Updated July 12, 2023
What is an Investment Partnership?
The term “investment partnership” refers to the type of business ownership where more than 90% of the business assets are held in the form of investments in financial instruments, such as equity stocks, bonds, futures & options, etc. Further, more than 90% of the income is generated from these financial assets.
How Does Investment Partnership Work?
In an investment partnership, a fund manager becomes a partner in the business by investing cash and only then earns the authority to exercise influence on the decision-making of the business. Therefore, the fund manager’s capital contribution to the business should be higher than that of the other general limited partners, who are mere investors and have no say in the investment decisions. The fund manager becomes eligible for additional profit distribution over and above the interest holding (owing to invested capital) if the profits derived from the business exceed a certain level of returns, which is also known as the hurdle rate.
Examples of Investment Partnership
Investment partnership businesses usually invest in alternative investment funds. Some of the most common examples of such investments are mentioned below:
1. Hedge Fund
Typically, institutional investors, high-net-worth individuals, and other accredited investors invest in this type of financial instrument. This investment vehicle is usually used to hedge risk by simultaneously buying and shorting assets in a long-short equity strategy, hence the “hedge fund.”
2. Private Equity
It is a type of alternative investment class that comprises capital that is invested in unlisted companies. Generally, this type of fund either directly invests in private companies or buyout public companies leading to their delisting from the stock exchange. It is considered to be a high-risk, high-return investment.
3. Venture Capital
This type of funding is usually extended to startup companies or small businesses that promise long-term growth potential. Typically, high net worth individuals, investment banks, and other financial institutions put their money into this type of fund to earn high returns over a relatively small period of time.
4. Mutual Fund
In this type of financial instrument, the fund manager pools money from a large number of investors and then invests the raised capital in different types of financial securities, such as equity stocks, bonds, short-term debt funds, etc. The collective holdings of a mutual fund are popularly called its portfolio.
How is an Investment Partnership Taxed?
An investment partnership enjoys favorable tax treatment, as reflected from the instances mentioned below.
In North Carolina, a firm operating as an investment partnership is not considered to be doing business. Hence, such a firm is not mandated to file an income tax return, nor is it liable to pay any income tax on behalf of its non-resident partners.
In Illinois, an investment partnership is not required to pay replacement tax for tax years ending on or after December 31, 2004. Also, its non-resident partner needs to pay tax on the income passed through the investment partnership, only if the partner’s contribution to the business is made in connection with a business conducted only partially within Illinois.
Advantages of Investment Partnership
Some of the major advantages of investment partnership are as follows:
- An investment partnership falls in the category of alternative investment funds, which means the investments go into risky securities that offer higher return potential.
- The regulations are limited for these investment funds. Hence, the fund managers enjoy a greater degree of discretion regarding managing the investments to generate higher returns.
- These investment funds, in many cases, put their money into companies that are just in their initial phase of business. These financing options help these start-ups secure their growth funding.
- One of the best things about investment partnerships is that the general partners or investors outsource the fund management to professionally trained fund managers.
- The profit distribution generated from the business enjoys favorable tax treatment.
Disadvantages of Investment Partnership
Some of the major disadvantages of investment partnership are as follows:
- First, in most cases, the general partners don’t possess much knowledge about the business, especially financial statements. Likewise, the investors have a very limited idea about how the fund managers are managed.
- Given these are high-risk, high-return investments, a wrong move with regard to an investment strategy can prove lethal and may wipe out the entire wealth accumulated over the years.
- Small retail investors seldom get an opportunity to invest in an investment partnership business as the fund managers usually seek funding from wealthy and accredited investors only.
Key Takeaways
Some of the key takeaways of the article are:
- In investment partnerships, more than 90% of the business assets are held in the form of investments in financial instruments. As a result, more than 90% of its income comes from these financial assets.
- The fund manager invests cash in the business to become one of the partners, after which he/ she can exercise influence on the decision-making. Typically, the fund manager’s contribution is higher than that of the other general limited partners.
- Investment partnership is classified as alternative investment funds. These funds invest in risky securities that offer higher return potential. Hence, even a slight mistake can wipe out the entire wealth accumulated over the years.
- Usually, fund managers prefer wealthy and accredited investors over small retail investors.
Conclusion
Apart from providing the required growth funding to start-ups, investment partnerships help investors earn amazing returns on their investments. In this way, this business model facilitates better efficiency in the financial market. However, the general partners or investors remain exposed to significant risk due to the investments’ nature and lack of transparency.
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