Reading 11 Concentrated Single-Asset Positions

by Thomas J. Boczar, Esq., LL.M., CFA, and Nischal R. Pai, CFA

Thomas J. Boczar, Esq., LL.M., CFA, is at Intelligent Edge Advisors (USA). Nischal R. Pai, CFA (USA).

© 2013 CFA Institute. All rights reserved.

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LEARNING OUTCOMES

The candidate should be able to:

1. explain investment risks associated with a concentrated position in a single asset and discuss the appropriateness of reducing such risks;
2. describe typical objectives in managing concentrated positions;
3. discuss tax consequences and illiquidity as considerations affecting the management of concentrated positions in publicly traded common shares, privately held businesses, and real estate;
4. discuss capital market and institutional constraints on an investor’s ability to reduce a concentrated position;
5. discuss psychological considerations that may make an investor reluctant to reduce his or her exposure to a concentrated position;
6. describe advisers’ use of goal-based planning in managing concentrated positions;
7. explain uses of asset location and wealth transfers in managing concentrated positions;
8. describe strategies for managing concentrated positions in publicly traded common shares;
9. discuss tax considerations in the choice of hedging strategy;
10. describe strategies for managing concentrated positions in privately held businesses;
11. describe strategies for managing concentrated positions in real estate;
12. evaluate and recommend techniques for tax efficiently managing the risks of concentrated positions in publicly traded common stock, privately held businesses, and real estate.

1. INTRODUCTION

Frequently, the wealth of individuals and families is concentrated in an asset or group of assets that has played a role in their (or their forebears’) accumulation of wealth. Wealth managers must be able to assist private clients with decisions concerning such positions. The three major types of “concentrated position in a single asset” (or “concentrated position”) examined in this reading are (1) publicly traded stock, (2) a privately owned business, and (3) commercial or investment real estate.

Exhibit 1 shows that ownership interests in privately owned business enterprises constitute much of the wealth of private clients in many countries.

Exhibit 1. Percentage of Global Private Clients Who Derive Their Wealth from a Private Business, by Region

Source: VIP Forum, Strictly Business: Strategies for Acquiring and Serving High-Net-Worth Business Owners (Arlington, VA: Corporate Executive Board, 2005).

Concentrated positions sometimes make up a large share of a client’s net worth. As the owner of a concentrated position ages, the asset may need to be sold or monetized to fund retirement needs, or for risk management purposes. (In general terms, to monetize something is to access its cash value without transferring ownership of it, as would be the case in a sale.)

Private clients often want to compare the potential results of continuing to hold these often illiquid assets with selling or monetizing them and reinvesting the proceeds in other asset classes. Wealth managers who understand their clients’ finances and personal long-term objectives are ideally suited to play a key role in assisting them to chart an efficient path in handling their concentrated positions.

Creating a globally relevant reading in this field for generalists presents many challenges. Decisions concerning the treatment of concentrated single-asset positions must always be made in the context of a specific single market and tax code. The available means for attempting to achieve a given objective vary across markets, as do tax codes. We show problems that arise worldwide, but the contexts and questions addressed are often simplified. Frequently, US considerations are mentioned, but other markets are not ignored. This reading provides a familiarity with various recurring themes. Expertise in the field is needed to address real-life problems of concentrated positions. This reading is organized as follows. Section 2 provides an overview of concentrated positions, including how investors typically acquire these assets and the risks inherent in owning them. Section 3 discusses the general principles associated with managing the risk of a concentrated position. Sections 4, 5, and 6 focus on the range of strategies that are available to the owners of concentrated positions in a single stock, private business equity, and real estate, respectively, and Section 7 summarizes the key points of the reading.

2. CONCENTRATED SINGLE-ASSET POSITIONS: OVERVIEW

There is no universally accepted definition of what is meant by a concentrated position. Practically speaking, a concentrated position is one that makes up a significant portion of a private client’s net worth. In practice, many wealth managers and fiduciaries consider 25% of a client’s net worth to be a relevant threshold, although many use a higher or lower threshold.

Concentration within asset classes poses problems that need to be managed. For instance, a holding of a highly illiquid stock might constitute only a modest portion of a private client’s net worth but might be a large percentage of his or her equity exposure. The equity component of the portfolio would then be undiversified and thus entail certain inherent risks. This type of concentration presents risks that also need to be managed.

A concentrated position is often a position that has been held by the private client for a long period, sometimes for decades, and that has greatly appreciated in value over its original cost (cost basis). It will often present tax, liquidity, or other considerations that make a simple sale problematic.

The three asset classes in which concentration risk most commonly arises are

• publicly traded single-stock positions,
• privately held businesses (including family-owned businesses), and
• investment real estate.

Publicly traded single-stock positions.

There are a number of ways an investor can end up owning a concentrated stock position. The investor might have worked at a publicly traded company as an executive, perhaps for many years, and received company stock, options, or some other financial instrument that is convertible into company stock as part of his or her executive compensation.

It is also not unusual for the seller of a privately owned business to receive stock in lieu of cash if the acquirer is a publicly traded company. Under many tax regimes, including Japan, the United Kingdom, and the United States, it is possible to structure a purchase using stock without triggering an immediate taxable event. In these situations, the owner goes from holding a highly appreciated position in a privately held stock to a highly appreciated position in a publicly traded stock.

A concentrated position in a publicly traded stock can also come about because of a successful long-term buy-and-hold investing strategy or as a result of a private company that elects to go public through an initial public offering.

Privately owned businesses.

Some successful privately owned businesses have been in existence for many years, with ownership passed down from one generation to the next. In other cases, an entrepreneur may have built a successful business in a much shorter period of time, a situation that is not uncommon in such industries as technology and social media.

Investment real estate.

Commercial or industrial real estate often constitutes a significant portion of the value of a private business enterprise. It is also often held as a standalone investment by private clients, as in the case of real estate developers. Typically, real estate is held for a long-term period. It is not uncommon when selling or monetizing a business that the buyer does not wish to purchase the real estate component of the business (because, for example, the buyer may already have sufficient space to accommodate the purchased operations). In that case, the seller is left with a large real estate holding.

Concentrated positions in investment real estate could also be derived from inheritance, from a lack of other investment opportunities in certain jurisdictions (e.g., China in the 1990s and 2000s, when financial markets were still in their infancy), or from rapid price appreciation leading to a bubble (e.g., Japan — especially Tokyo — in the 1980s).

Of course, the holder of each of these types of assets might have received his or her ownership stake in the asset through either gifting or inheritance, which is quite common. Ownership of concentrated positions is not a challenge reserved exclusively for private clients. Entities such as trusts, estates, and foundations often hold concentrated positions as the result of a gift or bequest. Pension funds are sometimes exposed to a heavy allocation of the fund sponsor’s company stock. Also, publicly traded companies sometimes hold a significant amount of shares of another publicly traded company for business or investment purposes.

2.1. Investment Risks of Concentrated Positions

The owners of concentrated positions face systematic risk and non-systematic risk, which can be company- or property-specific risk. Exposures to any of these risks may not be consistent with the individual’s willingness and capacity to bear risk or may be suboptimal with respect to asset allocation.

This section focuses on describing these risks. However, return consequences of concentrated positions can also be important. Some concentrated positions may not be expected to earn fair risk-adjusted returns, for example. There may be large opportunity costs in holding under-performing company stock or non-income-producing land.

2.1.1. Systematic Risk

Systematic risk is the component of risk that cannot be eliminated by holding a well-diversified portfolio. The capital asset pricing model as practically implemented equates systematic risk to equity market risk. More recently developed asset pricing models identify multiple sources of systematic risk; for example, one model based on macroeconomic factors identifies business cycle risk (unexpected changes in the level of real business activity), inflation risk (unexpected changes in the inflation rate), and three other factors, including that part of equity market risk that is unexplained by macroeconomic factors. If the concentrated position has systematic risk exposures that are similar to those of the human capital of the owner of the concentrated position, the individual may be exposed to investment portfolio losses at the same time that job earnings are jeopardized. An example is the founder of a securities firm with a concentrated position in the firm’s shares. In a bear market, the firm’s earnings and the founder’s compensation may be low at the same time that share returns are negative.

2.1.2. Company-Specific Risk

With respect to the ownership of a privately held business and publicly traded stock, we call specific risk company-specific risk. Company-specific risk is the non-systematic or idiosyncratic risk that is specific to a particular company’s operations, reputation, and business environment. To describe it in another way, it is the possibility that the value of the company may decline because of an event that affects that company but not the industry or market as a whole. Having a concentrated position can expose an individual to an unacceptably high level of company-specific risk. A negative corporate event may result in essentially permanent and irrecoverable losses in wealth. All else equal, the level of company-specific risk is positively related to volatility of returns; company-specific risk can range from relatively low to high for small undiversified or unprofitable companies.

The concept and importance of company-specific risk with respect to a publicly traded company can perhaps best be highlighted through a real life example. During the 1990s, Enron Corporation was one of the most admired companies in the United States. A position in Enron shares returned over 27% per year from 1990 through September 2000, compared with 13% for the S&P 500 Index for the same time period. During this period, thousands of Enron employees participated in the company’s defined contribution retirement plan and chose to invest in Enron stock. In January 2001, the retirement accounts were valued at US$2 billion, of which 62%, or US$1.24 billion, was invested in Enron shares even though the employees had the option to sell most of those shares tax free within the plan. Between January 2001 and January 2002, Enron’s share price fell from about US$90 per share to zero. On the other hand, the S&P 500 Index declined by only 12% in the same time period.

The higher volatility associated with company-specific risk of single-stock holdings significantly lessens the benefit of higher expected capital accumulation over time. For example, Exhibit 2 compares investing a dollar in a single security having a zero cost basis and 40% volatility with the alternative of selling it, paying a 20% capital gains tax, and reinvesting the net proceeds of 80 cents in a diversified portfolio with a volatility of only 17%. Either alternative has an annual expected pretax return of 10%. Exhibit 2 illustrates the comparison at the end of a 20-year horizon.

Exhibit 2. Holding a Security vs. Outright Sale of a Security: Probability Distribution of After-Tax Liquidation Value

Note: Annual expected return = 10%; dividends on stock = 0; dividends on diversified portfolio = 1.2%; horizon = 20 years; terminal liquidation.

Source: David M. Stein, “Taxes and Quantitative Portfolio Management,” in Developments in Quantitative Investment Models (Charlottesville, VA: Association for Investment Management and Research, 2001).

Although the expected value (i.e., arithmetic average) is higher for the single stock, the median outcome is much higher for the diversified portfolio. Moreover, the diversified portfolio has a much smaller chance of suffering large losses. The diversified portfolio strategy has only a 2% chance of losing money, versus a 39% chance for the single stock. As this example illustrates, a “tax minimization” strategy may not be optimal.

2.1.3. Property-Specific Risk

Property-specific risk is the non-systematic risk that is specific to owning a particular piece of real estate. It is the possibility that the value of that property might fall because of an event that could affect that property but not the broader real estate market.

For instance, a potential environmental liability associated with a particular property might be discovered that significantly reduces the value of that property even though the broader real estate market and similar properties are increasing in value.

As another example, an investor might own a large office building that is leased out to a few investment-grade tenants for a long-term period. If the tenants decide not to renew their leases for an additional term when their lease terms expire, the owner may have a difficult time leasing the entire property to a few large investment-grade tenants. Instead, the owner may have to lease the property to a number of smaller tenants, which could take more time, and therefore, a good portion of the property might sit vacant for some time. Also, the new and smaller tenants might not be investment grade, thus increasing the credit risk that the owner must incur in order to fully lease out the building. These types of changes with respect to the tenants/occupancy could negatively affect the resale value of that property even though the broader real estate market and similar office properties are increasing in value.

3. GENERAL PRINCIPLES OF MANAGING CONCENTRATED SINGLE-ASSET POSITIONS

The following sections review certain basic principles that are germane to managing concentrated positions.

3.1. Objectives in Dealing with Concentrated Positions

The financial adviser should first and foremost help clients identify and define their objectives.

3.1.1. Typical Objectives

Irrespective of the form of the concentrated position — whether it is a privately owned business, investment real estate, or a concentrated position in publicly traded stock — there are three objectives that are frequently considered in discussions with the client.

Risk is reviewed and the appropriateness of risk reduction considered. Any adverse results from risk reduction (e.g., loss of control of a business) should be weighed against the benefits. With such qualifications, a frequent (if not universal) objective is to reduce the risk of wealth concentration. Psychological considerations are often at work to cause owners to seriously underestimate the riskiness of their concentrated position and significantly overestimate the value of that asset.

Cash flow needs should be identified. An appropriate strategy for monetization and/or risk reduction should be developed. Often, an objective is to generate liquidity in order to diversify and satisfy spending needs. Illiquid private business equity, investment real estate, and concentrated stock positions need to be transformed into cash. A replacement source of income then needs to be created to satisfy essential lifetime spending needs. Fulfilling legacy and charitable intentions are also drivers of liquidity needs along with other aspirational desires.

Another typical objective is to optimize tax efficiency, which can be accomplished by either structuring transactions involving concentrated positions so as not to trigger an immediate taxable event, or if a taxable event will be triggered, structuring the transaction in a manner that minimizes the tax the owner will incur.

3.1.2. Client Objectives and Concerns

There are many objectives that the owner of the concentrated position might wish to achieve. For instance, the concentrated position could be used in conjunction with gifting strategies to satisfy the owner’s wealth transfer desires, such as leaving a legacy for the next generation or to satisfy his or her charitable intentions. The previous section indicated that risk reduction and diversification are common objectives. It is important to note that in order to achieve such objectives, it is not always appropriate for the owner to reduce or eliminate the concentration risk of a concentrated position.

With respect to concentrated stock positions, examples of objectives consistent with risk retention include the following:

• An executive might have received shares as part of his or her incentive compensation with the expectation or mandate that those shares be held for a long time period to motivate the executive to work hard as part of a team to grow the company and hopefully result in a much higher stock price in the future.
• The owner of a concentrated position might wish to maintain effective voting control of the company.
• The owner of a concentrated position might wish to enhance the current income of his or her stock position in the short term but in the long term still retain significant upside potential with respect to the stock.

With respect to privately owned businesses, the following are examples of client objectives:

• An entrepreneur might have recently founded a business, and it would be premature to sell that company because its growth phase has just begun.
• The owner of a mature and stable privately owned business might wish to maintain total control of the company.
• In return for years of prior service, the owner might wish to give senior management and other key employees the opportunity to eventually acquire control of the business.
• The business owner might have plans to pass control of the business to the next generation of his family.

With respect to investment real estate, examples of client objectives include the following:

• Maintain control because the property is an essential asset necessary for the successful operation of a business enterprise.
• Retain ownership in order to pass ownership of the real estate to the next generation.
• Benefit from a recent purchase or development through price appreciation.

3.2. Considerations Affecting All Concentrated Positions

Owners of concentrated positions face numerous constraints and obstacles that must be overcome in order for them to meet their primary and secondary objectives.

3.2.1. Tax Consequences of an Outright Sale

Concentrated positions are often highly appreciated versus their original cost. Therefore, simply selling the asset outright will usually trigger an immediate and sometimes significant taxable capital gain for the owner.

With respect to taxation, the tax cost basis is generally the amount that was paid to acquire an investment or capital asset. It serves as the foundation for calculating capital gain (or loss), which equals the selling price less the tax cost basis. For example, a share of stock bought for 10 monetary units and sold 20 years later for 100 monetary units would generate a capital gain of 90 monetary units.

In the case of concentrated positions, frequently the asset was acquired a long time ago and has a tax cost basis that is much lower than the current fair market value. The asset may therefore have a significant embedded capital gains tax liability.

The key point is that many, but by no means all, tax regimes throughout the world do impose a tax on capital gains.

Given that most families have accumulated the wealth represented by their concentrated positions through many years of hard work and calculated business risks, the fact that an outright sale of those assets would result in a tax obligation is often not psychologically palatable to the family. Therefore, deferring and, if possible, eliminating the capital gains tax is typically a primary objective for investors who own a concentrated position. There are a number of tools and strategies that can be used in many jurisdictions to achieve these objectives.

3.2.2. Liquidity

With the possible exception of concentrated positions in publicly traded stocks, concentrated positions are generally illiquid. This is especially true for the owners of privately owned businesses and investment real estate. Owners of concentrated publicly traded stock positions may also face this illiquidity if the trading volume of the company’s shares is small relative to the size of the concentrated position or if the shareholder is an insider and the timing or amount of any sales is restricted by applicable securities laws and regulations.

The sale of private business equity does not resemble the sale of shares of publicly traded stock because the latter trade on established stock exchanges or public trading venues where there are publicly quoted bids and offers and usually many ready buyers and sellers. That is, there is no readily available market for a private company’s shares. Rather, a buyer needs to be found for private business equity, and different classes of potential buyers may place a different value on the business. Therefore, the most important factors determining the amount that a business owner will receive when selling his or her business are ultimately the strategy that is employed and who the buyer is.

Direct ownership of investment real estate is also illiquid. A buyer needs to be found for a particular property, and different classes of potential buyers may place different values on that property.

Illiquidity in general acts as a constraint on the choice of strategies for dealing with a concentrated position.

3.3. Institutional and Capital Market Constraints

Various features of the institutional and capital market environment act as constraints on the choice of methods that may be effective in dealing with concentrated positions. Execution of any strategy is dependent on the governing law. The legal relationship that exists between the owners of a business depends on the type of entity that is being used (e.g., sole trader, partnership, limited partnership, or limited company, among other forms, in the United Kingdom), the laws governing that type of entity, and any documentation or agreements those laws require.

3.3.1. Margin-Lending Rules

Margin rules also present obstacles and additional complexity. Margin rules determine how much a bank or brokerage firm can lend against securities positions that their customers own. Various margin regimes exist throughout the world. They can be either rule based or risk based.

Under a rule-based system, the amount that can be borrowed against a security that the investor owns will depend on strict rules dealing with the use of the loan proceeds. If the purpose of the loan is to buy additional securities, the maximum loan proceeds are usually quite limited. For instance, in the United States, such a “purpose loan” is subject to a maximum of 50% of the value of the stock that is borrowed against even if that stock is completely hedged by a long put.

In contrast, portfolio margining is an example of a margin regime that is risk based. If an investor borrows against a stock that is completely hedged by a long put, the dealer will typically lend close to 100% of the put strike to the investor even if the investor wishes to purchase additional equity securities with the loan proceeds.

The implications of “portfolio margining,” which is available in the United States and other countries, are powerful, especially for ultra-high-net-worth investors. These rules provide advisers with additional flexibility to achieve the desired economic and tax results.

Certain forms of secured lending, such as a prepaid variable forward (collar1 and loan combined within a single instrument) in the United States, are considered “off-balance-sheet” debt and not subject to the margin rules. Such transactions are considered “sales” for margin rule purposes (so the margin rules do not apply and therefore there are no limitations on the use of proceeds) but are structured to not be sales for tax purposes (so capital gains taxes can be deferred or eliminated).

3.3.2. Securities Laws and Regulations

Company insiders and executives must often comply with a myriad of rules and regulations promulgated by governmental authorities. In most countries, such individuals, like any investor, cannot trade on material, non-public information. However, they typically must also comply with certain notice and disclosure/reporting requirements, and there may be specific limitations with respect to the timing and volume of sales or hedging transactions.

3.3.3. Contractual Restrictions and Employer Mandates

Beyond restrictions imposed by securities laws and regulations, contractual restrictions, such as initial public offering “lockups,” and employer mandates and policies, such as a prohibition of trading during certain “blackout periods” (i.e., periods when insiders cannot sell their shares) can greatly restrict the flexibility of insiders and employees to either sell or hedge their shares. In the case of private companies especially, there might be a right of first refusal, meaning that equity holders cannot sell their investment to a third party without first giving other equity investors the right to buy the interest at the same price and under the same conditions that the third party is offering. In addition to the right held by the investors, the entity may also have a right of first refusal, which further reduces the liquidity of an investment holding.

3.3.4. Capital Market Limitations

Certain characteristics of the underlying stock ultimately determine the feasibility of hedging different concentrated positions and in what degree they can be hedged.

The ability to borrow shares is critical because the dealer needs to manage the risk inherent in being a counterparty to the investor’s hedge. Managing this risk is achieved by first locating and borrowing the shares and then selling those shares in the marketplace. Although the investor executing the hedging transaction with the dealer could make its long shares available for the dealer to borrow if the shares were not restricted in any manner, the tax authorities could potentially view the transaction effectively as a sale.

In addition, the liquidity of the stock is vital because the dealer will periodically adjust its hedge, either borrowing and shorting additional shares or buying back shares and covering some of its outstanding short position. The average daily trading volume of the stock is important, and the dealer will observe whether the shares have had a propensity to “spike” either up or down. Because of this, most dealers will not execute collars or use other hedging techniques with respect to shares of a company that has recently undergone an initial public offering (IPO) because the dealer wants to be able to observe an established trading history/pattern of the stock prior to entering into such a transaction.

3.4. Psychological Considerations2

Various psychological considerations of clients can effectively act as constraints or obstacles to dealing with concentrated positions. Financial advisers hear many different types of rationalizations from their clients for declining to take any action with respect to the concentrated stock positions they own. Following are some common explanations that wealth managers often encounter:

• “It would be terribly disloyal for me to sell the stock after having worked at the company for so many years and the company treated me so well. What would my former colleagues think of me?”
• “My peers will look down on me if I sell the stock.”
• “My husband picked and owned this stock for many years and made me promise before he died that I wouldn’t sell it.”
• “I have a duty to pass on ownership of the business to subsequent generations.”

Advisers need to identify the cognitive and emotional biases that are affecting their clients and then communicate effectively with their clients to overcome the sometimes irrational decisions caused by these biases.

3.4.1. Emotional Biases

A number of emotional biases can combine to negatively affect the decision making of holders of concentrated positions, including the following:

• Overconfidence and familiarity (illusion of knowledge)
• Status quo bias (preference for no change)
• Naïve extrapolation of past returns
• Endowment effect (a tendency to ask for much more money to sell something than one would be willing to pay to buy it)
• Loyalty effects

When biases are emotional in nature, simply drawing them to the attention of the investor is unlikely to lead to a positive outcome; the investor may become defensive rather than receptive to considering alternatives.

To overcome emotional biases, it might be helpful to pose the question, if an equivalent sum to the value of the concentrated position were received in cash, how would you invest the cash? Often, the answer is to invest in a portfolio very different from the concentrated position. It may also prove useful to explore a deceased person’s intent in owning the concentrated position and bequeathing it: Was the primary intent to leave the specific concentrated position because it was perceived as a suitable investment based on fundamental analysis, or was it to leave financial resources to benefit the heirs? Heirs who affirm the latter conclusion are more responsive to considering strategies to reduce the concentration risk. It should also prove useful to review the historical performance and risk of the concentrated position.

3.4.2. Cognitive Biases

A number of cognitive biases can combine to negatively affect the decision making of holders of concentrated positions, including the following:

• Conservatism (in the sense of reluctance to update beliefs)
• Confirmation (looking for what confirms one’s beliefs)
• Illusion of control (the tendency to overestimate one’s control over events)
• Anchoring and adjustment (the tendency to reach a decision by making adjustments from an initial position, or “anchor”)
• Availability heuristic (the probability of events is influenced by the ease with which examples of the event can be recalled)

If cognitive errors are brought to the attention of the investor, he or she is likely to be more receptive to correcting the errors.

EXAMPLE 1

Constraints and the Concentrated Position Decision-Making Process

Zachary Sloan, CFA, serves as investment counsel for the Bailer family. Pierce Bailer was formerly the CEO of ABC Corp., a large public company, for over 20 years. During his tenure as CEO, Bailer accumulated a significant position in ABC Corp. stock. Bailer retired as CEO effective 1 January 2010 and continued to serve as a member of the board of directors until his term expired 31 December 2011. Bailer is currently 55 years old and healthy and has a life expectancy of 87 years. He is married to Brooke, who is also 55 and healthy.

Bailer currently owns a 3 million share position in ABC Corp. At the current market price, the position is worth $60 million and represents 80% of the Bailer family’s total investment portfolio, which is worth $75 million. The other 20% of their portfolio is invested evenly in high-quality fixed-income securities and a diversified portfolio of equities. Bailer has owned the ABC Corp. shares for many years, and the shares have increased significantly in value over that time. In addition, the stock has always paid, and continues to pay, a fairly attractive dividend, currently yielding approximately 2%. The dividend covers most of the Bailer family’s day-to-day living expenses. The tax cost basis of the ABC Corp. shares is close to zero, and the sale of the entire position would trigger a tax liability of approximately $9 million at a capital gains tax rate of 15%.

While Bailer was CEO, he was required by his employment contract and company policy to maintain a large position in ABC Corp. shares, and although occasional sales were permitted, sales and hedging transactions by executives and other employees were frowned upon and discouraged by the board of directors. In fact, it was company policy to encourage retirees to not sell their shares in order to protect the company against a hostile takeover because collectively the shareholder votes of the former employees might help stave off a takeover. In addition, until Bailer left the board of directors, he was deemed an “insider” and the securities laws and regulations limited the timing and amount of any sales or hedging activity. The country in which the Bailer family resides currently has a long-term capital gains tax rate of 15%. Because of the political situation in that jurisdiction and pending legislation, however, the capital gains tax rate is generally expected to increase significantly, very likely to 23%, effective 1 January of the following year. Also, in this jurisdiction, the shares would qualify for a “step-up” in tax cost basis upon the death of the owner. That is, upon inheritance of the shares, the recipient/beneficiary would receive a new tax cost basis equal to the value of the investment asset on the date of death. This new tax cost basis would then be used to compute any future gain or loss on the sale of the investment asset by the recipient/beneficiary.

Even though he no longer has any formal affiliation with ABC Corp., Bailer remains extremely loyal to ABC Corp., is a big fan of ABC Corp. stock, and follows the stock regularly. Although he has no better access to information about the company than any other investor, Bailer feels that he knows the company much better than other investors. Mrs. Bailer remembers that she and Pierce started their married life with a negative net worth and the family’s net worth grew over time as Pierce’s ABC Corp. position skyrocketed in value. Mrs. Bailer also realizes that for many years, the dividends paid on their ABC Corp. stake paid for a good portion of their living expenses.

Immediately following the expiration of Bailer’s term as a member of the board of directors, Sloan suggested a meeting to discuss an alternative asset allocation framework.

1. Identify primary investment objectives for the Bailer family’s concentrated single-asset position.
2. Identify primary constraints that might impede the Bailer family’s ability to achieve their primary objectives.
3. On the basis of the information given, discuss what emotional and cognitive biases may affect decision making of Mr. and Mrs. Bailer.

Solution to 1:

The family owns a concentrated position in ABC Corp. shares that constitutes 80% of their investment portfolio. The first objective should be to significantly reduce the concentration risk. The second objective should be to generate liquidity in order to diversify while satisfying spending needs. The third objective should be to achieve the first two objectives in the most tax-efficient manner.

Solution to 2:

The income tax consequences of an outright sale are a primary constraint to fulfilling the primary investment need. If the entire position was sold this year, a capital gains tax of approximately $9 million would be incurred. However, if the position is sold on or after 1 January of the following year, a capital gains tax of approximately $13,800,000 would likely be incurred because of the anticipated increase in the capital gains tax rate — an increase of $4,800,000. Although the tax is a constraint, the fact that the tax will likely be considerably higher in the near future should be an impetus for Bailer to sell the ABC Corp. position this year and lock in the current capital gains tax before it increases. The step-up in tax cost basis the shares would receive if Bailer held them until his death should also be considered. However, Bailer’s fairly long life expectancy of approximately 32 more years implies that the present value of the step-up is fairly low and should be greatly outweighed by the benefits of diversification over that long-term period.

Solution to 3:

The facts indicate that loyalty effects, overconfidence/familiarity (illusion of knowledge), and confirmation bias could be affecting Mr. Bailer, while status quo bias, naïve extrapolation of past returns, and anchoring and adjustment bias could be affecting Mrs. Bailer. Illiquidity is no longer an issue. For many years and until recently, Mr. Bailer was deemed an “insider” for securities law purposes and the timing and amount of any sales and hedging activity was restricted by applicable securities laws and regulations. In addition, for many years, he was bound by his employment contract and company policies to limit the sale and hedging of his ABC Corp. shares. However, these restrictions were completely eliminated when his term as a member of the board of directors ended.

3.5. Goal-Based Planning in the Concentrated-Position Decision-Making Process

Goal-based planning is one way to incorporate psychological considerations into asset allocation and portfolio construction that can be especially helpful for advisers to clients who own concentrated positions because it can highlight the consequences of selecting an asset allocation that is riskier than is appropriate for a particular investor.

A goal-based methodology expands the traditional Markowitz framework of diversifying market risk by incorporating several notional “risk buckets.” Asset allocation, including concentrated positions, subsequently occurs within each risk bucket.3

The first risk bucket can be referred to as the personal risk bucket. Here, the goal is protection from poverty or a dramatic decrease in lifestyle. The desire is to achieve almost certainty of protection. Allocations to this bucket limit loss but yield below-market rates of return. This bucket is where the client would allocate his or her home (primary residence), certificates of deposit, Treasury bills, and other “safe haven” investments.

The second risk bucket can be referred to as the market risk bucket. Here, the objective is to maintain the current standard of living — to have a high likelihood of maintaining the current status quo. Allocations to this bucket provide average risk-adjusted market returns. This bucket is where the client would allocate his or her stock and bond portfolio.

The third risk bucket can be referred to as the aspirational risk bucket. Here, the goal is the opportunity to increase wealth substantially — to have the possibility of moving upward in the wealth spectrum. Allocations to this bucket are expected to yield above-market returns but with substantial risk of loss of capital. This bucket is where the client would allocate his or her concentrated positions, including privately owned businesses, investment real estate, concentrated stock positions, stock options, and the like.

This type of risk allocation framework gives financial advisers a basis to sit down with a client and identify and highlight the significant risk that owners of concentrated positions are subject to. It may be the most effective way to open the conversation with a client about their concentrated positions because it can highlight when allocations to the personal risk and market risk buckets are not adequate.

In addition, concentrated-position owners need a touchstone for deciding whether to sell or monetize, and one useful metric might be whether the proceeds, when combined with the assets the owner already has outside the concentrated position, are at least sufficient to provide for the owner’s lifetime spending needs. We can refer to this amount as the owner’s primary capital, and it comprises allocations to his or her personal and market risk buckets. Ideally, the sale or monetization will generate even more than the primary capital requirement. We refer to this as the owner’s surplus capital, which comprises allocations to his or her aspirational risk bucket.4

To determine whether the sale or monetization of the concentrated position can achieve financial independence for the owner, the financial adviser needs to work with the owner to answer five key questions:

1. What are the lifetime spending needs and desires of the client after the sale or monetization of the concentrated position?
2. How much capital will it take today to know that these spending needs and desires will be satisfied throughout the owner’s lifetime with little or no chance of the investor running out of money (primary and surplus capital requirements)?
3. What is the current value of the concentrated position? Different strategies may result in significantly different values for the concentrated position.
4. What is the value of liquid and other assets that are available outside the concentrated position today — that is, how much capital does the owner have now outside the concentrated position?
5. Is the current value of the concentrated position under one or more of the monetization strategies that are available to the owner sufficient to “bridge the gap” between the capital the client currently has and his or her primary and surplus capital requirements?

For many concentrated-position owners, it’s key to come away from a sale or monetization event with a transaction that has the highest likelihood of meeting at least their primary capital requirement. Generation of surplus capital puts the owner a step ahead.

If wealth managers have a holistic view of their clients’ finances, an understanding of their personal long-term financial objectives, and expertise in investment management, they are well situated to assist their clients in determining their primary and surplus capital requirements. Goal-based planning works equally well with clients who own businesses, real estate, and concentrated stock positions. By using this approach, wealth managers can work with clients first to identify and highlight the concentration risk that each client faces and then to create a framework that should prove helpful in determining whether a sale or monetization event would cause the owner of the concentrated position to achieve financial goals. If it would, this approach may give the owner of the concentrated position the impetus to begin dealing with the emotional aspects of selling or monetizing the asset.

EXAMPLE 2

A Business Owner and the Concentrated-Position Decision-Making Process (1)

Bill Wharton is Fred Garcia’s financial adviser. Garcia is 60 years old and is CEO of an aircraft parts business that he founded 30 years ago. For over a decade, Garcia’s son had taken on increasingly important responsibilities, and Garcia’s exit plan was to pass on the business to his son. His son’s sudden decision to pursue other career opportunities was a shock to Garcia and provided the motivation for Garcia to consider selling or monetizing his business.

As Exhibit 3 portrays, Garcia owned a business worth $40 million, investment real estate consisting of an office building, warehouse, and land used by the business worth $5 million, a $3 million stock and bond portfolio, $1 million in cash, and an unmortgaged home worth $1 million. Garcia asked Wharton what he thought of his current financial picture.

Exhibit 3. Wealth Distribution Shown in Risk Buckets

“Personal” Risk
4%
Protective Assets

“Market” Risk
6%
Market Assets

“Aspirational” Risk
90%
Aspirational Assets

Home

$1,000,000

Equities

$1,500,000

Family Business

$40,000,000

Mortgage on Primary Residence

$0

Intermediate- and Long-Term Fixed Income

$1,500,000

Investment Real Estate

$5,000,000

Cash/Short-Term Treasury Bonds and Notes

$1,000,000

Total

$2,000,000

Total

$3,000,000

Total

$45,000,000

1. Using a goal-based planning framework (i.e., personal, market, and aspirational risk buckets), identify and highlight the significant risk(s) that Garcia is currently facing.

Garcia agreed with Wharton that the current asset allocation seemed very aggressive for someone his age and that it might be time to make some changes. Garcia then asked Wharton what he felt the next step should be in terms of helping to decide whether selling or monetizing his business might make sense.

1. Using a goal-based planning framework, describe the initial step that Wharton should work through with Garcia to help determine whether selling or monetizing his business might make sense.

After carefully considering Garcia’s lifetime spending needs, Garcia and Wharton determined that a primary capital requirement of $35 million should be more than sufficient to sustain Garcia’s current lifestyle with very little or no risk of running out of capital during his lifetime, even after considering such potential factors as severe market shocks, tax rate increases, inflation, and an unexpectedly long life span. Later in the reading, after providing the tool set for addressing the problem of obtaining the needed primary capital amount, we will return to Garcia’s needs in Example 6.

1. Explain how this knowledge — that the sale or monetization should meet Garcia’s $35 million primary capital requirement — should be helpful to Garcia in making a decision as to whether to sell or monetize his business.

Solution to 1:

Garcia currently has 90% ($45 million out of the $50 million) of his wealth allocated to a family-run business and commercial real estate, which falls in his high-risk/high-return aspirational risk bucket. That level would qualify as excessive risk taking for someone over 60 years old, especially now that Garcia’s son is no longer interested in taking over the business.

Solution to 2:

Wharton should work very carefully with Garcia to determine his lifetime spending needs. They should establish how much capital it would take today to know that Garcia’s spending needs would be satisfied throughout Garcia’s lifetime with little or no chance of Garcia running out of money. Put another way, they need to ascertain how much capital would need to be allocated to Garcia’s personal and market risk buckets (his primary capital requirement).

Solution to 3:

This knowledge is important because Garcia now understands that the sale or monetization of his business should generate sufficient after-tax proceeds to allocate to his personal and market risk buckets to cover his lifetime spending needs and desires. Put another way, Garcia now knows that the sale or monetization of his business can enable him to achieve financial independence as he has defined it.

3.6. Asset Location and Wealth Transfers

The implications of asset location (what type of account an asset is held within) for the holders of concentrated positions should be considered. In most tax regimes, a security’s asset class usually determines its tax profile when held in taxable accounts. For instance, interest income on fixed-income securities is often taxed differently from long-term capital gains on stocks.5 However, the account structure can override the normal tax treatment. Therefore, a relationship exists between deciding what assets to own and in which accounts they should be held. The choice of where to place specific assets is often referred to as the asset location decision. It is distinct from the asset allocation decision. The tax regime governing the investor ultimately determines the relative importance of asset location. The concept of asset location and gifting strategies can often be used together to minimize transfer taxes with respect to concentrated positions.

A second tool for addressing concentrated positions is wealth transfers. Undertaking wealth transfer planning early in the ownership life of a concentrated position often enables the owner to shift future wealth with little or no transfer tax consequences. Which methods will work depends on the tax regime of the country the owner is subject to, the owner’s age and family circumstances, whether he or she is charitably inclined, and whether the planning takes place before or after some value has accumulated.

Advisers who are able to work with clients before the concentrated position has appreciated greatly in value can have the most impact. At this point in time, the simplest strategies, such as direct gifts to family members, direct gifts to long-term trusts, and estate freeze strategies, typically add the most value. With the passage of time, after there has been some run-up in the concentrated position’s value, wealth transfer tools tend to be less efficient, more complex, and more costly to implement — which underscores the importance of addressing this subject with the owners of concentrated positions as early as possible.

In addition to direct gifting, a valuable concept in wealth transfer planning is that of an early ownership transfer of an estate, or estate tax freeze. Here the goal is to transfer future appreciation to the next generation at little or no gift or estate tax cost. An estate tax freeze is a plan usually involving a corporation, partnership, or limited liability company in which the owners transfer a junior equity interest to the children that will receive most or all of the future appreciation of the enterprise. Any gift or wealth transfer tax is based on the current market value of the interest transferred; future appreciation of the equity position transferred will not be subject to gift or transfer tax. Estate tax freezes were initially used by closely held family businesses but were later expanded to include other concentrated positions, including publicly traded stocks and real estate.

The classic corporate estate tax freeze involves recapitalizing a closely held family-owned corporation. The older generation, who owns all of the stock of the corporation, exchanges their existing company stock for two newly issued classes of stock. One class is voting preferred; the other is non-voting common. The non-voting common stock is gifted to the next generation. The transaction is structured so that the value of the voting preferred shares is equal to the value of 100% of the corporation. In addition, the value of the preferred stock should not appreciate greatly because those shares pay a fixed rate and resemble a bond. Therefore, the common stock has only a nominal value and can be gifted to the next generation and trigger little or no gift tax. The future appreciation in the value of the corporation should benefit the common shareholders. None of the appreciation is subject to gift or estate tax until the common shares are passed by gift or bequest to the next generation. The parents retain control because all the voting power is held in the preferred shares. The United States, Canada, and Australia, among others, allow some form of a corporate estate tax freeze. Note that although not all jurisdictions allow corporate estate tax freezes, it is the concept that is important, and other techniques have been developed that accomplish the same objectives as the corporate estate tax freeze.

EXAMPLE 3

A Corporate Estate Tax Freeze

John and Barbara Wilson live in a country that imposes a current gift tax of 40% on the transfer of any property directly (or indirectly through trusts) from parents to children that exceeds $10 million during their lifetimes. The Wilsons have already used the $10 million exemption by making prior gifts to their children. The Wilsons own a business currently worth $10 million, but they believe the business is poised for explosive growth that will begin shortly. Their children are already involved with the business. The Wilsons eventually want to pass control of the business to their children, but at this point, they feel their children don’t have the necessary experience to run the business, so the Wilsons would like to retain control. However, they would like the growth that is expected of the business to directly benefit their children, as contrasted with having that appreciation remain in their estate. Based only on the above information, address the following.

1. Would a direct gift of the company stock from the Wilsons to their children satisfy their objectives?
2. Would a direct gift of the company stock from the Wilsons to a trust set up for the benefit of their children satisfy their objectives?
3. Would a corporate estate tax freeze satisfy the Wilsons’ objectives?

Solution to 1:

No. They would give up control of the company, which they don’t want to do. Because they’ve already used their $10 million gift tax exemption, any further gifts would trigger an immediate 40% gift tax.

Solution to 2:

No, for roughly the same reasons stated in the Solution to 1. Although a trust could be set up such that voting control passes on to the children at a later date, a gift tax would still apply.

Solution to 3:

Yes. The Wilsons could recapitalize their company and keep new voting preferred stock (worth the current value of the company) and gift new non-voting common stock (with a current nominal value) to their children with little or zero gift tax due. The Wilsons retain control of the company, and all future appreciation of the company inures to the benefit of their children. Upon the Wilsons’s retirement or death, the company can redeem their preferred shares and the common shares can be given voting rights.

Although the greatest opportunities for estate planning and wealth transfer occur before the concentrated position has significantly appreciated, there are techniques the owner can use after significant appreciation has occurred to minimize transfer taxes.

A common technique for gifting an interest in a concentrated position is to contribute the concentrated position to an entity such as a family limited partnership. For instance, the parents who own a concentrated position might contribute their concentrated position to a partnership in a manner that does not trigger a current taxable event. The parents retain the general partnership interest and therefore retain control of the partnership and the concentrated position within it. The parents gift the limited partnership interests to their children.

When a limited partnership interest is valued for transfer tax purposes, the value is typically less than a proportionate value of the assets held in the partnership. This discount arises because of two factors. First, there is a lack of marketability. Family limited partnership interests are typically restricted and are difficult, if not impossible, to sell outside the family; therefore, an unrelated buyer would very likely not be willing to pay the pro-rata value for the partnership interest. Second, because the general partner retains control, the limited partner’s non-controlling interest is worth less because he has very little ability to influence management of the partnership and the underlying assets. Because of these two factors, the valuation of a limited partnership interest is often discounted from 10% to 40% of the value of the underlying assets. For instance, assuming a combined discount of 35%, a 20% interest in a $10 million concentrated position would be transferred at a gift tax valuation of $1.3 million (i.e., a 35% discount) instead of $2 million.

In addition to the gift tax savings at the time of transfer, substantial estate tax may be saved if the concentrated position appreciates further between the date of the gift and the date of the parent’s death. In the above example, if the $10 million concentrated position appreciates to $30 million by the time the donor dies, the children will hold an interest worth $6 million but only $1.3 million will be subject to transfer taxes.

Finally, if the owner of the concentrated position is charitably inclined, there are a variety of gifting and asset location strategies that the owner might consider using to avoid triggering any tax (i.e., the capital gains tax on the appreciation), as well as any transfer taxes (i.e., gift and estate taxes).

3.7. Concentrated Wealth Decision Making: A Five-Step Process

Working with the owners of concentrated positions can be quite complex. The following five- step process, if applied systematically to each client holding a concentrated position, should help assure that services are delivered to each client using a uniform and consistent methodology with the result that each client should implement the plan of action or strategy that best satisfies their objectives given their particular circumstances.

1. Step 1

Identify and establish objectives and constraints. The objective (or combination of objectives) of the owner of the concentrated position should be identified, established, and put in written form. Constraints should be identified and their impact analyzed.

1. Step 2

Identify tools/strategies that can satisfy these objectives. All the tools and strategies that could be used to satisfy the owner’s stated objectives subject to binding constraints need to be identified, while remembering that different techniques can often provide essentially the same economics.

1. Step 3

Compare tax advantages and disadvantages. The tax advantages and disadvantages of each tool/strategy should be compared.

1. Step 4

Compare non-tax advantages and disadvantages. The non-tax considerations of each alternative tool/strategy need to be thoroughly compared.

1. Step 5

Formulate and document an overall strategy. After weighing the tax and non-tax advantages and disadvantages of each alternative tool/strategy, the overall strategy that appears to best position the client to achieve his or her goals is selected.

These steps should be viewed as a dynamic process involving feedback loops so that when an element of the process or circumstance changes, the strategy may need to be adjusted.

4. MANAGING THE RISK OF CONCENTRATED SINGLE-STOCK POSITIONS

Diversification, one of the bedrock investment principles, seeks to balance risk and reward within a portfolio. A portfolio consisting of only a few stocks would not generally be considered prudent because of the risk from the concentrated position. The same reasoning applies to the holder of a concentrated position in a single stock.

To mitigate the risks of any concentrated position, be it publicly traded common stock, ownership of a private business, or ownership of real estate, there are several broad types of tools that can be used:

• Outright sale: Owners can sell the concentrated position, which gives them funds to spend or reinvest but often incurs significant tax liabilities.
• Monetization strategies: These provide owners with funds to spend or re-invest without triggering a taxable event. A loan against the value of a concentrated position is an example of a simple monetization strategy.
• Hedging the value of the concentrated asset: Derivatives are frequently used in such transactions.

Furthermore, a strategy can combine these elements. Exhibit 4 lists the tool set for managing single-stock positions. Selected tools will be discussed in more detail.

Exhibit 4. The Financial Tool Set for Managing a Single-Stock Position

1. Equity derivatives to hedge value:
2. Exchange-traded options (sometimes referred to as listed options)
3. Over-the-counter (OTC) derivatives
4. Options
5. Forwards
6. Swaps
7. Borrowing to monetize the position:
8. Margin loans
9. Recourse and non-recourse debta
10. Fixed- and floating-rate debt
11. Loans embedded within a derivative (e.g., a prepaid variable forward)
12. Other monetization:
13. Short sales against the box
14. Restricted stock sales
15. Public capital market–based transactions
16. Debt exchangeable for common (DEC) offerings
17. Rule 10b5–1 plans and blind trusts (United States)
18. Exchange funds (United States)

a Note: Recourse with respect to a debt means there is a right to collect beyond what collateral provides in the event of default against the borrower or some other party.

Please note that the tool set listed above is specific to the United States; investors in other jurisdictions may or may not have access to all of these tools. It is also possible that tools other than those mentioned may be available in other jurisdictions.

4.1. Introduction to Key Tax Considerations

There are a variety of financial tools that investors can use to hedge to achieve a desired economic result. For instance, an investor can synthetically dispose of a stock by shorting the stock directly or, alternatively, by using options, swaps, forwards, or futures.

Although each produces the same economic result, they may not be taxed similarly. Although most tax regimes governing the taxation of financial instruments are comprehensive in nature, they are not always internally consistent.

In most jurisdictions, the basic tax rules applicable to financial products have developed over time in a somewhat piecemeal fashion. The usual process is that investors first innovate and create a new product and the tax authorities later respond. Financial engineers develop a product that begins to trade in the marketplace. Tax authorities soon realize there is no provision in the tax law that currently addresses this particular financial instrument, and they respond accordingly with a tax provision crafted to address this new product.

However, the drafters of such tax laws may not consider that investors might use several different tools to achieve the identical economic objective, so there could be significant differences in the tax treatment among these different tools because of the different provisions that govern them. This is certainly the case in the United States as well as for most other tax regimes.

If there is internal inconsistency of tax codes, there may be an opportunity for well-advised investors to reap substantial tax savings or reduce tax risk by selecting and implementing the form of a transaction that delivers the optimal economic and tax result.

4.2. Introduction to Key Non-Tax Considerations

There are certain considerations unrelated to taxation that investors and their advisers need to consider when deciding whether to use an exchange-traded instrument (i.e., options or futures) or an over-the-counter (OTC) derivative (i.e., forward sale or swap).

4.2.1. Counterparty Credit Risk

With respect to an OTC derivative, the investor incurs the credit risk of the single counterparty that he or she contracts with. With respect to exchange-traded instruments, because a clearinghouse (that is typically owned and jointly and severally backed by all its members) is the counterparty and guarantees the instrument, the investor incurs significantly less counterparty credit risk.

4.2.2. Ability to Close Out Transaction Prior to Stated Expiration

The investor can close out exchange-traded instruments prior to their stated maturity by acquiring exactly offsetting positions with any market participant. With respect to OTC derivatives, the investor can attempt to negotiate an early termination of a particular contract, but the counterparty can and usually does extract a concession in return for permitting early termination.

4.2.3. Price Discovery

By their very nature, exchange-traded instruments should achieve robust price discovery. In contrast, an OTC derivative is priced through negotiation with a single dealer, although fiduciaries and advisers should get bids from at least several dealers to ensure that reasonable price discovery has occurred. (Basic financial analysis of derivatives can independently provide a reasonableness benchmark for transaction prices.)

4.2.4. Transparency of Fees

Fees and expenses are more transparent in exchange-traded transactions. All commissions and fees must be identified on trade tickets, trade confirmations, and monthly statements. It is much easier for dealers to build their fees into OTC derivative transactions, especially such instruments as prepaid variable forwards, where the collar and loan are combined into a single instrument.

4.2.5. Flexibility of Terms

OTC derivatives give the investor maximum flexibility with respect to negotiating the key terms and conditions of any transaction. Exchange-traded instruments do not give investors the same degree of flexibility.

4.2.6. Minimum Size Constraints

Exchange-traded instruments typically have a smaller minimum than OTC derivatives. OTC derivatives have a minimum size that is typically around US$3 million.

4.3. Strategies

There are three primary strategies that investors use in the case of a concentrated position in a common stock:

• Equity monetization
• Hedging
• Yield enhancement

4.3.1. Equity Monetization

Investors holding a concentrated position can (1) hedge against a decline in the price of a stock, (2) defer the capital gains tax, and (3) generate liquidity (cash), which can be used to diversify, by implementing an equity monetization strategy.

Equity monetization generally refers to the transformation of a concentrated position into cash. Equity monetization usually refers to transactions that are designed to empower an investor to receive cash for their stock position through a manner other than an outright sale in a way that avoids triggering a current taxable event.

In addition to avoiding an immediate tax liability associated with an outright sale, there are other factors that might make the use of an equity monetization strategy attractive to a holder of a concentrated position, such as the following:

• The investor may be subject to a diverse array of securities law restrictions that are applicable to a sale of stock.
• The investor might own a large percentage of outstanding shares of the company and may not wish to cede control of the company or give the opportunity to another investor to acquire a large block of company shares.
• The investor may be subject to contractual provisions, such as an IPO lockup or an employment agreement or policy, that prohibit the sale of shares.

Equity monetization entails a two-step process:

• The first step is for the investor to remove a large portion of the risk inherent in the concentrated position. The process of hedging the concentrated stock position could be fraught with complex tax regulations. In the United States, for example, the IRS has been known to scrutinize hedging transactions closely, especially for ultra-high-net-worth individuals and families. Care should be taken in structuring the hedge such that the economic incentives (as well as disincentives) of holding the concentrated stock position are not, for practical purposes, eliminated.
• The second step is for the investor to borrow against the hedged position. In most instances, a high loan-to-value (LTV) ratio can be achieved because the stock position is hedged; the loan proceeds are then invested in a diversified portfolio of other investments.

4.3.1.1. Equity Monetization Tool Set

The four basic tools an investor can use to establish a short position in a stock are6

• a short sale against the box,
• a total return equity swap,
• options (forward conversion), and
• a forward sale contract or single-stock futures contract.

For instance, assume an investor owns 1 million shares of ABC Corp. stock and ABC Corp. shares are currently trading at $100 per share, so the investor is long $100 million of ABC Corp. shares. To establish an exactly offsetting short position in ABC Corp. shares, the investor could use any of the four techniques mentioned above and described below.

A short sale against the box involves shorting a security that is held long. In our example, the investor could borrow 1 million shares of ABC Corp. stock from a broker/dealer and then sell those shares in the marketplace, thus establishing a $100 million short position in ABC Corp. stock.

Because the investor is simultaneously long and short the same number of shares of the same stock, any future change in the stock’s price will have absolutely no effect on the investor’s economic position. Likewise, any dividends or other distributions that are received on the long shares are passed through to the lender of the shares that were sold to open the short position.

Because the long and short positions together constitute a riskless position, the investor will earn a money market rate of return on the $100 million position. The investor has economically transformed the risky ABC Corp. stock position into a riskless asset that will earn a money market rate of return.

Because the short sale against the box creates a riskless (i.e., devoid of price risk) position, margin rules typically allow the investor to borrow with a high loan to value (LTV) ratio against the position. It is usually possible to borrow up to 99% of the value of the stock that is hedged, and there are usually no limitations on the use of the proceeds. The proceeds are typically invested in a portfolio of securities and other investments to achieve diversification. The net cost of borrowing through a short sale against the box is quite low because the interest income earned on the completely hedged stock position greatly offsets the interest expense associated with the margin loan.

The short sale against the box is the least expensive technique that is available to hedge, monetize, and potentially defer the capital gains tax on a concentrated position. It is the “paradigm” among all hedging and monetization strategies. The strategy is less costly than the other tools that enable investors to establish a synthetic short position in a stock (i.e., swaps, options, and forwards/futures, discussed below) because a derivative dealer need not be involved. That is, there are typically fewer dealer fees involved in a short sale against the box versus synthetic short sales.

A total return equity swap is a contract for a series of exchanges of the total return on a specified asset in return for specified fixed or floating payments.

In our example, the investor and a derivative dealer could agree to an exchange of cash flows based on a $100 million notional amount of ABC Corp. shares as follows:

• The investor agrees to pay the dealer any appreciation on her ABC shares plus any dividends and other distributions received on her shares.
• In return, the dealer agrees to pay the investor any loss in the value of the ABC shares plus one-month Libor (less a dealer spread).

Note the similarity to the short sale against the box. The investor is fully hedged and is earning a money market rate of return on the full value of the position. Because a derivative dealer is involved, the money market rate of return earned on the position would likely be slightly less than what would be earned on a short sale against the box position because of the larger dealer spread charged to implement the total return swap. Because the ABC Corp. stock position is completely hedged, monetization with a very high LTV ratio should be possible.

A forward conversion with options involves the construction of a synthetic short forward position against the asset held long. This strategy is based on the fact that the payoff of a short forward position is identical to the payoff of a long put and a short call on the same underlying asset.

In our example, the investor could buy ABC Corp. puts and sell ABC Corp. calls with the same strike price (i.e., $100) and the same termination date covering 1 million shares. By doing so, the investor has locked in a price of $100 no matter which way the stock moves. If the stock price goes to zero, the investor would exercise the puts, deliver her shares, and receive $100 from the dealer. If the stock price increased to $200, the calls would be exercised against the investor; she would deliver shares and receive $100 from the dealer.

Because the position created is riskless, a forward conversion should be priced in the marketplace to generate a money market rate of return for the investor. Because the ABC Corp. stock position is perfectly hedged, monetization with a very high LTV ratio should be possible.

An equity forward sale contract is a private contract for the forward sale of an equity position.

In our example, the investor could agree today to sell her ABC shares to a dealer three years from now. In return, the investor will receive the “forward price” from the dealer three years from now. A forward contract on an individual stock allows the investor to sell her stock at some future date at a guaranteed price (i.e., the forward price). If the market price is above the forward price at the termination of the contract, the investor will receive the forward price and will not participate in any market increase above that price.

Because the position created is riskless, a forward contract will generate a money market rate of return for the investor, which is reflected in the forward price. Because the ABC Corp. stock position is perfectly hedged, monetization with a very high LTV ratio should be possible.

To summarize, by using any of these four techniques, an owner of a concentrated position accomplishes the following:

• A riskless position is created by establishing a direct or synthetic short position covering the same amount of shares that she is long.
• A money market rate of return is generated on the full value of the long position.
• Borrowing against the hedged position with a very high LTV ratio is possible (it is similar to borrowing against a government bond).
• Borrowing is quite inexpensive because the income generated on the hedged position greatly offsets cost of borrowing.
• The borrowed proceeds can be invested in a diversified portfolio.

4.3.1.2. Tax Treatment of Equity Monetization Strategies

Equity monetization strategies allow an investor to transfer the economic risk and reward of a stock position without transferring the legal and beneficial ownership of that asset. Put another way, equity monetization can eliminate concentration risk and generate about the same amount of cash that would be generated by an outright sale. The basic premise in most tax regimes is that economic gains (including unrealized gains on a stock position) do not constitute “income” and are therefore not subject to tax unless and until they are “realized.”7

Historically, the concept of capital gain realization has been tied to the “sale or disposition” of appreciated securities. In the case of monetization transactions, there has been no actual transaction in the appreciated securities themselves. That is, there is no formal legal “connection” between the monetization transaction and the appreciated securities. The investor still owns the securities and, if the securities are viewed in isolation, remains fully exposed to the risk of loss and opportunity for profit associated with the securities. The investor can assert that entering into a monetization arrangement does not, as a matter of legal form, constitute a sale or disposition of the appreciated securities.

The critical question is whether an equity monetization strategy will be treated as a taxable event for tax purposes in a particular country. If the tax regime treats the long and short (or synthetically short) position separately for tax purposes, tax on the appreciation of the long position will be deferred. Put more succinctly, if the tax authorities of a country respect legal form over economic substance, which is typically the case, equity monetization techniques should not trigger an immediate taxable event.

A comprehensive comparative tax analysis of how different countries’ tax systems deal with equity monetization strategies is beyond the scope of this reading. However, it is important that advisers, irrespective of the country where their client is domiciled, know how to appropriately appraise equity monetization strategies. Exhibit 5 broadly classifies the various tax regimes that exist in the world today. No matter which tax regime is being examined, certain questions should be asked and a certain process followed as investors and their advisers seek to ensure that the strategy that is used is the most tax efficient. Along these lines, working with the client’s tax adviser to answer the following questions should help in selecting the tool that minimizes the tax cost to the client.

1. When unwinding or cash settling the hedge, if there is a gain generated by the hedge, is it short term or long term in nature? Long-term gain is generally preferred in many jurisdictions.
2. When unwinding or cash settling the hedge, are potential losses generated by the hedge short term or long term in nature, and is it currently deductible or instead added to the tax cost basis of the shares being hedged? Short-term loss and currently deductible are generally preferred.
3. If the contract is physically settled by delivering shares, is the gain short term or long term in nature? Long-term gain is usually better.
4. Are the carrying costs associated with monetization (i.e., interest expense or the equivalent) currently deductible or instead added to the tax cost basis of the shares being hedged? Current deductibility is preferred.
5. Does the hedge in any way affect the taxation of dividends or distributions received on the shares? No impact is preferred.

Exhibit 5. Classification of Income Tax Regimes

Regime

1. Common Progressive

2. Heavy Dividend Tax

3. Heavy Capital Gains Tax

4. Heavy Interest Tax

5. Light Capital Gains Tax

6. Flat and Light

7. Flat and Heavy

Ordinary Tax Rate Structure

Progressive

Progressive

Progressive

Progressive

Progressive

Flat

Flat

Interest Income

Some interest taxed at favorable rates or exempt

Some interest taxed at favorable rates or exempt

Some interest taxed at favorable rates or exempt

Taxed at ordinary rates

Taxed at ordinary rates

Some interest taxed at favorable rates or exempt

Some interest taxed at favorable rates or exempt

Dividends

Some dividends taxed at favorable rates or exempt

Taxed at ordinary rates

Some dividends taxed at favorable rates or exempt

Some dividends taxed at favorable rates or exempt

Taxed at ordinary rates

Some dividends taxed at favorable rates or exempt

Taxed at ordinary rates

Capital Gains

Some capital gains taxed favorably or exempt

Some capital gains taxed favorably or exempt

Taxed at ordinary rates

Some capital gains taxed favorably or exempt

Some capital gains taxed favorably or exempt

Some capital gains taxed favorably or exempt

Taxed at ordinary rates

Example Countries

Austria, Brazil, China, Czech Republic, Finland, France, Greece, Hong Kong, Hungary, Ireland, Italy, Japan, Latvia, Malaysia, Netherlands, Nigeria, Philippines, Poland, Portugal, Singapore, South Africa, Sweden, Thailand, United Kingdom, United States, Vietnam

Argentina, Indonesia, Israel, Venezuela

Columbia

Canada, Denmark, Germany, Luxembourg, Pakistan

Australia, Belgium, India, Kenya, Mexico, New Zealand, Norway, Spain, Switzerland, Taiwan, Turkey

Kazakhstan, Russia, Saudi Arabia (Zakat)

Ukraine

Sources: Stephen Horan and Thomas Robinson, “Taxes and Private Wealth Management in a Global Context” (CFA Institute, 2009). Classification based on information provided in International Business Guides from Deloitte Touche Tohmatsu (available at www.deloitte.com) and online database of worldwide taxation provided by PricewaterhouseCoopers (www.taxsummaries.pwc.com).

4.3.2. Lock In Unrealized Gains: Hedging

Hedging is a useful strategy when the holder of a concentrated position would like to protect against downside risk but would also like to capture either unlimited or a significant amount of potential upside with respect to the stock. There are two major hedging approaches investors can consider:

• Purchase of puts
• Cashless, or zero-premium, collar

4.3.2.1. Purchase of Puts

Investors holding a concentrated position can purchase put options to (1) lock in a floor price, (2) retain unlimited upside potential, and (3) defer the capital gains tax.

Investors usually buy put options with a strike price that is either at or, more typically, slightly below the current price of the stock (that is, either “at-the-money” or slightly “out-of-the-money” puts). The investor pays an amount, referred to as the premium, to acquire the puts.

Conceptually, this is very similar to the payment of an insurance premium. In return, the investor is fully protected, subject to the credit risk of the counterparty, from any loss resulting from a decline of the stock price below the strike price of the put. The premium paid will vary depending on a number of factors, including the volatility of the stock, the strike price, and the maturity. The investor retains any dividends received and voting rights.

As an example, suppose an investor, Bill, owns shares of ABC Corp. that are currently trading at $100. ABC one-year put options with a strike price of $90 currently trade at $5, and Bill buys these puts. If the stock price has decreased below the $90 strike price at maturity, the puts can be exercised and Bill will deliver his long shares for $90 from the exercise of the puts. His total initial investment was $105 — $100 in stock and $5 worth of puts. If ABC closes at or above $90 at expiration, the puts will expire worthless but Bill will have paid $5 for this “wasting” asset, which can be thought of as “term” insurance. The trade will make sense in retrospect only if the underlying stock price declines below $85 per share, assuming that no put was purchased.

The concept of combining a long stock position with a long put position is intuitively extremely appealing: downside protection with unlimited upside price participation. However, the out-of-pocket expenditure necessary to acquire puts can be significant. Therefore, investors often seek to lessen their out-of-pocket costs. Described below are a few ways for investors to accomplish this.

The most common way is to lower the strike price. An at-the-money put will cost considerably more than an out-of-the-money put. With an out-of-the-money put, the investor, in essence, “self-insures” down to the strike price. Of course, the lower the strike price, the greater the downside risk the holder retains.

Along similar lines, puts with a shorter maturity will cost less than puts with a longer maturity because the “term insurance” doesn’t last very long.

Another popular strategy is to combine the purchase of put options with the sale of put options with a lower strike price and with the same maturity as the long puts, which is known as a “put spread.” The idea is to lessen the cost of the long puts by selling puts to bring in some premium income in order to partially finance the purchase of the long puts. In this case, the investor will be protected from the strike price of the long put down to the strike price of the short put. However, below the strike price of the short put, the investor is fully exposed to further declines in the underlying stock price.

Another, less frequently used way to lessen the cost of put protection is to use a “knock-out” option. A knock-out put is an “exotic” option that can be acquired only through an over-the-counter dealer (i.e., these types of options are not traded on an exchange). This type of put is less expensive than a “plain vanilla” put because the protection “knocks out” or disappears before its stated expiration if the stock price increases to a certain level. The rationale for using knock-out puts is that once the stock price increases to a certain level, the downside protection of the put is no longer necessary. Such exotic options can be implemented only for fairly large positions (i.e., there is a high minimum size requirement among the OTC dealers).

However, by far the most common way for stockholders to reduce the out-of-pocket expenditure necessary to achieve the desired downside protection is to enter into a cashless, or zero-premium, collar, which is discussed in the next section.

4.3.2.2. Cashless (Zero-Premium) Collars

Investors holding a concentrated position can implement what is commonly referred to as a cashless, or zero-premium, collar to (1) hedge against a decline in the price of a stock, (2) retain a certain degree of upside potential with respect to the stock, and (3) defer the capital gains tax while avoiding any out-of-pocket expenditure. The investor retains any dividend income and voting rights.

Cashless collars are a very popular tool that investors around the globe frequently use to hedge their concentrated positions.

When structuring cashless collars, investors buy puts with a strike price that is either at or, more typically, slightly below the current price of the stock. The investor must pay a premium to acquire the puts and in return is fully protected (subject to the credit risk of the counterparty) from any loss should the stock price fall below the strike price of the puts.

Simultaneously, the investors sell calls with the same maturity with a strike price that is above the current price of the stock and in return receives premium income. The strike price of the calls is set at the level that brings in exactly the amount required to pay for the puts. In other words, the sale of the calls fully finances the purchase of the puts.8 Note that investment risk is reduced but not eliminated.

Therefore, although the investor forfeits some of the upside potential of the underlying stock (i.e., the amount the stock price is above the call strike at maturity), by using a cashless collar, no out-of-pocket expenditure is required, and this is perceived to be a huge advantage by most investors and their financial advisers.

Consider again the investor who owns shares of ABC Corp. that are currently trading at $100. As before, ABC one-year puts with a strike price of $90 currently trade at $5. Suppose now that ABC one-year calls with a strike price of $120 currently trade at $5. The investor simultaneously sells the calls and buys the puts, with the $5 premium received for selling the calls fully financing the $5 premium paid to acquire the puts; therefore, no out-of-pocket expenditure is required.

If the stock price has increased above the $120 strike price at maturity, the calls will be exercised. In this case, Bill could deliver his long shares and receive $120 ($120 from the exercise of the calls plus the $5 call premium received less the $5 put premium paid).

If ABC closes between $90 and $120 at expiration, both the puts and calls will expire worthless and Bill will have paid the $5 put premium and received the $5 call premium. If the stock price decreases below the $90 strike price at maturity, the puts will be exercised. In this case, Bill could deliver his long shares and receive $90 ($90 from the exercise of the puts plus $5 from the sale of the calls less the $5 cost of the puts).

The concept of a cashless collar is very appealing to many investors and advisers. Nevertheless, investors often look for ways to increase the upside potential that is retained.

The most common way to accomplish this is to lower the strike price of the put. The lower the strike price, the lower the premium required to pay for the put. Therefore, a call with a higher strike price can be sold to finance the put purchase, resulting in greater upside potential. Of course, the lower the strike price of the put, the greater the downside risk the holder retains.

Another popular strategy is to combine a “put spread” (described above) with the sale of a call of the same maturity. The idea is to lessen the cost of the long put by selling a put to bring in some premium income to partially finance the purchase of the long put. This, in turn, allows a higher strike price call to be sold in order to fully finance the net cost of the put spread. The investor will be protected from the strike price of the long put down to the strike price of the short put. However, the investor is fully exposed to declines of the underlying stock below the strike price of the short put. In return for taking this risk, the investor will have more upside potential than with a plain vanilla cashless collar.

Along the same lines, investors sometimes pay a portion of the put premium “out of pocket,” which is often referred to as a “debit” collar. It allows a higher strike price call to be sold in order to finance the net cost of the put.

4.3.2.3. Prepaid Variable Forwards

A collar hedges the value of the concentrated position. The value of the concentrated position can concurrently be monetized by means of a margin loan. A prepaid variable forward (PVF) where the hedge and the margin loan are combined in one instrument achieves an identical economic result. The margin loan advanced to the client depends on the precise collar structure and its term. A PVF, in essence, is an agreement to sell a security at a specific time in the future with the number of shares to be delivered at maturity varying with the underlying share price at maturity. For example, an investor holding ABC Corp. shares currently trading at $100 might enter into a PVF requiring the dealer to pay the investor $88 up front in exchange for the right to receive a variable number of shares from the investor in three years pursuant to a preset formula that embodies the economics of a particular collar (e.g., a long put with a $95 strike and a short call with a $110 strike). The formula, in this case, would require the investor to deliver all its ABC Corp. shares if the price of ABC shares in three years is less than $95. If the price of ABC shares is greater than $95 but less than $110, the investor must deliver $95 worth of shares. If the price of ABC shares is above $110, the investor must deliver $95 worth of shares plus the value of the shares above $110.

Alternatively, a PVF can be cash settled. If the price of ABC shares is less than $95 three years from now, the investor will pay the dealer the then-current value of ABC shares in cash. If the price of ABC shares is between $95 and $110, the investor will pay the dealer $95 in cash. If the price of ABC shares is above $110, the investor will pay the dealer $95 plus the difference between the then-current price of ABC shares and $110. The investor could enter into another PVF to get the liquidity to satisfy its obligations under the original PVF. A PVF combines the economics of a collar and a borrowing against the underlying stock within a single instrument.

EXAMPLE 4

Hedging a Concentrated Position

Rachel LeMesurier recently retired from Denton Corp., where she experienced a long and successful tenure as a senior executive. During her 30-year career with Denton Corp., LeMesurier received a considerable portion of her compensation in the form of Denton Corp. shares. She currently owns 100,000 shares of Denton Corp. stock, which are currently trading at $40 per share.

LeMesurier has decided that she would like to hedge the risk of her $4 million position (= 100,000 shares × $40) in Denton stock. LeMesurier has been exploring various hedging alternatives with her financial adviser and feels that a cashless collar will give her the downside protection that she needs while still allowing her to participate to a certain extent should the price of Denton Corp. shares increase.

LeMesurier and her financial adviser know that there are two types of options: exchange traded and over the counter (OTC).

LeMesurier likes the transparency of exchange-traded options, as well as the fact that her counterparty will be a clearinghouse that is owned and guaranteed by all the exchange members as opposed to a single dealer, which means there is less counterparty risk when using exchange-traded options.

Currently, Denton Corp. one-year exchange-traded puts with a strike price of $36 are trading at a premium of $3 per share, and Denton Corp. one-year exchange-traded calls with a strike price of $48 are trading at a premium of $3 per share. Through her financial adviser, LeMesurier submits a spread order to simultaneously sell the calls and buy the puts covering her entire $4 million Denton Corp. stock position, with the $300,000 premium received for selling the calls fully financing the $300,000 premium required to purchase the puts.

The price of Denton Corp. shares traded in a range during most of the one-year period the collar was in place. On the expiration date of the collar, Denton Corp. shares closed at $42, and both the puts and calls expired worthless on that date.

In the country where LeMesurier is domiciled, like many other countries, the tax code does not treat all financial instruments that achieve the same economic result the same. The tax code in her country treats the call premium received on short calls as a current short-term capital gain whereas the premium paid to acquire puts is treated as a deferred long-term capital gain that merely increases the tax cost basis of the shares that were hedged.

1. Can this treatment result in a less-than-optimal tax result?

In the jurisdiction where LeMesurier is domiciled, OTC derivatives, including options, forwards, and swaps, are taxed more favorably than exchange-traded options. For instance, a forward contract or a swap could be used to achieve the same collar-like economics. By their very nature, the embedded call and put premiums are netted, and the economics of a long put/short call structure are built into a single contract, with the premiums automatically netted.

OTC options could also be used to implement a collar. Because the terms of such a collar are negotiated with a single dealer, the transaction could be structured and documented as a single contract, with the premiums effectively netted out. The trade confirmation for either type of collar will not show the cost of the call and put separately but will instead show a net cost of zero. Most option exchanges do not yet allow collars to be structured as a single contract.

1. Could OTC derivatives deliver a potentially more tax-efficient result than exchange-traded options?
2. Would there have been a cost to LeMesurier if she decided to implement her collar with OTC derivatives in lieu of exchange-traded options?

Solution to 1:

Yes. Because LeMesurier used exchange-traded options, she faces an immediate taxable gain on the expired calls. More specifically, the $300,000 premium LeMesurier received on the sale of the calls will be taxable in the year the options expired as a short-term capital gain.

However, because the tax code does not permit LeMesurier to deduct the $300,000 premium paid to acquire the puts in the year the options expired, the put premium instead increases her tax cost basis in her Denton Corp. shares. Therefore, LeMesurier gets the tax benefit of her loss on the puts only when she sells those shares, and she has no plans to sell her Denton Corp. shares.

Solution to 2:

Yes. If LeMesurier had used a collar based on OTC derivatives documented as a single instrument in lieu of exchange-traded options, she could have achieved a more tax-efficient result. Instead of being currently taxed on $300,000 of short-term capital gains and having deferred long-term capital losses of $300,000, which was added to her tax cost basis, LeMesurier could have had no taxable event at all had she used an OTC derivative and documented the collar properly.

Solution to 3:

Yes, the cost to LeMesurier of using an OTC derivatives–based collar in lieu of exchange-traded options is that the non-tax advantages (e.g., lower counterparty risk, transparency in pricing) of exchange-traded options are forfeited. However, many investors in LeMesurier’s situation feel this is a fair price to pay for the enhanced tax efficiency that an OTC derivative–based collar documented as a single instrument can deliver in certain jurisdictions.

4.3.2.4. Choosing the Best Hedging Strategy

The tax characteristics of the shares or other instrument that is being hedged can help determine which strategy will deliver the optimal result for the client.

To illustrate, it is not unusual for employees to receive compensation in the form of either restricted company shares or various forms of employee options to acquire common shares of their employer in the future. Because these types of instruments are received as compensation for services rendered, tax regimes often tax these types of instruments differently from common shares that have been held as an investment asset for a long-term period by an investor. For instance, restricted shares and employee stock options are often treated in a manner similar to other forms of compensation income, such as salary and bonus. These types of “ordinary income” are often taxed at significantly higher rates than long-term capital gains income.

A key tax issue that arises when hedging restricted shares and employee stock options is the potential tax inefficiency that can result if the instrument being hedged and the tool that is being used to hedge it produce income and loss of a different character. This problem is called a mismatch in character.

For example, when an employee exercises employee stock options, any gains are typically treated like cash salary and bonus — that is, as ordinary income. In contrast, most derivative-based hedging tools give rise to capital gains or losses. Therefore, in some jurisdictions, the use of a derivative-based collar to hedge employee stock options can create the potential for ordinary income on one hand (i.e., the employee stock options) and capital losses on the other (i.e., the derivative-based hedge). That is, if the underlying stock continues to appreciate above the strike price of the employee stock option, the investor will have ordinary income on the stock option and a capital loss on the hedge. Unless the employee has capital gains from other sources, the loss may not be currently deductible because capital losses are generally deductible against capital gains, not against ordinary income.

EXAMPLE 5

Mismatch in Character

David Hawk, a senior executive at US-based Garner-Price Corp., receives a large portion of his compensation in the form of stock options. These options will be taxed as ordinary income upon their exercise. Hawk decides to hedge his employee stock options using an option-based collar. During the period the collar is in place, the employee stock options increased in value by $10 million above the strike price of the collar.

1. Taking no account of either potential tax implications or the net cost of the collar, has Hawk benefitted economically from this increase in value?
2. Explain the problem of “mismatch in character” in hedging.
3. Describe the mismatch in character that potentially affects Hawk.

Solution to 1:

Economically and taking no account of potential tax implications, Hawk has not benefited from this increase in value because the $10 million of additional income on his employee stock options is exactly offset by the $10 million loss on the collar.

Solution to 2:

A mismatch in character occurs when the gain or loss in the concentrated position and the offsetting loss or gain in hedge are subject to different tax treatments.

Solution to 3:

When the collar expires and Hawk exercises his employee stock options, he will have an additional $10 million of ordinary income and $10 million of capital losses from the collar, resulting in a mismatch in character between the employee stock option income (ordinary) and the losses on the hedge (capital). Unless he has sufficient capital gains, he won’t be able to fully use those losses.

Therefore, while this option-based collar provided the desired economics (downside protection), it also resulted in $10 million of ordinary income in the current year with no offsetting deduction.

In Example 5, Hawk’s strategy was subject to a mismatch in character that implied taxes would be payable at ordinary income rates. Is there a possible solution to this dilemma? That is, is it possible to avoid such a mismatch in character? The answer depends on the tax treatment of alternatives to the collar used. In the United States, Hawk could consider a swap that has the optionality of a collar embedded within it. If the stock price rises above the embedded call strike, the investor will incur a loss on the swap. If the investor makes a payment to the dealer to terminate his obligation under the swap, depending on application of local tax law, the termination payment may or may not be treated as a deduction from ordinary income. With the appreciation of the employee stock options treated as ordinary income, if the loss on the swap is treated as a deduction from ordinary income, no mismatch in character would occur.

The key point is that the tax attributes and characteristics of the shares or other instrument that is being hedged can influence the decisions as to what hedging tool should be used and how the transaction should be documented.

4.3.3. Yield Enhancement

Investors can enhance the yield of a concentrated stock position while decreasing its volatility by writing covered calls against some or all of the shares.

Investors typically sell call options with a strike price that is above the current price of the stock and in return receive premium income. The amount of premium received will vary depending on a number of factors, including the volatility of the stock, the strike price, and the maturity. The investor retains any dividends received on the shares and voting rights.

The strategy effectively allows the investor to establish a liquidation value (the strike price) for the shares he or she writes call options against. However, the investor does retain full downside exposure to the shares (to the extent the stock price decreases by more than the premium received) and has capped the upside potential (the call strike price plus the premium received).

For example, suppose that Denton Corp. shares are currently trading at $100. Denton Corp.’s one-year call options with a strike price of $120 currently trade at $5, and Rachel LeMesurier sells these call options. If the stock price has increased above the $120 strike price at maturity, the calls will be exercised and LeMesurier will deliver her long shares. In that case, she will receive a total of $125: $120 upon the exercise of the calls and $5 from the initial sale of the calls. If Denton Corp. closes at or below $120 at expiration, the calls will expire worthless and LeMesurier will retain the $5 premium and the long shares. The end result is that LeMesurier is better off so long as the stock price at call expiration is below $125 (i.e., the strike price plus the call premium received).

Covered call writing is often viewed as attractive if the holder believes the stock will be stuck in a trading range for the foreseeable future. Covered call writing can be a good substitute for a structured selling program. Many financial advisers recommend that investors simply set multiple price targets today and sell a fixed number or percentage of their shares if and when the stock price reaches the previously established price targets. Essentially, the same economics can be achieved by entering into a covered call writing program (i.e., by selling call options with staggered maturities and strike prices), but the economics are considerably improved because the investor receives the call premium.

Perhaps the most significant benefit of implementing a covered call writing program, even if only on a portion of the concentrated position, is that it can psychologically prepare the owner to dispose of those shares.

4.3.4. Other Tools: Tax-Optimized Equity Strategies

Tax-optimized equity strategies seek to combine investment and tax considerations in making investment decisions. They start with the generic concept of tax efficiency and quantitatively incorporate dimensions of risk and return in the investment decision-making process. In the context of managing the risk of a concentrated stock position, these strategies are used in two primary ways: (1) as an index-tracking strategy with active tax management and (2) in the construction of completeness portfolios.

An index-tracking separately managed portfolio is funded by cash, from a partial sale of the investor’s concentrated stock position, from the monetization proceeds derived from the hedged stock position, or a combination of any of these. The portfolio is quantitatively designed to track a broad-based market index (e.g., the S&P 500 Index) on a pre-tax basis, and outperform it on an after-tax basis. The goal from an investment-return perspective is not to perfectly replicate the benchmark but to track it closely. Furthermore, these strategies use opportunistic capital loss harvesting and gain deferral techniques that can be used by the holder of the concentrated stock position to sell a commensurate amount of stock without incurring any capital gains taxes.

In contrast, a completeness portfolio incorporates the risk characteristics of the concentrated stock position to build a portfolio such that the combination of the two portfolios tracks the broadly diversified market benchmark to the best extent possible. The completeness portfolio minimizes correlation with the concentrated stock by not including similar industry and sector bets. Capital loss harvesting in the completeness portfolio allows a concurrent sale of the concentrated stock position without a tax liability. Over time, the size of the concentrated stock position is whittled down to zero, whereas the completeness portfolio becomes an index-tracking one.

This strategy is certainly one way for an investor to diversify out of a concentrated position, but it does come with certain risks and costs.

First, and most importantly, this strategy is intended to be implemented over time, so the investor continues to retain the company-specific risk of the remaining, albeit a progressively diminishing, concentrated stock position.

Second, in a perfect world (that is, assuming the concentrated stock position does not decrease precipitously early on during this process and the index proxy manager performs well), the best possible result will be that the client moves from holding a single low-basis stock to holding a diversified portfolio of lower-basis (i.e., not current) stocks. Hence, when this diversified market portfolio needs to be liquidated, there could be a tax associated with it.

4.3.5. Other Tools: Cross Hedging

In certain circumstances, it may not be possible for an investor to directly hedge a position. For instance, the derivatives required to accomplish this task may not exist in the marketplace or may be prohibitively costly to execute or the securities laws may preclude an insider or affiliate from executing a hedging transaction. In such a case, the investor might wish to consider an indirect or cross hedge by using derivatives on a substitute asset with an expected high correlation with the investor’s concentrated stock position.

After a careful analysis of a pool of securities with characteristics similar to the investor’s stock position, a security or basket of securities could be selected that have the highest correlation with the investor’s concentrated stock position. Another alternative would be to select a broad or targeted index that is investable to serve as the substitute asset.

By using a cross hedge, the investor is at least able to hedge market and industry risk. However, the investor retains all of the company-specific risk of the concentrated position.

Investors considering a cross hedge should probably limit themselves to purchasing puts on the proxy asset even though this will entail an out-of-pocket cost. If a cashless collar or short position is used, the investor is exposed to considerable risk should the concentrated stock position drop in value because of factors specific to that company while the proxy asset or index increases in value. In that case, if the proxy asset or index increases above the call strike or short-sale price, the investor is responsible for that amount when the stock position is down in value.

As always, all else being equal, the investor should use the derivative tool to implement the transaction that should deliver the desired economics in the most tax-efficient manner.

4.3.6. Exchange Funds

An exchange fund is an investment fund structured as a partnership in which the partners have each contributed their low-basis concentrated stock positions to the fund. Each partner (contributor to the fund) then owns a pro rata interest in the partnership potentially holding a diversified pool of securities. Participating in the exchange fund is not considered a taxable event; the partners’ cost basis in the partnership units is identical to the cost basis of the contributed concentrated stock positions. For tax purposes, each partner must remain in the fund for a minimum of seven years, after which he or she has the option to redeem his or her interest in the partnership and receive a basket of securities at the discretion of the fund manager equal in value to the pro rata ownership of the partnership or continue his or her investment in the fund.

5. MANAGING THE RISK OF PRIVATE BUSINESS EQUITY

As Exhibit 1 depicted, although there is slight variation from region to region throughout the world, a high percentage of private clients derive their wealth from the ownership of a privately owned business. Indeed, owning or controlling a private company can be a very exciting and rewarding experience for its owners. However, as discussed previously, business owners are exposed to a significant degree of concentration risk and illiquidity. Furthermore, they often significantly underestimate the risks inherent in owning and managing their businesses and may overestimate the value of their businesses.

Before a discussion on the risk concentrations of owning a privately held business, it is important to note that sale or divestiture of that business can have many more motivations apart from risk management compared with someone who owns a concentrated stock position, for instance. Some of these other considerations might include the time and effort needed to manage the business, the potential or disposition of heirs to succeed the business owner, and a myriad of other human, emotional, and family issues. It is prudent for an adviser to be cognizant of these non-investment issues before educating the business owner of the risks of his or her concentration.

Business owners are often asset rich but relatively cash poor. That is, many private company owners have most of their personal net worth tied up in their businesses. The owners quite often would like to generate liquidity to diversify in other investments in order to reduce their concentration risk. But there is likely little or no liquidity among the existing shareholders, and in fact, there is likely a prohibition against selling shares to anyone other than the company or its existing shareholders.

As they age and approach retirement, many business owners come to appreciate the high risks they face in continuing to own and operate their businesses and realize they must soon sell or otherwise monetize their private business equity to fund their retirement lifestyles. In many cases, the owner’s shares are likely to be highly appreciated versus their tax cost basis, and accessing meaningful liquidity can, and often does, trigger an immediate and sometimes significant taxable event. In addition, generating liquidity can, and often does, result in a loss of control or dilution of one’s ownership stake. Exhibit 6 lists major tools for dealing with a concentrated business equity position.

Exhibit 6. The Financial Tool Set for Managing Private Business Equity

Strategies that are available to allow company owners to generate full or partial liquidity include

• Sale to third-party investor:
• Strategic buyer
• Financial buyer
• Other investor
• Sale to insider:
• Management (management buyout, or MBO)
• Employees (employee stock ownership plan, or ESOP, in the United States)
• Sale or transfer to next generation of family
• Recapitalization
• Divestiture of non-core assets (often real estate)
• Personal line of credit against company shares
• Initial public offering (IPO)

These strategies use different sources of capital that can include

• Senior debt
• Mezzanine debt (debt that is subordinate to other debt including senior debt)
• Equity

The conduciveness of the market for business sale and monetization transactions varies greatly over time. At any given point in time, many factors determine the attractiveness of the market from the seller’s perspective, including

• Valuation level of target companies (at, above, or below historical norms)
• Tax rate applicable to a particular exit strategy
• Condition of the credit markets
• Level of interest rates
• Amount of buying power in the marketplace (strategic and financial buyers)
• Currency valuation

5.1. Profile of a Typical Business Owned by a Private Client

Most businesses owned and managed by private clients can be characterized as “middle-market” businesses. There is no universally accepted definition of the term “middle-market,” but these are businesses that are privately owned and worth anywhere from $10 million to over $500 million.

The business often comprises the bulk of the owner’s net worth. For instance, the private client might have a liquid portfolio of $3 million but own and manage a business that is worth $30 million. Real estate can often form a significant portion of the assets and value of the business. Alternatively, real estate may be held individually and leased to the business.

The business is typically the owner’s primary source of income and a means to fulfill legacy and charitable objectives. It is also usually a source of pride and personal identity for the business owner.

5.2. Profile of a Typical Business Owner

It is very difficult to generalize regarding business owners, but there are some commonalities that are worth noting. The business and personal lives of business owners are usually entangled because of the demands of managing and operating the business. Family members and business partners are often involved. Long-term objectives can vary and often change quickly.

Owners often underestimate the risks inherent in running their businesses. There is also a tendency to overestimate the value of their enterprise. Often the business has been owned and managed by the family for many years or decades. The owner has probably received unsolicited inquiries from potential buyers in the past.

In many cases, a business owner may not have an exit plan in place. The owner may know little about the process that should be used in deciding whether, when, and how to sell, monetize, or otherwise transfer the business. Aging aside, an unforeseen event may trigger the owner into action. Such events can include

• an unsolicited inquiry or offer from a competitor,
• illness of the owner or a family member, or
• the realization that a son or daughter does not wish to work in the business.

5.3. Monetization Strategies for Business Owners

Most business owners and their financial advisers are not familiar with the range of strategies that can be used to monetize their private business equity. Rather, most incorrectly assume that it is a “sell or hold” decision. In addition, most believe it is a one-time decision. It is possible, by using certain techniques, to implement an exit plan that is staged or phased over time to generate liquidity in more than one event. Conditions in the capital markets and the merger and acquisition deal market will ultimately influence the attractiveness of these strategies, and these factors differ greatly over time.

5.3.1. Sale to Strategic Buyers

Strategic buyers are competitors or other companies involved in the same or a similar industry as the seller. Most strategic buyers tend to take a long-term view of their investments in other companies. Because of this fact, they will typically pay the highest price for a business because of potential revenue, cost, and other potential synergies.

Strategic buyers are usually quite active in the marketplace, executing “add-on” or “fill-in” acquisitions, many of which involve middle-market companies. Strategic buyers view these types of acquisitions as a low-risk way to enhance revenue and earnings growth and view them as especially attractive in a slow growth environment.

5.3.2. Sale to Financial Buyers

Private equity firms are often referred to as financial buyers or financial sponsors. Private equity firms typically raise funds from institutional investors which they manage within investment funds known as private equity funds. They are investment advisers. They make direct investments in mature and stable middle-market businesses. They look for companies that provide the opportunity for them to create significant value.

Private equity firms typically will not pay as high a price as a strategic buyer primarily because they do not have the same opportunity as strategic buyers to take advantage of financial and operational synergies. They target earning a high internal rate of return on their invested capital over a fairly short period of time, typically three to five years, at which time the company will ideally either be sold to a strategic buyer or go public. To achieve their return targets, private equity firms have to be careful to not overpay at the outset.

5.3.3. Recapitalization

A leveraged recapitalization is a strategy that is especially attractive to middle-market business owners who would like to reduce the risk of their wealth concentration and generate liquidity to diversify but who are not yet ready to exit entirely and have the desire to continue to grow their businesses.

A leveraged recapitalization is essentially a leveraging of a company’s balance sheet, usually accomplished by working with a private equity firm. The private equity firm generally invests equity and provides or arranges debt with senior and mezzanine (subordinated) lenders.

The owner transfers a portion of her stock for cash and retains a minority ownership interest in the freshly capitalized entity. Doing so allows the owner to monetize a large portion of her business equity (typically 60–80%) and retain significant upside potential (20–40%) from that point forward. Because of the retained stake, the owner should remain highly motivated to grow the business.

From a tax perspective, the owner is typically taxed currently on the cash received. If structured properly, a tax deferral is achieved on the stock rolled over into the newly capitalized company. This strategy should be especially appealing to business owners who are considering cashing out in the near future and are domiciled in jurisdictions where tax rates are either scheduled to increase in the near future (such as Japan, at the time of writing) or viewed as likely to increase in the near future (such as the United States, at the time of writing).

The after-tax cash proceeds the investor receives could be deployed into other asset classes to help build a diversified portfolio.

A recapitalization is an example of a “staged” exit strategy in that it allows the owner to have two liquidity events, one up front and another typically within three to five years, when the private equity firm seeks to cash out its investment (which could be an IPO, a sale to a strategic or financial buyer, or another recapitalization). Because the owner is now partnering with a resource-rich private equity firm, the owner can focus on growing the business and will no longer have to personally guarantee bank debt. The owner does relinquish overall control of the company but may maintain day-to-day operating responsibility for the business and retains his or her title, salary, benefits, and reputation in the community as a successful entrepreneur.

Private equity firms are increasingly investing in middle-market companies. The recapitalization has become their vehicle of choice for doing so. For all these reasons, recapitalization is an attractive alternative to an outright sale to a third-party buyer.

5.3.4. Sale to Management or Key Employees

A group of senior managers or employees can acquire control of a business from the company owner through a management buyout (MBO).

For a sale to senior management or a group of key employees, the current owner knows the abilities of the key employees and the employees know the inner workings of the company. However, a serious risk is that these key employees may not, in fact, be successful entrepreneurs. That is, once the risk of owning and running the business is completely on their shoulders, they may not perform as hoped, and this is a huge uncertainty. For this reason, it is usually very difficult for senior managers and key employees to obtain financial backing from private equity firms and financial institutions; therefore, they usually cannot raise sufficient funds to make a serious cash offer. In most instances, the amount offered by management/employees rarely matches the sum offered by a third party if a third party is bidding.

As a result, in management buyout situations, the owner is often asked to finance a substantial amount of the purchase price in the form of a promissory note with a significant portion of the purchase price therefore deferred and sometimes contingent on the financial performance of the company. The negotiations often end when the owner sees the mix of consideration offered by the employees, typically a very low cash component and a large promissory note, and realizes the considerable risk he or she would be taking by selling to management/employees with unknown entrepreneurial capabilities and then acting as creditor to them.

Another important consideration is that because the owner is negotiating with people who work for him or her, a failed attempt to do an MBO has the potential to negatively affect the dynamics of the employer–employee relationship.

As a general rule of thumb, unless the owner has accumulated sufficient investable assets outside the business to sustain his or her desired lifestyle after the sale of the business, an owner should probably sell to key management/employees only if the pricing, terms, and conditions of their purchase offer matches or exceeds that of a third-party buyer.

5.3.5. Divestiture (Sale or Disposition of Non-Core Assets)

If a business owner is not yet ready to retire and wishes to continue to run the business but would like to generate some liquidity now in order to diversify, the owner may wish to sell or dispose of non-core assets. Non-core assets can be broadly defined as those that are not essential to the continued operation or growth of the company. This process is often referred to as a divestiture.

For instance, a company may be considering the possibility of exiting a certain line of business or closing a division that does not fit in with the future growth plans of the company, yet this business line or division may have value to a competitor. As another example, a company may hold real estate used for company operations that has a greater value in an alternative use. For example, agricultural real estate located near population centers may have a greater value when developed as residential or commercial property than in continued agricultural use.

5.3.6. Sale or Gift to Family Member or Next Generation

Private company owners can sell or transfer their business, usually through a combination of tax-advantaged gifting strategies, to a family member or members who are typically actively involved in the business.

Family members may not have the necessary capital to buy the business. It is difficult for family members to obtain the financial backing of private equity firms or financial institutions for the same reasons senior management has difficulty obtaining financing to implement an MBO. Family members usually cannot raise sufficient funds to make an acceptable cash offer. If a sale does occur, the owner may carry a significant portion (sometimes all) of the purchase price in the form of a promissory note.

Gifting strategies are often used to transfer ownership to the next generation. However, unless the owner has accumulated sufficient investable assets outside the business to sustain his or her desired lifestyle without regard to the business, gifting might not be feasible.

5.3.7. Personal Line of Credit Secured by Company Shares

The owner might consider arranging a personal loan secured by his or her shares in the private company. This option is usually completely overlooked, yet it can be an attractive alternative to the other strategies.

One of the key benefits is that this type of borrowing should not cause an immediate taxable event to the company or the owner if structured properly. This technique basically uses corporate debt capacity (assuming it is available) to avoid a taxable stock sale or dividend.

The transaction is usually structured with a “put” arrangement back to the company to make the lender comfortable. The company can support this put obligation either through its existing credit arrangement or with a standby letter of credit issued for this specific purpose.

The exercise of the put to the company as a source of repayment of the loan would likely be considered a taxable event to the business owner. Also, at some point the debt will need to be repaid.

In the interim, the owner maintains full ownership and control of the company, has access to cash to diversify his or her concentration risk, and avoids triggering a taxable event. In addition, in most jurisdictions, the interest expense paid on the loan proceeds should be currently deductible for tax purposes.

5.3.8. Going Public through an Initial Public Offering

An initial public offering (IPO) is possible if the company is in an industry deemed attractive by investors and has a history of steady and significant growth.

The costs associated with going public are significant, although the pricing received in numerous instances more than offsets these costs. Importantly, the privacy and authority that many private business owners find attractive and have come to take for granted are eliminated. The owner will be the CEO and an employee of a publicly traded company and will be subject to significant scrutiny. Any and all decisions are open for the investment community to question. The necessity and pressure to meet short-term quarterly revenue and earnings expectations of the investment community cannot be overstated.

As a general rule, if the owner’s objective is to exit from the company in the near term, an IPO is not a viable exit strategy. Rather, an IPO should be viewed as a financing tool that can be used to grow and take the company to a new level, assuming the owner wishes to remain actively involved in the company at least for the foreseeable future.

5.3.9. Employee Stock Ownership Plan

In some countries, legislation has been enacted that makes it attractive for a business owner to sell some or all of his or her company shares to certain types of pension plans.

For instance, in the United States, an employee stock ownership plan (ESOP) is a qualified retirement plan (i.e., a form of pension plan) that can be created by the company and is allowed to buy some or all of the owner’s shares of company stock.

In a version known as a leveraged ESOP, if the company has borrowing capacity, the ESOP borrows funds (typically from a bank) to finance the purchase of the owner’s shares.

US tax rules permit the deferral of the capital gains tax for a sale of stock to an ESOP, which can be an attractive benefit to the owner. However, this deferral benefit is available only to the shareholders of “Subchapter C” corporations, the details of which are beyond the scope of this reading.

The tax deferral benefit, combined with a possible step-up in basis at death (i.e., the elimination of tax on the capital gains), can make this strategy quite compelling for the owners of a Subchapter C corporation.

An ESOP is another example of a staged or phased exit strategy in that the company owner does not have to sell all of his or her shares to the ESOP. By using an ESOP, the owner can partially diversify his or her holdings, in a tax-advantaged manner, and diversify while retaining control of the company and maintaining upside potential in the retained shares.

Despite several potential disadvantages, including setup and maintenance costs, the strategy of selling shares to an ESOP, where it is a feasible strategy, can be attractive.

5.4. Considerations in Evaluating Different Strategies

In evaluating different strategies, the objective should be to maximize the after-tax proceeds that are available to the business owner to re-invest as opposed to simply maximizing the sales price. Astute transactional tax planning and structuring is extremely important and can result in significant tax savings for the owner.

The strategies described above may result in different values for the company that is being sold or monetized. The sale of private business equity differs from the sale of shares of publicly traded stock, where the shares trade on an established stock exchange and there are ready buyers and sellers. Rather, a market needs to be created for private business equity, and the potential buyers discussed above may place different values on the business and different equity interests therein. Therefore, the most important factor determining the amount that the business owner will receive after monetizing the business is the strategy that is ultimately used. As stated previously, a strategic buyer will typically pay the highest amount for a business.

The bulk of the consideration received by the business owner pursuant to a sale or monetization transaction is typically paid up front, but it is not uncommon for a portion of the purchase price, sometimes a significant portion, to be deferred or even to be contingent upon the occurrence of certain future events. For instance, the seller might lend the buyer a portion of the purchase price. Another example is when the seller and buyer agree to bridge the gap between what they each feel the company is worth by using an “earn-out.” With respect to an earn-out, the payout is based on the company meeting or exceeding certain milestones, such as revenue or earnings targets. If the targets are met, the seller receives the post-closing payment (which may have been held in escrow). Therefore, when considering the “sale price,” one must consider how much is paid up front in cash (or stock) and how much is deferred or contingent (and how likely it is that it will actually be received). As indicated, after-tax amounts are relevant to decision making. Example 6 builds on Example 2.

EXAMPLE 6

A Business Owner and the Concentrated-Position Decision-Making Process (2)

Recall that Fred Garcia had been persuaded by his financial advisor, Bill Wharton, that a sale to a strategic buyer or a recapitalization would satisfy his primary capital requirement of $35 million. Wharton then introduced Garcia to an investment banking firm to explore all exit strategies. The following facts were established:

• The government in Garcia’s country is expected to increase the tax rate on capital gains, effective the following year.
• Garcia wants to spend more time with his family.
• Garcia is very attached to his identity as CEO of an aircraft business.
• Garcia believes that if his company had a capital infusion, his company would be positioned to triple its earnings within several years.

The financial data are shown from Exhibit 3, repeated here.

Exhibit 3. Wealth Distribution Shown in Risk Buckets (repeated)

“Personal” Risk
4%
Protective Assets

“Market” Risk
6%
Market Assets

“Aspirational” Risk
90%
Aspirational Assets

Home

$1,000,000

Equities

$1,500,000

Family Business

$40,000,000

Mortgage on Primary Residence

$0

Intermediate- and Long-Term Fixed Income

$1,500,000

Investment Real Estate

$5,000,000

Cash/Short-Term Treasury Bonds and Notes

$1,000,000

Total

$2,000,000

Total

$3,000,000

Total

$45,000,000

1. Discuss which factors favor a sale to a strategic buyer and which factors favor a recapitalization.

Suppose that Garcia decides on a recapitalization. Garcia receives 80% of the value of the company in cash from a private equity firm, taxed at the current 15% capital gains tax rate. Investment real estate is included in the transaction. Assume that $10 million of proceeds are added to Garcia’s personal risk bucket and the remaining balance of proceeds is added to his market risk bucket. The private equity firm shares Garcia’s optimism about the potential growth of the company and is ready to extend debt financing to it on favorable terms.

1. Calculate the (after-tax) amount monetized by the recapitalization and the value of his stake in the business immediately after recapitalization.
2. Explain the meaning of primary capital in this context. Evaluate whether the amount monetized, combined with his existing portfolio, meets Garcia’s requirement for $35 million in core capital. Justify your answer.
3. Describe a likely management objective of the recapitalized company.

Solution to 1:

These facts favor a sale to a strategic buyer:

• In a sale, Garcia would be relieved of the day-to-day pressure of owning and running the business and therefore have more time to spend with his family.
• A sale to a strategic buyer would generally realize the highest current proceeds. A sale now would avoid the expected higher tax rate.

These facts favor a recapitalization:

• Garcia would retain his highly valued identity as CEO of his firm.
• A recapitalization could raise capital that would allow the expansion to realize a major increase in earnings and value of the company within a relatively short time frame.

Solutions to 2:

1. Sales price × Percent of equity sold × (1 — Tax rate) = $45 million × 0.80 × (1–0.15) = $30.6 million, which is the amount monetized. The value of Garcia’s 20% stake is $9 million before any possible valuation discounts for the lack of control or limited marketability of the shares.
2. Primary capital is the sum of the personal risk bucket and the market risk bucket. Yes, the recapitalization will meet Garcia’s primary capital needs. The personal risk bucket becomes $2 million + $10 million = $12 million. That leaves $30.6 million — $10 million = $20.6 million. The market risk bucket is $3 million + $20.6 million = $23.6 million. Primary capital is $12 million + $23.6 million = $35.6 million. Exhibit 7 diagrams the allocation of Garcia’s wealth after the recapitalization with some assumed asset allocations of the invested proceeds.

Exhibit 7

“Personal” Risk
27%
Protective Assets

“Market” Risk
53%
Market Assets

“Aspirational” Risk
20%
Aspirational Assets

Home

$1,000,000

Equities

$6,000,000

20% Interest in Recapitalized Business

$9,000,000

Mortgage on Primary Residence

$0

Intermediate- and Long-Term Fixed Income

$6,000,000

Inflation Indexed Treasury bonds

$5,000,000

Alternative Investments

$11,600,000

Cash/Short-Term Treasury Bonds and Notes

$6,000,000

Total

$12,000,000

Total

$23,600,000

Total

$9,000,000

Note how Garcia’s risk allocations have changed: 27% to personal risk, 53% to market risk, and only 20% to aspirational risk based on the new after-tax portfolio value of $44.6 million. Note also, however, that Garcia’s net worth on paper has declined 10.8%, from $50.0 million to $44.6 million, as a result of gains realization and portfolio realignment decisions.

Solution to 3:

With the capital the private equity firm may add through a debt infusion, if growth expectations are realized, the private equity firm may seek to exit from its investment by either going public or selling out to a strategic buyer several years down the road. This second exit could be very profitable for Garcia.

EXAMPLE 7

Short Sale against the Box

Sam Smith, age 73, is the founder and 100% owner of ScreenTime, Inc., a technology company. The investment banker of Peak Products, Inc., a publicly traded competitor, has approached Smith with a two-pronged offer to buy. Smith engages the investment banker, Beverly Capital (BC), to evaluate Peak’s offer. Other pertinent facts are as follows:

• One offer is $300 million, all cash, for all of Smith’s shares.
• A second offer is $350 million in Peak shares in exchange for all of Smith’s shares, with no cash consideration.
• The capital gains tax rate is 25%.
• BC advises that, as structured, the second offer qualifies as a tax-free stock swap (i.e., a type of business sale transaction that does not trigger an immediate taxable event). The tax cost basis that Smith has in ScreenTime shares, essentially zero, would become his tax cost basis in Peak shares transferred to the Peak shares.
• Although referred to as a tax-free stock swap, the actual result is a deferral of the capital gains tax. That is, a taxable gain would occur if and when Smith sold his Peak shares.
• Smith is domiciled in a country where the current tax regime allows for a stepped-up basis in shares held at the time of the investor’s death. That is, upon Smith’s death, the Peak shares received by Smith’s estate or beneficiaries would receive a tax cost basis equal to fair market value on the date of Smith’s death. Thus, at death, accrued gains permanently escape income taxation.
• Smith is unwilling to bear the risk of holding Peak shares. Suppose that if Smith accepts a tax-free stock swap, he is able to sell the Peak shares short against the box. He would realize 99% of the value of the Peak shares with no limitations on the use of proceeds. The after-tax cost to access the proceeds would be locked in at 30 bps per year. Smith would be able to keep the position in place indefinitely.

1. Discuss the implication of Smith’s unwillingness to bear the risk of the Peak shares.
2. Determine the value of the all-cash offer.
3. Determine the value of the tax-free stock swap offer with immediate sale of the Peak shares.
4. Determine the value of the tax-free stock swap offer with a short sale against the box.
5. Recommend a strategy to Smith.

Solution to 1:

The implication is that Smith needs to consider the all-cash offer, the tax-free stock swap offer with immediate sale of Peak shares, or the tax-free stock swap offer along with a long-term hedging strategy to remove the risk of Peak shares.

Solution to 2:

The all-cash offer is worth $300 million × (1–0.25) = $225 million.

Solution to 3:

The tax-free stock swap offer with immediate sale of Peak shares is worth $350 million × (1–0.25) = $262.5 million (assuming the block of stock can be sold without any adverse price impact and ignoring the cost to sell the Peak shares).

Solution to 4:

This strategy monetizes 0.99 × $350 million = $346.5 million at a cost of 0.0030 × $346.5 million = $1.04 million per year.

Solution to 5:

The tax-free stock swap offer in exchange with short selling against the box realizes the greatest value for Smith. The 25% capital gains tax will be indefinitely deferred, and if the shares are held until death, the capital gains tax will be eliminated because the Peak shares will receive a step-up in basis upon Smith’s death. At that point, Smith’s estate could close the short position, and no tax would be due. With Smith well into his 70s, the present value of the step-up in basis should be fairly high.

6. MANAGING THE RISK OF INVESTMENT REAL ESTATE

Real estate can constitute a significant portion of the value of a business. It can also be held as a stand-alone investment. Real estate can also constitute a significant portion of a private client’s net worth.

Real estate owners are often exposed to a significant degree of concentration risk and illiquidity. In addition, real estate owners may underestimate those risks and overestimate the value of their properties.

Real estate owners may want to generate liquidity to diversify and reduce their concentration risk. Especially as they age and approach retirement, real estate owners may better recognize the risks inherent in owning real estate and the benefits of selling or otherwise monetizing their property to fund their retirement.

The owner’s property is likely to have been held for a long period and to be highly appreciated versus its original tax cost basis. Accessing meaningful liquidity may trigger recognition of a tax liability.

Various forms of debt and equity financing are the primary capital markets tools that investors use to facilitate monetization events involving their real estate investments. Mortgage financing can be recourse or non-recourse and can be either fixed rate or floating rate. The conduciveness of the market for investment real estate sale and monetization transactions varies over time. At any given time, numerous factors determine the attractiveness of the market from the seller’s perspective including the following:

• Current valuation of real estate relative to historical levels and future expectations
• Tax rate applicable to a particular property and transaction
• Condition of the credit markets and lending conditions
• Level of interest rates

6.1. Monetization Strategies for Real Estate Owners

As for private businesses, the strategies that real estate owners can use to monetize their properties include exit plans that are staged or phased to generate liquidity in more than one event. Real estate monetization decisions should never be motivated solely for tax reasons. The business or investment rationale for the transaction needs to make sense. If it does, then the next step is to explore the most tax-efficient execution.

6.1.1. Mortgage Financing

Besides an outright sale, which is the most common strategy, the use of mortgage financing is the next most common technique investors use to lower concentration in a particular property and generate liquidity to diversify asset portfolios without triggering a taxable event.

Consider an investor who owns a high-quality, income-producing property with a fair market value of $10 million. Suppose that the property has a tax cost basis close to zero. An outright sale of the property, given a capital gains tax rate of 25%, would result in the investor receiving $7.5 million in after-tax proceeds from the sale. The investor would have no further benefit if the property increased in value in the future.

As an alternative to an outright sale, the owner might obtain a fixed-rate mortgage against the property. He could seek to set the LTV (loan to value) ratio at the point where the net rental income generated from the property equaled the fixed mortgage payment (composed of interest expense and amortization of the loan principal). Assuming this cash flow–neutral LTV ratio is 75%, the investor could monetize $7.5 million of the real estate’s value with no limitations on the use of the loan proceeds. The proceeds could be invested in a liquid, diversified portfolio of securities. The loan proceeds will not be taxed because they are not “income” for tax purposes. In addition, the net rental income derived from the property exactly covers the cost of servicing the debt and other expenses of the property, so the net income from the real estate is zero. Therefore, there are no income tax consequences from the transaction. If the value of the real estate increases over time, the investor will be able to borrow more against the property without triggering a taxable event.

If the investor is able to structure the borrowing as a non-recourse loan (meaning that the lender’s only recourse upon an event of default is to look to the property that was mortgaged to the lender), the investor has economically acquired the equivalent of a put issued by the lender with a strike price of $7.5 million that has been 100% monetized, thereby reducing her concentration risk in the property.

Borrowing against appreciated, income-producing real estate, especially on a non-recourse basis, can be an attractive technique to effectively “realize” unrealized real estate gains. In lieu of selling the asset outright to realize the gain and trigger an immediate taxable event, the owner can often borrow against the property to access the same or a similar amount of proceeds that a sale would have generated but without paying any tax — and often with a net cost of carry close to zero — while capturing 100% of any increase in the property’s value.

6.1.2. Real Estate Monetization for the Charitably Inclined

The implications of asset location for taxable investors can be significant. Asset location is not a concept that is applicable only to securities. Rather, asset location is important for concentrated positions, including real estate. For instance, financial advisers serve many clients who are charitably inclined, and there are many tools and techniques that can be used under different tax regimes to achieve their philanthropic goals that involve asset location.

In the United States, if a client would like to build a significant endowment fund over the next few years and allow the assets to grow tax free until grants are made, the use of a donor-advised fund (DAF) can deliver a very attractive result. For example, suppose an investor owns a rental property that is worth $2 million. The investor wants to endow a named professorship at the university from which he graduated several years ago. The amount needed to fund the professorship is $3 million. Especially if the investor believes that the property’s growth prospects are less compelling than those of some other asset classes (e.g., publicly traded securities), the investor might decide to contribute the property directly to a DAF. If the property is then sold by the DAF to be invested in those more promising investments, there will not be an immediate taxable event. The appreciation forever escapes taxation. Nor are the accumulated depreciation deductions taken by the investor ever “recaptured.” Therefore, the full $2 million would be available to invest and manage. Importantly, those proceeds grow tax free because the DAF qualifies as a charitable organization. In addition, the investor would qualify for an immediate $2 million charitable contribution deduction with a potential value of $700,000, given an applicable 35% income tax rate.9 When the target of $3 million is reached, the DAF could then fund the professorship at his alma mater.

Similarly, in most common law jurisdictions, a tax-exempt charitable trust would achieve the same purpose as a DAF. The trust would have a defined and charitable purpose, the contributor would receive a tax deduction from the donation to trust, and the trust would not be taxed on property sale proceeds or investment income emanating from the property.

6.1.3. Sale and Leaseback

A sale and leaseback is a transaction wherein the owner of a property sells that property and then immediately leases it back from the buyer at a rental rate and lease term that is acceptable to the new owner and on financial terms that are consistent with the marketplace. In a typical transaction, a corporation will sell its real estate asset(s) to another party, which could be a real estate investment trust (REIT) or an institutional or private investor, and then lease the property back at a rental rate based on current market conditions.

The primary goal of a sale and leaseback is to raise capital or free up the owner’s equity (that is invested in the property) for other uses while retaining use of the facility. When credit markets tighten (as they did throughout the world in 2008), sale and leasebacks may still be available for raising capital for business owners who are occupants of office buildings, manufacturing facilities, and industrial warehouse facilities.

The potential benefits of a sale and leaseback include the following:

1. It provides a source of capital to distribute to shareholders.
2. It provides 100% of the value of the asset compared with traditional mortgage debt financing, which rarely exceeds 75% unless the tenant is investment grade from a credit perspective. However, a taxable event is triggered and the after-tax proceeds will be less than 100% unless the company has a capital loss that can shield the gain from taxation.
3. The owner can redeploy the capital into the core focus of the business, and doing so may yield greater returns than would be generated by real estate investment.
4. Any debt that was associated with the real estate is removed from the balance sheet.
5. There is typically complete rental payment deductibility for tax purposes, meaning that rental payments under a sale and leaseback structure are typically 100% deductible against the company’s taxable income, versus only the interest expense component of a mortgage payment. Sale and leasebacks have flexible lease terms — usually 10–20 years with built-in renewal options.

In sum, for individuals who wish to monetize their real estate assets to fund a liquidity event for shareholders, to invest the capital in their core business, or to use it for other strategic purposes, a sale and leaseback can be an attractive financing alternative to traditional lending sources.

6.1.4. Other Real Estate Monetization Techniques

There are many real estate monetization techniques that are available but are outside the scope of this reading, including joint ventures, condominium structures, and sales of buildings with the seller retaining control through a long-term ground lease. In the United States, it is possible to implement what is referred to as a “monetizing tax-free exchange,” which effectively allows a holder of an appreciated property to hedge, monetize, and defer and eventually eliminate the capital gains tax.10

EXAMPLE 8

Refinancing or Sale Leaseback?

Albert Lee is the owner of a medium-size business and is seeking to raise capital to facilitate the growth of the business. Lee wishes to either (1) sell and leaseback or (2) refinance his free and clear warehouse to raise capital. The warehouse is worth $5 million. Assume the following facts:

• By refinancing, Lee can achieve an LTV ratio of 75% and raise $3.75 million. By using a sale and leaseback, Lee can raise, on a pre-tax basis, 100% of the value of the warehouse, or $5 million.
• The warehouse is owned by Lee, not by the business, and is not key to the success of the business.
• Lee has $5.0 million of capital losses to carry forward, resulting in a deferred tax asset of $1.5 million related to capital loss carryforwards.
• The capital gains tax rate is 25%.

State and justify two reasons in favor of a sale and leaseback (to the corporation) rather than a refinancing.

Solution:

(1) Lee can realize $1.25 million more through a sale and leaseback. (2) The warehouse is not a key business asset.

If Lee refinances the warehouse, he can deduct the interest expense and defer the payment of any taxes. However, the maximum amount he can raise is $3.75 million = $5 million × (1–0.25). If the sale and leaseback is used, without any capital loss carryforwards, Lee would monetize $3.75 million, but he would also have to pay the capital gains tax. However, the $1.5 million in capital loss carryforwards could be used to fully offset the 25% capital gains tax of $1.25 million. Thus, a sale and leaseback would realize $5 million. Note that with a sale and leaseback, Lee can deduct the annual lease payment. If the warehouse was a key business asset, that would be a point in favor of refinancing, which would leave Lee with full ownership and control over the property. However, that is stated not to be the case.

SUMMARY

Much of the wealth owned by private clients throughout the world is held in the form of concentrated single-asset positions (concentrated positions), which include concentrated positions in publicly traded stock, privately owned businesses, and investment real estate.

• Owners of concentrated positions can face significant investment risks, including systematic, company-specific, and property-specific risk. Concentrated positions are also typically illiquid.
• There are three primary objectives that concentrated position owners should address. The first is to reduce the risk of wealth concentration by diversifying asset holdings. The second is to generate sufficient liquidity within a portfolio to meet current and future spending needs. The third is to optimize tax efficiency.
• Investors face many constraints when managing a concentrated position, including the income tax consequences of an outright sale, the inherent illiquidity of concentrated positions, and psychological considerations, such as the existence of any cognitive or behavioral biases.
• The concept of asset location and gifting strategies can often be used together to minimize transfer taxes for concentrated positions. Advisers able to work with clients before the concentrated position has appreciated greatly in value can have the most impact. With the passage of time, after there has been some increase in the concentrated position’s value, wealth transfer tools, while still useful, tend to be less efficient, more complex, and more costly to implement, which underscores the importance of planning the management of an owner’s concentrated positions as early as possible.
• There are often several economically equivalent ways to hedge or monetize a concentrated single-stock position. Because tax regimes governing the taxation of financial instruments differ, the tax results might be disparate. Investors can reap substantial tax savings or reduce tax risk by selecting and implementing the form of a transaction that delivers the optimal tax result.
• When hedging a concentrated single-stock position, investors can use either exchange-traded instruments (i.e., options or futures) or over-the-counter (OTC) derivatives (i.e., options, forward sales, or swaps). Each has its own advantages and disadvantages.
• Equity monetization refers to the transformation of a concentrated stock position into cash. Equity monetization usually refers to transactions designed to generate cash through a manner other than an outright sale in a way that avoids triggering a current taxable event.
• Equity monetization entails a two-step process. The first step is to remove most of the risk of the concentrated position. That is, the investor establishes a nearly riskless position in the stock. The second step is for the investor to borrow against the hedged position. In most instances, a high loan-to-value (LTV) ratio is achieved because the stock position is hedged and the loan proceeds are then invested in a diversified portfolio of other investments.
• The four basic equity monetization tools are (1) short sales against the box, (2) total return equity swaps, (3) forward conversion with options, and (4) forward sale contracts or single-stock futures contracts.
• Most tax regimes respect the legal form of a transaction over economic substance, and therefore, equity monetization techniques, if structured properly, do not typically trigger an immediate taxable event.
• Investors who wish to hedge their concentrated single positions but want to retain some upside potential can consider the use of long puts and cashless collars.
• The economics of a collar can be achieved through a variety of derivative tools, including exchange-traded options, OTC options, forwards, and swaps. Because these tools may be taxed differently, the investor should use the tool that delivers the most tax-efficient result, which often involves avoiding a mismatch in character.
• Business owners may be asset rich but cash poor because many private company owners have most of their personal net worth tied up in their businesses. The owners often want to generate liquidity to diversify into other investments in order to reduce their concentration risk, but there is typically little or no liquidity among the existing shareholder base.
• The common assumption of business and real estate owners that the monetization decision is a “sell or hold” decision and a “once and done” decision is not correct; exit plans can be staged or phased over time to generate liquidity in more than one event.
• Different business monetization strategies often result in different values for the company that is being sold or monetized. Strategic buyers may place higher values on the business compared with financial buyers. Selling to employees is also a possibility, although usually the seller will have to finance a portion of the sale price.
• In business and real estate sale and monetization transactions, the objective should be to maximize the after-tax proceeds that are available to re-invest.
• In a leveraged recapitalization, a business owner partners with a private equity firm and transfers his or her stock for cash and a minority ownership interest in a freshly capitalized entity. The owner monetizes a large portion of his or her business equity (typically 60–80%) and retains significant ownership (20–40%) from that point forward. Because of the retained stake, the owner should remain highly motivated to grow the business.
• Borrowing against appreciated, income-producing real estate, especially on a non-recourse basis, can be an attractive technique to effectively “realize” unrealized real estate gains. In lieu of selling the asset outright to realize the gain and trigger an immediate taxable event, the owner can often borrow against the property to access a large fraction of the proceeds that a sale would have generated but without paying any tax. However, with borrowing, the investor still bears the economic risk of the underlying property.

PRACTICE PROBLEMS

© 2013 CFA Institute. All rights reserved.

John C. Hill, sole owner of JCH Equipment Leasing Co. (JCH), is evaluating a future sale of his company and approaches Mary Keller, a wealth adviser, for advice. Three discussions from their most recent meeting are shown in Exhibit 1.

Exhibit 1. Selected Discussions from Hill–Keller Meeting

Discussion Number

Speaker

Discussion

1

Hill:

I would like to sell JCH in three to five years and use the proceeds to fund my retirement. Up to this point, I have reinvested the majority of the profits back into the business and have not accumulated any meaningful wealth outside the business.

Keller:

The first thing we need to consider is the cyclical nature of the equipment leasing industry. Although the economy is expanding today, the stage of the business cycle three years from now is uncertain.

2

Hill:

I have several good employees, but I make all of the strategic operating decisions for the company. I take great pride in the stellar reputation of the company and have been reluctant to cede any meaningful control. I have started the process of looking for a person to assist with the day-to-day operations of the company.

Keller:

Because you are the sole owner and chief operator of the business, you are exposed to the consequences of a negative corporate event that may result in essentially permanent losses in wealth.

3

Hill:

I believe the operating enterprise is worth $45 million. There is a good chance that a large acquirer would not want the real estate associated with it.

Keller:

I am concerned about the rural location, size, tailored nature of the structure, and the old fuel tanks located behind the warehouse.

1. For each discussion, identify what type of investment risk is being discussed by Hill and Keller. Justify each choice. Answer Question 1 in the Template provided below.

Template for Question 1

Discussion

Investment Risk
(circle one)

Justification

1

systematic

non-systematic

2

systematic

non-systematic

3

systematic

non-systematic

The following information relates to Questions 2–11

Hill refers his friend, Richard Morrison, the former CEO of Masury Bridge and Iron (MBI), to Keller to discuss his wealth goals. Keller meets with Morrison and gathers the following information:

• Richard Morrison is 50 years old and his spouse, Meredith, is 49 years old. Both are healthy and both expect to live at least an additional 40 years.
• The Morrisons have a 20-year-old son and would like to transfer 5% of their wealth to him during their lifetime.
• Richard Morrison retired two years ago and intends to spend his time serving on philanthropic boards; Meredith does not work.
• The Morrisons own 2 million shares of MBI, currently valued at $50 million, representing approximately 90% of their wealth.
• MBI is a large, publicly traded company, and the Morrisons’ position equals approximately 1% of the total market capitalization.
• The Morrison family depends on dividends from MBI for their day-to-day living expenses.
• The cost basis of their MBI shares is close to zero, and the capital gains tax rate is 15%.
• Richard Morrison is loyal to MBI, follows the stock closely, believes he knows the company better than other investors, and expects the company to continue to be a good investment in the future just like it has been in the past.
• The Morrisons’ key objective is to maintain their current standard of living during retirement.

1. Identify and describe three primary objectives Keller would typically discuss with clients in the Morrisons’ position.
2. State and discuss two constraints on the Morrisons’ ability to achieve their primary objectives using an outright sale of MBI shares.
3. Explain three emotional biases that may affect Richard Morrison’s decision making.

Keller realizes that the Morrisons’ decision making is influenced by psychological considerations and decides to use a goal-based planning approach. Keller constructs Exhibit 2 to simplify the discussion at their next scheduled meeting.

Exhibit 2. Morrison Family Wealth Distribution

Personal Risk Bucket

Market Risk Bucket

Aspirational Risk Bucket

3% of Assets

7% of Assets

90% of Assets

Home: $1,110,061
Cash/Short-term Investments: $556,606

Equities: $1,850,505
Fixed Income: $1,800,404
Commodity: $237,980

MBI Stock: $50,000,000

Total: $1,666,667

Total: $3,888,889

Total: $50,000,000

1. Describe Keller’s use of goal-based planning to highlight the consequences of the Morrisons’ selecting an asset allocation that is too risky.
2. Determine if the current wealth distribution is consistent with the Morrisons’ stated key objective. Justify your response.

Keller tells the Morrisons:

“Diversification is a bedrock investment principle, and there are several tools that can be used to mitigate the risk of a concentrated single stock position.”

1. Identify and describe three tools Keller is referring to in the above statement.

Keller and Richard Morrison discuss several hedging techniques and Morrison makes the following statement:

“I like the strategy that allows me to lock-in a floor price and retain unlimited upside potential.”

1. Identify and discuss the hedging tool that Morrison is most likely referring to in the above statement.
2. Explain one drawback of this hedging strategy.

Keller also discusses a yield enhancement strategy and asks Morrison to establish a liquidation value at which he would be willing to sell 10% of his position in MBI.

1. State and discuss the tool Keller is most likely recommending to Morrison.
2. Explain two drawbacks to this strategy.

Keller and John C. Hill, the sole owner of JCH Equipment Leasing Co. (JCH), meet to further consider alternate strategies to achieve his objectives of selling JCH, diversifying his single asset concentration, minimizing taxes, and retiring within a 3−5 year time period. Hill believes that tax rates are likely to increase in the near future. In the course of a discussion with Hill, Keller recommends that Hill meet with a reputable “middle market” private equity firm to discuss a leveraged recapitalization strategy.

1. Describe a leveraged recapitalization strategy and determine if this strategy will accomplish Hill’s objectives.
2. Explain two disadvantages to this exit plan.

SOLUTIONS

1. Template for Question 1

Discussion

Investment Risk
(circle one)

Justification

1

Discussion 1 best describes systematic risk. Systematic risk is the component of risk that cannot be eliminated by holding a well-diversified portfolio. Systematic risk includes macroeconomic factors such as unexpected changes in the level of real business activity and unexpected changes in the inflation rate. Given the cyclical nature of the equipment leasing business and 3 to 5 year target horizon to sell the company, Hill’s concentrated position in JCH is exposed to systematic risk.

systematic

non-systematic

2

Discussion 2 best describes non-systematic risk, or company-specific risk. This type of risk is specific to a particular company’s operations, reputation, and business environment. Hill is the sole owner and chief operator of JCH (key person); therefore, his concentrated position exposes him to a decline in value of the company should he become unable to run the day-to-day operations. Such a negative corporate event may result in essentially permanent losses in wealth.

systematic

non-systematic

3

Discussion 3 best describes non-systematic risk, or property-specific risk. It is the risk that the value of a particular property might fall in value because of an event that could affect that property, but not the broader real estate market.

systematic

non-systematic

1. The typical objectives Keller would discuss include reducing the risk of wealth concentration, generating liquidity to diversify and satisfy spending needs, and achieving the prior objectives in a tax-efficient manner.
2. Two constraints that may inhibit the Morrisons from achieving their primary objective are the tax consequences of a sale and the attachment of Mr. Morrison to his company as an investment. With a cost basis of nearly zero, an outright sale in the current year would result in the Morrisons incurring a capital gains tax of approximately $7.5 million.
3. A number of emotional biases can negatively affect the decision-making of holders of concentrated positions. Specifically, Richard Morrison’s decision to diversify may be negatively affected by loyalty effects, overconfidence/familiarity, and status quo/naïve extrapolation of past returns. The facts indicate that Mr. Morrison is extremely loyal to MBI (loyalty effect); he believes he knows the company better than other investors (overconfidence/familiarity); and he expects the company to continue to be a good investment as it has been in the past (status quo/naïve extrapolation of past returns).
4. Goal-based planning allows the adviser to incorporate psychological considerations into the asset allocation and portfolio construction process. This approach highlights the consequences of selecting an asset allocation that is riskier than is appropriate for a particular investor. A goals-based methodology extends the Markowitz framework of diversifying market risk by incorporating several notional “risk buckets.” The first bucket is the personal risk bucket, which includes assets such as a personal residence, certificates of deposit, treasury securities, and other safe investments. The goal of this bucket is protection from poverty or a decrease in lifestyle. The second bucket is the market risk bucket, which includes assets such as stocks and bonds. The goal of this bucket is to maintain the current standard of living. The third bucket is the aspirational risk bucket and includes assets such as a privately owned business, commercial and investment real estate, and concentrated stock positions. The goal of this bucket is the opportunity to increase wealth substantially. This type of risk allocation framework would give Keller a basis to sit down with the Morrisons and identify the significant risk they face from their concentrated position and highlight that their allocations to the personal risk and market risk buckets are inadequate.
5. The Morrisons’ current distribution of wealth is inconsistent with their stated objective of maintaining their current standard of living. The Morrison family portfolio has 90% of their wealth allocated to MBI stock, which falls into the high risk/high return aspirational risk bucket, and only 10% allocated to the personal risk and market risk buckets. A significantly greater allocation to the personal risk and market risk buckets combined with diversification of the single asset concentration (MBI) would be consistent with the stated goal of maintaining their current standard of living into retirement.
6. The three tools for addressing a concentrated position in a publicly traded common stock include outright sale, monetization, and hedging. With an outright sale, owners can sell the concentrated position, which gives them funds to meet a spending need or reinvest. An outright sale typically results in significant tax liabilities. Monetization strategies provide the owners with funds to spend or reinvest without triggering a taxable event. A loan against the value of a concentrated position is an example of a monetization strategy. The owner of a concentrated position can hedge the value of the concentrated position with derivatives. A long put position is an example of a hedge.
7. The hedging tool Morrison is most likely describing is a protective put position. The strategy is the combination of a long stock position and a long put position, which would provide downside protection (lock in a floor price) with unlimited upside participation. Morrison would buy put options equivalent to the number of shares to be hedged. The put options would have a strike price that is either at or, more typically, slightly below the current stock price. Morrison would pay an amount, referred to as the option premium, to acquire the puts. Conceptually, this is similar to the payment of an insurance premium. If the price of MBI falls below the strike price during the term of the option, the put option could be exercised at the strike price, providing downside protection. If the share price is above the strike price at maturity, Morrison would let the option expire and retain the upside.

A zero-premium collar would not accomplish Morrison’s goal to lock in a floor price and retain unlimited upside potential. A cashless collar is established by buying puts and selling calls on the shares to be hedged. The long put protects the owner of the shares from any loss below the strike price of the puts. However, the investor forfeits some of the upside potential of the underlying stock. Like a cashless collar, a prepaid variable forward (PVF) would not accomplish Morrison’s goal. A PVF combines the economics of a collar and borrowing against the underlying stock within a single instrument.

1. There are two potential drawbacks with this hedging strategy. The strategy requires an out-of-pocket expenditure to purchase the put options, which can be significant depending on a number of factors, including the volatility of the stock, the strike price, and maturity. Another potential drawback is the credit risk of the counterparty. Counterparty risk is greater for an over-the-counter (OTC) derivative because the investor incurs the credit risk of a single counterparty. With respect to exchange-traded instruments, because a clearinghouse is the counterparty and guarantees the instrument, the investor incurs significantly less counterparty risk.
2. Keller is most likely recommending writing covered calls against 10% of Morrison’s shares in MBI. Morrison would sell call options with a strike price that is above the current price of MBI and in return receive premium income (yield enhancement) from the sale of the call options. The strategy effectively allows the investor to establish a liquidation value (the strike price) for the shares he/she writes call options against. If the stock price increases above the strike price at maturity, the calls will be exercised and Morrison will deliver his long shares. He would receive a total sum equal to the strike price of the calls and the premium from the initial sale of the calls. If MBI closes at or below the strike price at expiration, the calls will expire worthless and Morrison will retain the option premium and the long shares. One of the most significant benefits of implementing a covered call writing program is that it can psychologically prepare the owner to dispose of his/her shares.
3. There are two potential drawbacks with this strategy: The investor retains full downside exposure to the shares (to the extent the share price decreases by more than the premium received), and the upside potential is limited (the call strike price plus the premium received).
4. A leveraged recapitalization is a strategy that involves retooling a company’s balance sheet in partnership with a private equity firm. A recapitalization strategy is a “staged” exit strategy, which allows the owner to have two liquidity events, one up-front and a second typically within a 3 to 5 year timeframe, when the private equity firm cashes out of the investment. The private equity firm generally invests equity capital and arranges debt with senior or subordinated lenders. The owner transfers his/her stock for cash and an ownership interest in the newly capitalized entity. This allows the owner to monetize a significant portion of his/her business equity (typically 60% to 80%) and retain significant upside potential with the remaining ownership (typically 20% to 40%). The after-tax proceeds the investor receives could be deployed into other asset classes to help build a diversified portfolio. Additionally, the retained stake motivates the owner to grow the business.

From a tax perspective, the owner is taxed currently on the cash received and typically receives a tax deferral on the stock rolled over into the new entity. This strategy would be appealing to a business owner considering selling a private business in the near future and residing in a jurisdiction where tax rates are scheduled to increase.

A leveraged recapitalization strategy appears to be appropriate to meet Hill’s objectives. The strategy would allow Hill to reduce the risk of his wealth concentration, generate liquidity to diversify his single asset concentration, minimize his tax liability before tax rates increase, and retire in a 3−5 year time period.

1. There are two potential disadvantages to employing a leveraged recapitalization strategy. Private equity firms are financial buyers and, as such, they typically will not pay as high a price as strategic buyers because they do not have the same opportunity as strategic buyers to take advantage of financial and operating synergies. A second potential disadvantage is that the owner relinquishes control of the company.

NOTES

1A collar is the combination of a long put (to limit potential losses) and a short call (to cap potential gains) below and above their respective strike prices.

2The discussion within this section draws heavily on the CFA Program Level III readings “The Behavioral Biases of Individuals” and “Behavioral Finance and Investment Processes.”

3For further reading on goal-based planning, see Ashvin Chhabra, “Beyond Markowitz: A Comprehensive Wealth Allocation Framework for Individual Investors,” Journal of Wealth Management, vol. 7, no. 4 (Spring 2005) and Jean L.P. Brunel, “Goal-Based Wealth Management in Practice,” Journal of Wealth Management, vol. 14, no. 3 (Winter 2011).

4Similar to “surplus capital” is the concept of “discretionary wealth” in Jarrod Wilcox, “Harry Markowitz and the Discretionary Wealth Hypothesis,” Journal of Portfolio Management (2003).

5Stephen M. Horan and Thomas R. Robinson, “Taxes and Private Wealth Management in a Global Context,” Reading 11 of 2013 CFA Program Level III Curriculum.

6Some of these tools may not be available in practice, depending on the jurisdiction.

7Paul Hayward, “Monetization, Realization and Statutory Interpretation,” Canadian Tax Journal, vol. 51, no. 5 (2003).

8When using exchange-traded put and call options to implement a collar, in almost all cases, there will be two contracts involved: one involving the puts and another involving the calls. The purchase and sale of the puts and calls, respectively, can be executed on an option exchange simultaneously pursuant to what is referred to as a “spread order” — that is, without concern that the investor buys the puts without selling the calls (and vice versa). Nonetheless, on almost all exchanges, there will be two separate contracts involved: one for the puts and one for the calls.

9Any unused deduction can be carried forward for an additional five years.

10In the United States, a variation of the traditional 1031 tax-free exchange, a “monetizing 1031 exchange,” can be attractive for investors who wish to hedge, monetize, and defer and possibly eliminate the capital gains tax on their real estate investment.