10.1.

19: Liquidity
Investors in an investment partnership understand, when they subscribe, that their interests are illiquid.
However, as circumstances change, investors may want to get out before the partnership liquidates.
[1]
The
question is whether and how they can do so.
[2]

If a limited partner can find a private buyer, then the unit can be sold, absent some curious and unusual
contractual restriction that limits alienability absolutely, or a legal restriction based on the possibility that
the transfer would subject the remaining partners to a loss of benefits or status.
[3]
To be sure, in order to
qualify technically as a partnership, the investment units are supposed to lack the element of free
transferability, the theory being that free transferability is a corporate, not a partnership, attribute.
[4]
To
satisfy this requirement, partnership agreements routinely provide that the GPGP must,
[5]
as a technical
matter, approve the admission of any transferee as a substituted limited partner.
[6]
This convention is,
however, artificial because a transfer by assignment of the economic substance involved is not restrained,
except in specific circumstances. Without threatening the fiction that the interests are not freely
transferable, limited partner A can transfer all the economic value he owns to Assignee B at will. The
technical constraint-that, absent the permission of the GPGP, Assignee B cannot become a limited partner
and, therefore, cannot vote on matters appropriate for limited partner action-is largely trivial since limited
partners are ordinarily indifferent to the existence of that right in the first instance.
[7]
In short, partnership
shares are freely transferable unless subject to a specific limitation in the agreement. Indeed, master
limited partnership interests (a scheme by which certificates of participation are sold in a single interest
held by a sole limited partner) were traded on the New York Stock Exchange until the Code was amended
to tax publicly traded partnerships as corporations.
However, it may be that a limited partner cannot find an assignee and wants the partnership to cash him
out. The problem is that the very nature of a PIV makes it awkward to allow partners to withdraw prior to
liquidation. The valuation problems have been alluded to; moreover, the partners as a group have invested
on the assumption that a critical mass of assets would exist. Although partnership funds may be held in
liquid form, once the cash and liquid securities shrink to around the 50 percent mark, the partnership is
viewed as fully invested because of the necessity of allocating funds for follow-on investments in existing
portfolio companies. Accordingly, it is the rare instrument that allows limited partners the unilateral right
to withdraw their stake.
Nonetheless, involuntary withdrawal issues cannot be avoided in some instances: for example, an
individual partner dies or a general partner elects to quit.
[8]
It could prove to be a severe hardship to insist
that a partners estate sit on an illiquid, hard-to-value investment for several years. Hence, there are
circumstances in which the managers will wish to consent, albeit on an ad hoc basis, to withdrawals.
Complications arise, however, in the course of an interim liquidation of a partners interest because the
book value of the partners capital account does not, except by virtue of the rarest of coincidences,
effectively reflect fair value. The securities in any active portfolio almost certainly entail unrealized
appreciation or depreciation. A public mutual fund marks to market every day; shares are traded on the
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basis of current net asset values, and transactions in mutual fund shares do not entail individual capital
adjustments. In the case of an interim withdrawal by a partner, however, not only must the valuation
hurdle be resolved but distributions in excess of the partners capital account (by reason of his interest in
unrealized appreciation) must also be made. The method commonly employed to accomplish this result is
to hypothesize a sale at fair value of all the partnerships assets as of the effective date of the withdrawal,
to allocate the resulting profits (or losses) to the capital accounts of all the partners pro rata and to
distribute the withdrawing partners capital account, as adjusted, to him or his estate. Distributions in
redemption may, of course, be made in kind and no tax is due at the partnership level (because the
partnership is not a taxpaying entity)
[9]
on the distribution of appreciated securities or other property.

Finally, there is the problem of payment; the partnership may not be liquid enough to pay out a sizable
sum and it may be awkward to break up the partnerships stockholdings. The better drafted agreements,
accordingly, provide for staged payments over time. In the case of a general partner who dies or who
simply wants to quit, no payment may be necessary-the parties may agree that the general partner
interest is converted to that of a special limited partner and the business carried on to liquidation without
any payout of partnership assets. However, each general partners interest in profits is in reality awarded-
albeit not for tax purposes, as compensation for past and future services. Thus, the withdrawing general
partners share of the carried profit interest may have to be recaptured to compensate a new general
partner.
Admission of a new partner, general or limited, poses problems that are mirror images of the foregoing. If
a new partner is admitted somewhere down the road, the assets will have appreciated (or in some cases,
depreciated). The question arises whether it is fair, or tax efficient to allow the newly admitted partner to
share in profits from appreciation antedating his arrival. One preferred provision, from an economic and
tax standpoint, is to adjust all capital accounts as if there were a withdrawal, assigning the appreciated
profits or losses
[10]
to the existing partners, and starting the newly admitted partner on a level playing
field, entitled to share only in profits and losses as they occur from and after the date of admission.
[11]
It
is easier to describe in principle the theories that underlie partnership provisions governing withdrawals
and admissions than to draft the actual language. The task of setting out in precise detail what happens to
profits interests and capital accounts is formidable, particularly when it is necessary to run two sets of
partnership books. The virtue of the partnership formits enormous flexibilitycreates such a wide range
of possibilities that drafting becomes enormously complicated. Just as the draftsman thinks hes covered
all contingencies another interesting hypothetical comes to his attention.
[1]
One way for a partner to get out, rarely exercised, is to round up enough votes to dissolve the
partnership. (See discussion).
[2]
The admission of new limited partners at the beginning of the partnership can be controversial if the
sponsors pursue a multiple closing strategy. The first-in limiteds may object if subsequent investors take
a ride on their money and ordinarily want to close the offering down on a fixed and early date. One
method of dealing with this issue is to provide that latecomers are responsible for a pro rata share of the
management fee as if they had been admitted as of the earliest possible date. Some PIVs, e.g., Hellman,
Friedman, make latecomers sit out deals closed before they sign up.
[3]
If the partners wish to restrict assignments (versus a technical restraint on admission of the assignee to
the partnership), a first refusal option would be the normal device. Note that such a provision does not
restrict transferability for purposes of I.R.C. 7701. See Treas. Reg. 301.7701-2(e)(2). An absolute
Page 2 of 4 10.1.19: Liquidity - Encyclopedia - Library - VC Experts
restriction on alienation would be of dubious legality in some states. R.U.L.P.A. 702, suggests that the
agreement may restrict assignments, but the Comment says there was no intention to affect in any way
usual rules regarding restraints on alienation of personal property. Presumably, the partnership
agreement may restrict assignments if a legal rule would be broken by reason of the transfer. In that
category are the ban on unregistered public offerings in the 33 Act; the loss of an exemption (fewer than
100 beneficial holders) from the Investment Company Act of 1940; the threat the partnership might be
treated as a publicly traded partnership and thus taxed as an association or the provision in 708 of the
I.R.C. providing that a partnership terminates for tax purposes if 50% or more of the capital or profits
interest are sold in any 12-month period. Indeed, the threat of a premature termination for tax purposes
may be significant even though, as is often the case, the termination is viewed as technical and the
partnership reconstituted by the remaining partners. Under 737 of the Code, the procedure may be
deemed to have triggered a contribution of appreciated assets to the (technically) new partnership by
the partners, thereby creating net precontribution gain, in turn creating a taxable event if the partnership
is liquidated within 5 years and assets distributed in ratios which do not precisely mimic the ratios
obtaining when the partnership was reconstituted. See New Tax Provision Could Threaten VCs, Venture
Cap. J. 5 (Dec. 1992).
[4]
I.R.C. 7701. See 24.5 for the -4 attribute test.

[5]
Under the R.U.L.P.A. 704(a), the assignor may give the assignee the right of admission in
accordance with authority in the certificate; that authority is routinely conditioned in the certificate on
GPGP approval.
[6]
The substitution of one partner for another as of a date other than the close of the fiscal year (which is
almost always the calendar year) occasions tax issues as to the ownership of losses and profits incurred up
to the date of substitution. Technically, a partnership does not realize a profit or loss until the end of the
accounting period. However, the admission of partners on the 364th day of a tax-shelter partnerships
year, such partner purporting to buy an entire year of losses, was offensive to the tax collectors
sensibilities. Therefore 706(d)(3) of the Code provides for pro-ration.
[7]
It appears clear that an assignee, not admitted as a limited partner, is nonetheless a partner for tax
purposes. There are some dissenters from that position, see Halloran at 81, but the issuance of millions of
dollars in master limited partner units has gone forward without challenge (as yet) to counsels opinion
that holders of the economic interest, though not formally admitted as partners, are partners for tax
purposes. However, in light of the fact that such units actively trade, counsel to the MLPs are unwilling to
advise that the partnership lacks the corporate characteristic of free transferability even though the
master partnership interest never moves. New 7704 of the I.R.C. treats publicly traded partnerships as
corporations for tax purposes unless invested principally in real estate or oil and gas. Existing MLPs are not
affected until 1997.
[8]
The agreement will routinely provide that no general partner may withdraw unless the limited partners
consent since, among other things, the withdrawal of the last general partner terminates the partnership.
In fact, if the individual who is the driving force behind the partnership should die or retire, the agreement
may give the limited partners a right to liquidate the partnership, even though technically nothing has
happened because the key individual was a partner in an entity-the GPGP-which continues as the general
partner of the investor partnership. If the last remaining general partner nonetheless disappears despite a
ban on withdrawal-i.e., he dies-the agreement usually provides that a majority of the remaining limited
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partners can elect to continue as long as a new general partner can be found in a timely fashion with
adequate net worth to continue pass through tax status-i.e., to satisfy the unlimited liability criterion of
7701. See 14.5. In such event, the agreement can compel the minority limited partners to remain as
partners but not beyond, of course, the remaining stated term of the partnership; although the
Regulations provide apodictically that a limited partnership under the U.L.P.A. lacks continuity of life,
Treas. Reg. 301.77012(b)(3), query the result if a majority of partners have the fight to continue the
business indefinitely.
[9]
Under the 1984 amendments to the IRC, distributions in kind by a corporation became a taxable event
at the corporate level; the tax measured by the fair value of the property less the corporations adjusted
basis. I.R.C. 311 (d)(1), now I.R.C. 311 (b)(1). A tax may also be assessed on the recipient
shareholders. A partner may realize gain upon any distribution by the partnership but only to the extent
any money distributed exceeds the adjusted basis, of its interest. I.R.C. 731(a)(1).
[10]
One way to accomplish the procedure is to run a system of phantom capital accounts to which
unrealized appreciation and depreciation are posted as of each appraisal period- See Halloran at 91-96.
[11]
A partnership technically terminates under 708(b)(1)(B) of the Code if, within a 12-month period,
there is a sale of 50 percent or more of the total interest in partnership capital and profits. The effect of
such a technical termination is to treat the partnership as having distributed all its assets to the partners,
who contribute them to a new partnership. Gain is recognized to the extent that money distributed to a
partner exceeds the partners adjusted basis. I.R.C. 73 l(a)(1). The termination may also result in an
adjustment in the basis of the partnerships assets and other random consequences can result from, e.g.,
the partnerships taxable year closing. See Nad, Dispositions of Partnership Interests and Partnership
Property, 43 N.Y.U. Ann. Inst on Fed. Taxn 29[12] (1985). The most troublesome consequence concerns
the possibility of gain on liquidation triggered by the enactment in 1992 of 737 of the Code.
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