Direct participation programs, or DPPs, are pooled investment vehicles that enable investors to benefit from an underlying venture’s cash flow or tax advantages. DPPs typically invest in real estate or energy-related fields such as oil and gas. They can also invest in other areas such as agricultural businesses, condominiums or business development companies that provide financing for small businesses.
They are nontraded, meaning they can’t be bought and sold on a public exchange. Instead, investment is made through private placements or direct solicitations.
DPPs can offer many benefits to investors but are not without drawbacks. Here is what financial advisors and investors should know before investing in a direct participation program.
What Are Direct Participation Programs?
DPPs work by pooling investors’ money to purchase an income-producing venture. There is usually a general partner to manage the investment and limited partners who invest their money in return for cash flow or tax benefits.
“You are committing a sum of money for a sponsor to execute on a business plan,” says David Koehler, a certified public accountant and financial planner based in San Jose, California. “The returns are generated by successful execution of the business plan and certainly are impacted by internal fees, industry-specific and national economic issues and business cycle timing.”
DPPs typically have a target maturity date — for example, five or 10 years — at which point the investment is dissolved. Before maturity, most DPPs are passively managed.
“They are basically limited partnerships that are set up for a fixed period of time in which the entity isn’t taxed at the corporate level, but all income, tax deductions and tax obligations flow through to the individual,” says Robert Johnson, professor of finance at the Heider College of Business at Creighton University.
To illustrate this concept, picture a real estate partnership that wants to purchase 12 distribution warehouses, says Faron Daugs, a certified financial planner and CEO and founder of Harrison Wallace Financial Group. The investors, or limited partners, get to participate in the cash flow from rents paid by the tenants and some of the business’s tax benefits such as depreciation, he says. But the investors’ “return is dependent on the general partner choosing good tenants and good locations.”
At the maturity date, the buildings may be sold, or the general partner may list the real estate investment trust, or REIT, as an initial public offering on one of the exchanges, Daugs says. “Both create a liquidity event and allow for investors to get some, all or more than their original investment back.”
Risks of Investing in DPPs
Direct participation programs are not without their drawbacks, and the most salient is illiquidity risk. Since DPPs aren’t traded on open exchanges, they have limited to no liquidity until the partnership is dissolved or taken public. As such, investors should be prepared to lock their money up for the entire duration of the DPP, which could be several years.
Trying to access the principal before liquidation may come at a steep cost, Daugs says.
“DPPs are a tool in the toolkit to consider for certain clients,” Daugs says. They can provide many benefits, such as asset class diversification, reduced correlation to the stock or bond market, regular cash flow, tax savings benefits and the opportunity for capital appreciation at maturity.
Not being listed on an exchange can also be a benefit to DPPs, Koehler says, as this means they won’t fluctuate with the daily whims of the market.
Rules to Know Before Investing in DPPs
Due to their illiquid nature, the U.S. Securities and Exchange Commission requires most investors to meet the accredited investor qualification. In other words, individual investors must have over $1 million in net worth (excluding a primary residence) or joint net worth with a spouse or spousal equivalent. Or they must have income of at least $200,000 ($300,000 in joint income) in each of the previous two years. They must reasonably expect to receive the same income in the current year.
Investors with certain professional certifications, designations or credentials from an accredited education institution, such as a Series 7, 65 or 82 license, may be exempt from the net worth or income requirement as of 2020.
Simply meeting the definition of an accredited investor isn’t necessarily enough to justify investing in a DPP.
“These investment vehicles are illiquid, overly complicated and, thus, are not appropriate for the vast majority of investors,” Johnson says. Additionally, he says, they complicate tax obligations for the investor.
Investors and advisors should tread carefully and do their due diligence before investing, Koehler says.
Make sure both you and your client read the investment risk section of the prospectus or offering documents before investing.
“There are always startup and ongoing internal costs to the programs that you should understand and confirm before investing,” he says. “Make sure the investment is backed by a solid business plan with qualified program sponsors that have solid track records, financial and organizational stability.”
How to Advise Clients on DPPs
Each direct participation program and client situation is unique and should be evaluated individually. “These are not one-size-fits-all types of plans,” Daugs says. Ensure the investor understands the type of asset he or she is investing in. The cash flow may vary due to market conditions, and the tax benefits may or may not come to fruition.
Advisors should also help their clients assess the opportunity costs of investing in a DPP, especially since they are long-term investments, Daugs says. What other investment options could the client use instead?
Most investors would be better served investing in a low-cost diversified index fund, Johnson says.
In general, experts say, no investor should put more than 10% of their portfolio into a DPP.
Some states have requirements on the maximum percentage of an investor’s net worth that should be invested in a DPP or other nontraded investment, so check the individual state requirement before investing.
“Direct participation programs can be a great fit for a client’s situation,” Daugs says. “They are an alternative to the typical stock and bond portfolio (and) can provide cash flow and exposure to unique investment opportunities for a client.”
But the key is to make sure both you and your client understand the ins and outs of a DPP before investing. With that information, you can determine how and why it is a good fit for your client’s portfolio.
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How to Advise a Client on Direct Participation Programs originally appeared on usnews.com