For decades, inflation and interest rates in the United States and globally have been in retreat, hitting fresh nadirs in the wake of the global financial crisis of 2008 and subsequent easing by major central banks.

The long-term falling interest and inflation rates rewarded stock and bond buyers, who found debt and equity issues worth more as rates fell in a very broad long-run bull market. “A rising tide lifts all boats,” as they say.

But an inflection point has been reached, with fundamental consequences. In particular, in May of this year, yields on benchmark 10-year U.S. Treasuries rose above 3 percent for the first time since 2010. And, unlike in 2010, presently the U.S. economy is defined by historically low unemployment, and near zeniths in property and equity values.

Meanwhile, the U.S. Federal Reserve System issues regular edicts on its resolve to guide the economy to higher interest rates. Inflation, long subdued, may inch higher in 2018 and 2019, as oil prices bite and labor markets tighten further.

STOCK AND BOND MARKETS

For investors, the 2018 outlook is not bad — “bad” was 2008. Nevertheless, fresh perspectives might be needed, and some suggest recent rising volatility presages a stock-market correction.

Beyond dispute, if interest rates rise, then bond values are mechanically decreased, while the relative desirability of equities is also reduced. The steeper bill for credit will color property markets, too.

The outlook for traditional investments should encourage some investors to seek idiosyncratic or alternative investments, or other vehicles that provide diversity against the typical portfolio of stock, bonds and the family home.

Direct participation programs (DPPs) — also known as direct participation plans, direct investment programs or direct investment plans — may offer an option.

DPPs

The Washington, D.C.–based Institute for Portfolio Alternatives (IPA) posits DPPs are a worthy addition to investor portfolios, and now are becoming more readily available.

“The IPA is devoted to ensuring that all investors have access to real assets and the opportunity to effectively balance their investment portfolios,” says Tony Chereso, president and CEO of the IPA. “While [direct asset investing] is a well-recognized diversification strategy for institutional portfolios, individual investors typically have limited access to alternative investment products.”

By marching to a different drummer, DPPs may zig when general securities markets zag and, therefore, sometimes become ballast during traditional investment storms.

DEFINING A DPP

The short story on DPPs is this: Individual investors pool resources to become limited partners in private, generally nontraded or unlisted business ventures, often to acquire real estate. The unlisted REIT, for example, is a common DPP.

Investors in DPPs are still considered “passive” in terms of liability, so, as with traditional bond and stock buyers, generally the investor’s financial downside and legal downside are limited to the amount invested. This can be important.

An individual direct owner of a specific apartment building, for example, can face civil or even criminal charges. But investors in real estate limited partnerships or limited liability corporations are considered passive, and legal exposure is limited to the general partner and the partnership/corporation.

To sum up, the downsides in a DPP are generally limited to the amount invested and opportunity costs, though there have been exceptions.

In the 2008 property bust, some DDP real estate investors were unnerved when REITs or partnerships called for additional infusions of investor capital. In the recessionary property markets of that time, rents or occupancies had fallen enough in some property DPPs that they could not meet operating expenses and mortgage payments. The banks would end up with the DPP asset unless investors coughed up more money.

On the other side of the coin, the DPP upside is determined by performance of the investment vehicle, after management and marketing costs.

SPONSORS

Of course, as a practical matter, individual investors rarely spontaneously organize to invest, but rather are brought together by a sponsor or promoter, who often becomes the general partner as well, in any particular DPP. Sponsors collect fees to successfully organize and market a DPP and, if also serving as general partner, collect management fees. Generally, investors can expect about 15 percent of invested capital to be consumed by fees, often up front.

Liquidity can also be a concern. Unlike stock and bonds, which might be traded and held for hours, days, weeks or the long-term, most DPPs shoot for a five- to 10-year lifespan, and they are usually illiquid for the duration.

TAXES

A direct participation program usually is a legal entity defined as a limited partnership, a general partnership, or a subchapter S corporation or similar. Under these formats, DPP income, losses, gains, tax credits and deductions (including real estate depreciation) are transferred through to the limited partner (the investor) on a pre-tax basis. The DPP pays no corporate tax; rather, the ordinary income to the investor is taxed.

Recent Trump administration tax changes are generally beneficial to DPP investors, says Dan Cullen, partner in the Chicago office of Baker McKenzie. The new tax laws provide a 20 percent reduction in federal tax against REIT ordinary income, he says. Also, although some businesses may lose the ability to deduct mortgage interest under the new tax laws, property concerns — such as unlisted REITs — still can, explains Cullen.

TYPICAL DPP SECTORS

DPPs have long been associated with real estate. Indeed, by some measures about two-thirds of DPPs are nontraded REITs. DPPs are also nonlisted business development companies (BDC), typically issuing debt and sometimes mezzanine debt to medium-size businesses. There is a thriving DPP oil-and-gas sector, and filling out the bill are equipment-leasing corporations.

SIZE OF DPP INDUSTRY

Though often below the financial-media radar, DPPs have become a giant industry, by some definitions. The real estate sector alone accounts for $97 billion of DPPs, reports the IPA, and business development companies equate to another $20 billion. Moreover, the IPA says the industry is evolving and will continue to grow.

“Today’s [portfolio diversifying investment] products offer more flexible structures, enhanced transparency and lower fees, while large institutions are expanding distribution in the wire-house channel,” says Chereso. “New technology is transforming how our businesses operate, offering a more seamless experience for investors.”

KNOW THY SPONSOR

Even industry proponents repeatedly admonish investors to ascertain the track record of DPP sponsors, general partners and relevant vendors.

“It’s critical to evaluate the capabilities and experience of a particular issuer or sponsor, and their ability to manage a particular investment strategy,” advises Chereso. “The quality, experience and integrity of an investment manager is often a good indicator of an investment’s return, regardless of the product structure.”

But therein lies the rub for many DPP vehicles. Evaluating the track record of a sponsor is difficult, perhaps impossible, as DPPs generally are nonlisted. Advertised DPP-sponsor track records may employ dubious methodologies. Moreover, the “Yelp” culture of online reviews has not yet pervaded the DPP world.

This often leads investors to rely on anecdotal information, or to trust DPP sponsors — not based on their actual track records, but on longevity in the business, or persona.

Careful investors should look a bit deeper, which is a bit of work, but one need not be a forensic accountant. One investor strategy, which also applies for registered investment advisers, is to check who the sponsor “is in bed with.”

“A legitimate sponsor will be able to identify legal counsel, financial or tax advisers, and lenders it has worked with to serve as references,” advises the Chicago-based Syndicated Equities. “Further, the offering documents should include opinions from a reputable, independent law or accounting firm.”

Finally, investors may wish to ascertain if the sponsors have substantial skin in the game. That is, have the sponsor and its limited partners invested their own capital in the DPP? Or is the sponsor limited to collecting fees as a general partner?

The answers to those questions can mean the difference between a successful investment and a financial misadventure.

Benjamin Cole (7continents7@gmail.com) is a freelance writer based in Thailand.