general partner, the general partner is often a company.
A limited partnership is a legal entity separate from its partners. In this way, it is like a company, which has a legal identity separate from its shareholders: both a company and an LP can enter into contracts, sue others, be sued, and so on, without the investors behind the entity being personally liable. However, a limited partnership has very different tax implications from those that apply to a company. A company pays tax in its own right. A limited partnership, on the other hand, does not pay tax in its own right. Rather, the individual partners pay tax on profits, and gain the benefit of any losses (up to the amount of their committed capital – a similar arrangement to a look-through company (LTC)).
Why have a limited partnership?
Tax drives the establishment of most limited partnerships – though sometimes they seem to be driven by being something new and different. The good reasons for setting up an LP include:
- Tax: Where investors in a joint venture are on different tax rates (for example, an charity forming a property development joint venture with a private trust), then a limited partnership allows each investor to pay tax on profits at its own rate (zero per cent for the charity; 33 per cent for the private trust), rather than the JV company paying its own tax. Similar issues might apply when a New Zealand and Australian investor are doing business together.
- Tax (mark 2): Where significant losses are expected upfront (as might be the case with a forestry venture, or a dairy conversion), the LP structure allows losses to be used by the limited partners personally, rather than remaining in the company. This can be very tax advantageous to investors.
- Streamlining: We used to see partnerships of loss attributing qualifying companies, or LAQCs (now look through companies, or LTCs), for tax efficiency. Though it has an inherent degree of complexity, a limited partnership is less cumbersome than these kinds of structures, and has fewer restrictions on ownership than an LTC.
- Overseas investment: This is perhaps the real reason for limited partnerships being established as a legal structure: to attract overseas investment. How? Because the structure is well understood overseas, and because an overseas investor can be taxed at his/her home rate, rather than the New Zealand company tax rate.
- Confidentiality: This is often underrated as an advantage. The name of the limited partnership and the identity of the general partner are a matter of public record. The identity of the limited partners must be disclosed to the Registrar, but is not a matter of public record. With a company, the names of shareholders must be disclosed; with a limited partnership, investors’ names can remain hidden.
- Liability as between investors: This is perhaps a less well-known point. In a company, directors owe duties to shareholders and to the company. Shareholders can also owe duties to each other, particularly in a ‘quasi-partnership company’, where the shareholders are a close-knit group with expectations of trust and confidence, where they work in the business together, and (usually) where there are restrictions on share transfers. These duties can be those of utmost good faith (fiduciary duties) – a step above contractual duties. Under the Limited Partnerships Act, partners can expressly provide that they do not owe fiduciary duties to each other, thereby limiting their legal risks as between each other.
When not to have a limited partnership (1)
There are negatives to any business structure. The key negatives for a limited partnership include:
- Complexity: A limited partnership is inherently more complicated than, say, an ordinary company – and an ordinary company, with its director duties, shareholder remedies, and creditor rights, is often more complex than many people recognise.
- Time: A company is easy to set up, while a limited partnership is not. A limited partnership is also not well suited to a situation where you want a new entity fast and cheap. A detailed limited partnership agreement is compulsory, and registration can take some time. The costs involved in setting up and registering a limited partnership are much higher than for a company.
- Involvement: Conceptually, the limited partnership structure is based around a division between management and investment – between the general partner and the limited partners. If all investors want to be actively involved in the business, then a limited partnership is not really the ideal structure. It may still be usable, but conceptually the fit is wrong. For this reason, limited partnerships are better suited to hands-off, passive investors than they are to hands-on businesses, such as professional service firms. I don’t think limited partnerships are right for most professional service firms, or your average small business where Mike and Jim both want employment, ownership, and control in the business. A standard company is generally better.
When not to have a limited partnership (2)
There are some reasons for a limited partnership that people think are good, but that can really be bad:
- Tax: Tax can be a good reason. But should tax drive all commercial decision making? Of course not.
- “They sound cool/different/trendy”: So did finance companies, once upon a time. There should be good commercial reasons for having a limited partnership structure, not just because it sounds more intriguing than an ordinary company.
Key issues needing attention
Governance and exit strategies are two critical points that often go largely unconsidered in limited partnership agreements. As limited partnerships become more common, it is important – essential – that advisers become more sophisticated about them. It is too easy for limited partnership agreements to be based on templates unsuited to the parties and their situation.
For example, where there are only two limited partners, exit strategies need to be very different than if there are six or 10 limited partners. Do they have roughly the same resources, if A needs to buy B out? Or will B always win a ‘bidding war’ between the two? If B breaches the agreement, what will A do? Should A have the ability to pay out B over a period of time, rather than immediately? What if A and B fall out and simply cannot agree on a decision requiring a resolution of the limited partners? The answers to these kinds of questions need to be tailored, and a standard template pre-emption clause won’t do the trick.
Again, where there are only two limited partners, do they need an advisory committee? This appears in many templates, but is it really necessary? What if there are four or five limited partners? Is it any more necessary then?
Commercial lawyers have become quite used to dealing with these issues in the context of shareholders’ agreements. It is now essential for limited partnership agreements to reach the same levels of customisation. As headings, we could ask:
- Are limited partners also shareholders and directors in the general partner company? Do they want to be?
- Is an advisory committee really necessary? What will it add to the governance of the limited partnership?
- What decisions are fundamental to the limited partnership (eg the line of business the limited partnership undertakes)? What influence do limited partners have? What role do limited partners have in decision making?
- How will A exit the limited partnership? Is there a standard pre-emption provision, or something more detailed (Russian Roulette; Drag-Tag; etcetera)? Will A find his/her own buyer, or sell out to another limited partner? Can A require B (or B and C) to buy out A’s limited partnership interest?
- Will payment be immediate or staggered?
- If another limited partner joins, will the agreement remain in place, or be renegotiated to take into account what might be different governance arrangements?
- If A sells his/her limited partnership interest, is A also required to leave the general partner company?
- What warranties is A providing on exit?
- If the limited partnership is to borrow money, what bank guarantees will be required?
- Are limited partners obliged to provide these?
- Are limited partners required to contribute work to the limited partnership? How are these obligations documented? Do they fall within the safe harbours of the Act?
This list is far from exhaustive, but I believe there are many limited partnership agreements that have been signed up with only cursory attention to issues of governance, exit, and contribution.
Sale of an LP interest
It is still early days of course, and it seems there are (so far) many more limited partnership agreements than there are agreements for the sale of an interest in a limited partnership. These too require more detailed attention, in terms of sale price, valuation, timing, settlement obligations, and warranties. The negotiation of warranties on departure from a limited partnership may well come to vex an increasing number of lawyers.
The sale of a limited partnership interest bears a familial resemblance to the sale of shares in a company, but the two are of course quite distinct, and need to be documented in very different ways.
Limited partnerships are an increasingly common, but still immature, business structure. In the world of ‘Limited Partnerships 2.0’, advisers need to look beyond what a limited partnership is, and beyond the use of templates, into second-generation questions like:
- Why use a limited partnership?
- When? When not?
- What model of governance best suits this limited partnership?
- What is the best model of funding?
- What exit strategies should be put in place?
- How will I document my exit from this LP?
Increasingly, parties to a limited partnership will be better served by customised and tailored arrangements. These should take into account the points raised above, and many others besides. Otherwise, those entering into limited partnership arrangements may get more confusion, and less clarity, than they bargained for – and the 2.0 issues will be ones of concern and loss, rather than opportunity and prosperity.
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