Guide To Understanding Direct Investments

Direct investment in tangible, or hard, assets, such as real estate, leased equipment, and energy resources, is an alternative asset class you may want to consider adding to your portfolio. When you invest this way, you own a share of the actual assets of an operating company and may benefit from the assets’ value, typically the income they produce. One way to put money into tangible assets is through investment programs called direct participation programs (DPPs). The most common DPPs are nontraded real estate investment trusts (REITs), equipment leasing corporations, and energy exploration and development limited partnerships. A DIFFERENT APPROACH Investing through a DPP gives you partial ownership of actual physical assets. For example, if you invest in a nontraded REIT, you’re a part owner of the real estate holdings of the REIT. If you invest in an equipment leasing corporation, you’re part owner of the actual equipment offered for lease by the corporation. And if you invest in an oil development corporation, you’re part owner of the corporation’s wells and the proceeds of oil sales. In fact, the pooled investment structure of DPPs is sometimes described as a way to provide the average investor with opportunities previously available only to the wealthy. Because you invest as part of a group, you don’t need the means to acquire a large percentage stake in the venture or fund your own start-up company to invest in new businesses. Direct Investment Overview A snapshot of this asset class can help you picture where it might fit in your portfolio. BUSINESS STRUCTURE In each case, the sponsors who offer DPPs pool your funds and the funds of other participating investors—typically 1,000 or more of them—to make investments they have identified as appropriate to the program’s investment goals. The sponsors are responsible for managing the assets of the program as long as it continues to operate and for devising an appropriate strategy for ending it. The legal structures that provide the foundations for different types of direct investment programs vary. REITs are a special type of corporation. Equipment leasing businesses are structured as limited liability corporations (LLCs). Energy ventures are formed as limited partnerships. In practice, however, the investments behave as limited partnerships, regardless of their differing legal structures. In brief, a limited partnership has a general partner—in this case the sponsor—who runs the business and a number of limited partners who invest but aren’t involved in the partnership’s operation or liable for losses beyond their own investment. A BRIEF PARTNERSHIP HISTORY Limited partnerships are a uniquely American vehicle for setting up new businesses. They originated in the pre-Revolutionary War period when the country was still under the dominion of England, and the British refused to issue charters to American businesses. American merchants, left to their own resources, pooled their capital and credit in order to share the risks of trading their goods. Soon a more formal partnership structure was developed, which became part of the economic foundation of the new country. In 1728, Benjamin Franklin’s printing shop was a partnership venture. By 1748, he had enough investment income to devote himself to invention, scientific discovery, and the arts. THE VALUE PROPOSITION Direct investments are generally income investments, providing a regular stream of dividend payments based on real estate rentals, mortgage payments, equipment leases, and oil or natural gas sales. In some cases, investors realize capital gains at the end of the investment term from the sale of their interest. Many direct investments also provide tax benefits, including tax deferral on a portion of the regular distributions paid to you, tax deferment for depreciation, depletion allowances, and other deductions. DPPs are not without their risks though, including the risk of rental property vacancy, mortgage defaults, lease defaults, equipment failure, dry oil wells, and dropping energy prices, among others. But many of the risks are nonsystematic, and relate to specific investments, so you can protect yourself by researching the management, quality of assets, performance history, and business plan of the venture. Much of this analysis is performed in the normal course of due diligence by independent research A SUITABLE CHOICE? Despite their potential advantages, DDPs aren’t right for all investors. There are net worth and income thresholds you must meet, which vary from state to state and by type of direct investment. And there are upfront fees that may be as high as 16% of the amount you invest. For these reasons and others, you should get professional advice before considering any direct investment. Your adviser can determine whether you meet the requirements and help you evaluate whether direct investments are appropriate for you. firms and by broker-dealers before they agree to sell any DPP. Your financial adviser will also want to evaluate the sponsor’s management team, business strategy, track record of program performance, and financial strength. UNDERSTANDING THE APPEAL Direct investments are a long-term commitment, usually lasting between 7 and 12 years, though terms vary. The programs are nontraded, which means there are no formal secondary markets—no NYSE or Nasdaq—where you can resell your investment interest. While informal secondary markets exist, particularly for the most successful programs, and some have buyback provisions, the penalty for selling can be stiff, and the number of transactions permitted per year is low. In fact, most advisers agree that you probably shouldn’t consider a direct investment if you go into it with the expectation of reselling. Yet the illiquidity of a direct investment can help insulate you against the volatility of the market because it’s not subject to daily fluctuations in price. As a result, a direct investment can have a stabilizing effect on your portfolio. Direct Participation Programs Energy exploration and development Equipment leasing Real estate investment trusts 11 10 D I R E C T I N V E S T M E N T S D I R E C T I N V E S T M E N T S D I R E C T I N V E S T M E N T S D I R E C T I N V E S T M E N T S VIRGINIA B. MORRIS ANd keNNeth M. MORRIS •Equipment Leasing $6. 95 U. S. Personal Finance •Portfolio Diversification •Limited Partnerships •Risk and Return •Direct Participation Programs •Energy Exploration and Development Lightbulb Press, Inc. 112 Madison Avenue New York, NY 10016 www. lightbulbpress. com info@lightbulbpress. com Phone: 212-485-8800 GuIde tO uNdeRStANdING dIRect INVeStMeNtS explores how nontraded REITs, equipment leasing companies, and energy partnerships may provide greater diversification and reduce the overall investment risk of a portfolio of publicly traded securities. The guide explains what direct investments are and how they work, the significance of owning income-producing hard assets, and how these sponsored programs may be appropriate for individual investors. •Nontraded REITs