CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r11 concentrated single asset positions IFT notes

Common concentrated positions Examples of concentrated single-asset positions and individuals who hold these types of positions include: Concentrated position Investor example Publicly

Concentrated Single-Asset Positions

1 Introduction 1

2 Concentrated Single-Asset Positions: Overview 1

2.1 Investment Risks of Concentrated Positions 1

3 General Principles of Managing Concentrated Single-Asset Positions 2

3.1 Objectives in Dealing with Concentrated Positions 2

3.2 Considerations Affecting All Concentrated Positions 3

3.3 Institutional and Capital Market Constraints 4

3.4 Psychological Considerations 4

3.5 Goal-Based Planning in Concentrated-Position Decision-Making Process 6

3.6 Asset Location and Wealth Transfers 6

3.7 Concentrated Wealth Decision Making: A Five-Step Process 7

4 Managing the Risk of Concentrated Single-Stock Positions 7

4.1 Introduction to Key Tax Considerations 8

4.2 Introduction to Key Non-Tax Considerations 8

4.3 Strategies 8

5 Managing the Risk of Private Business Equity 12

5.1 Profile of a Typical Business Owned by a Private Client 12

5.2 Profile of a Typical Business Owner 12

5.3 Monetization Strategies for Business Owners 13

5.4 Considerations in Evaluating Different Strategies 14

6 Managing the Risk of Investment Real Estate 15

6.1 Monetization Strategies for Real Estate Owners 15

Overview 16

Summary 17

Examples from the Curriculum 22

Example 1 Constraints and the Concentrated Position Decision-Making Process 22

Example 2 A Business Owner and the Concentrated-Position Decision-Making Process (1) 24

Example 3 A Corporate Estate Tax Freeze 25

Example 4 Hedging a Concentrated Position 26

Example 5 Mismatch in Character 28

Example 6 A Business Owner and the Concentrated-Position Decision-Making Process (2) 29

Example 7 Short Sale against the Box 31

Example 8 Refinancing or Sale Leaseback? 33 This document should be read in conjunction with the corresponding reading in the 2018 Level III CFA® Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright

2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute

1 Introduction

Often, the wealth of individuals and families is concentrated in an asset or group of assets that has played a part in their accumulation of wealth If a holding represents more than 25% of an investor’s wealth it is generally considered ‘concentrated’ As private wealth managers, we need to advise our clients on whether to hold on to concentrated positions or to monetize and reinvest

2 Concentrated Single-Asset Positions: Overview

Defining a concentrated position

Because we are discussing individual investors, it is difficult to give broadly-applicable advice on the subject of concentrated positions Indeed, there is no specific definition of a “concentrated” position The curriculum tells us that, for practical purposes, a single asset that makes of 25% or more of an individual’s net worth can be considered to be a concentrated position

Common concentrated positions

Examples of concentrated single-asset positions and individuals who hold these types of positions include:

Concentrated position Investor example

Publicly-traded single-stock - An executive of a publicly-traded company who has received

share-based compensation

- The owner of a company who has been paid in shares by a listed company (non-cash merger)

- An investor who has pursued a long-term buy-and-hold strategy

- The owner of a company that started out private and went public in

an IPO

Privately held business - An entrepreneur

- An entrepreneur’s family

Investment real estate - A real estate developer

- An entrepreneur who has sold his or her business but still owns the property where the business operates

- An investor who has inherited real estate

2.1 Investment Risks of Concentrated Positions

This section addresses LO.a:

LO.a: Explain investment risks associated with a concentrated position in a single asset and discuss the appropriateness of reducing such risks

Investors who hold concentrated positions are exposed to three specific types of risk:

Systematic Risk

 This is the market risk that comes from holding equities and is quantified by market beta

 Systematic risk cannot be eliminated by holding a well-diversified portfolio

 Having human capital risk exposure similar to systematic market risk can be dangerous

Company-specific (Unsystematic) Risk

 Unlike overall market risk, this is the specific risk faced by a single company

 Company-specific risk can be eliminated by holding a broadly diversified portfolio

 A concentrated position has higher expected return and higher risk (higher probability of low/negative returns) relative to a diversified portfolio

Property-specific Risk

 Similar to company-specific risk, this is the risk that an event will affect the value of a specific property without affecting the overall real estate market

 Example: a major tenant may break its lease

As you have learned at Levels I and II, a well-diversified portfolio is desirable because it eliminates unsystematic risk, which for the purposes of this reading can be considered both company-specific risk

as well as property-specific risk

3 General Principles of Managing Concentrated Single-Asset Positions

3.1 Objectives in Dealing with Concentrated Positions

This section addresses LO.b:

LO.b: Describe typical objectives in managing concentrated positions

Regardless of the form of the concentrated position, there are three objectives that are normally considered in discussions with the client:

1 Reducing the risks (discussed above) associated with holding a concentrated position

2 Generating liquidity to satisfy spending needs

3 Accomplishing 1 and 2 in a tax efficient manner

While diversification is desirable, investors may have reasons to maintain their concentrated position:

Concentrated Position Reasons to Maintain Concentrated Position

Publicly-traded single-stock - An executive who has received share-based compensation may not

be allowed to sell these shares until a later date

- Maintain control of company

- Retain upside potential

Privately held business - Maintain control of company

- Retain upside potential

- Give management/employees opportunity to buy-out company

- Transfer ownership to the next generation Real Estate - Property is an integral asset to the owner’s company

- Transfer ownership to the next generation

- Retain upside potential

3.2 Considerations Affecting All Concentrated Positions

This section addresses LO.c:

LO.c: Discuss tax consequences and illiquidity as considerations affecting the management of concentrated positions in publicly traded common shares, privately held businesses, and real estate

As noted above, it is difficult to make general conclusions about concentrated single-asset positions However, the tax consequences triggered by an outright sale of a concentrated position and an owner’s ability to meet his or her liquidity needs will be important considerations in all cases

Tax Considerations

With concentrated single-asset positions, the primary tax consideration is the capital gains liability that will be incurred when the position is sold Concentrated positions are often characterized by low cost basis, which means that the vast majority (if not all) of the position’s value will be subject to capital gains tax at the time of sale It is therefore desirable to take steps to defer, reduce or even eliminate this liability

Liquidity Considerations

Owners of privately held companies and real estate investments cannot convert their positions into cash The process of selling either of these positions is time-consuming and the number of potential buyers is limited Concentrated positions in publicly-traded shares are more liquid as shares listed on a public exchange can be traded relatively quickly and the number of potential buyers is relatively large However, there may be institutional and capital market constraints that reduce the liquidity of these

positions These limitations are discussed in Section 3.3 Illiquidity acts as a constraint on the choice of

strategies for dealing with a concentrated position

3.3 Institutional and Capital Market Constraints

This section addresses LO.d:

LO.d: Discuss capital market and institutional constraints on an investor’s ability to reduce a concentrated position

Constraint Description

Margin-Lending

Rules

Holders of concentrated positions often cover their short-term liquidity needs

by borrowing against the value of their asset Margin lending rules establish the maximum amount (as a percentage of the asset’s value) that a financial institution is allowed to lend in such cases Borrowers may be able to increase the amount of the loan by employing a hedging strategy to protect against a decline in the value of the asset that they are borrowing against

Securities Laws and

Regulations

In most countries, executives of publicly-listed firms are considered “insiders” and must comply with various rules and regulations before they can trade in their company’s shares

to give a potential buyer the opportunity to buy before receiving offers from other potential buyers This is known as the “right of first refusal”

Capital Market

Limitations

As mentioned in Section 3.2, concentrated positions in publicly-traded shares are generally more liquid than those in private companies or real estate However, someone who wants to sell a position that is several times larger than

a share’s average daily trading volume will likely need to accept a discount from the quoted share price Additionally, dealers may be unwilling to act as a counterparty in hedging transactions for certain shares

3.4 Psychological Considerations

This section addresses LO.e:

LO.e: Discuss psychological considerations that may make an investor reluctant to reduce his or her exposure to a concentrated position

The holder of a concentrated position (or his or her heir) often has psychological concerns about selling these shares These concerns generally emerge as a result of the investor’s long-time attachment to the company These psychological biases can be classified as either emotional or cognitive

The emotional biases that holders of concentrated positions may exhibit include:

Overconfidence

and familiarity

Also known as illusion of knowledge, this bias can be observed when an investor believes that he or she has superior knowledge about an investment This can be a particular concern in the case of retired top executives (or even founders) who no longer have access to inside information about their former company

Status quo bias Investors, including holders of concentrated positions, are often unwilling to

change their holdings and prefer to stick with the status quo

Endowment effect This bias occurs when an investor’s selling price for an asset is higher than what

he or she would be willing to pay to acquire it (or an investment with an identical risk/return profile) Entrepreneurs who have founded a company (or their heirs who have inherited this position) can be particularly susceptible to this bias

Loyalty effects Employees of publicly-traded companies are often encouraged (and even given

financial incentives) to purchase shares This act can be seen as showing confidence in their firm and even protecting it against a takeover, which makes the decision to sell these shares seem disloyal

Holders of concentrated positions may also display the following cognitive biases:

Conservatism Someone who maintains his or her beliefs about an investment and fails to

incorporate new information as it becomes available is exhibiting conservatism bias

Confirmation This bias is evident when an investor seeks out information that confirms his or

her established beliefs and discounts or ignores information that contradicts these beliefs

Illusion of control An investor who believes (incorrectly) that he or she can influence a company’s

results is exhibiting illusion of control bias A retired executives who had previously been influential in shaping a company’s direction, may find it difficult

to accept that his influence no longer exists

Anchoring and

adjustment

The tendency to stick closely to an investment forecast and inadequately adjusting it as new information becomes available Note that this is very closely related to confirmation bias

Availability

heuristic

Giving a greater probability to a possible event based on how easily other examples of this event can be recalled

As discussed in The Behavioral Biases of Individuals, cognitive biases are easier for a financial advisor to

moderate than emotional biases, which are bases in an individual’s attitudes and feelings

Refer to Example 1 from the curriculum

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

This section addresses LO.f:

LO.f: Describe advisers’ use of goal-based planning in managing concentrated positions

A financial advisor working with the holder of a concentrated position who exhibits one or more of the psychological biases discussed in Section 3.4 may wish to use goals-based planning Rather than using the traditional mean-variance optimal diversified portfolio, goals-based planning considers asset allocation within the context of three “risk buckets”, each of which has a distinct investment objective (or goal) and asset allocation

Risk Bucket Investment Objective Typical Asset Allocation

Personal Protect against poverty or a

dramatic decrease in income

 Primary residence (can be sold)

Using this framework, an advisor can show a client if he or she has failed to make a sufficient allocation

to the personal and market risk buckets If such a case, it may be possible to convince the investor to sell

a portion of his or her concentrated position (or otherwise reallocate assets) in order to set aside sufficient funds to meet the objectives of the personal and market risk buckets This allocation is referred to as primary capital By contrast, the funds allocated to the aspiration risk bucket are referred

to as surplus capital

In Example 2, we see that the goals-based planning framework is used to help the founder and CEO of a private company come to the rational decision of moving assets out of his aspiration risk bucket and into his personal and market risk buckets in order to meet his primary capital objectives

Refer to Example 2 from the curriculum

3.6 Asset Location and Wealth Transfers

This section addresses LO.g:

LO.g: Explain uses of asset location and wealth transfers in managing concentrated positions

Asset Location

Asset location refers to the type of account in which an asset is held and, in particular, how assets held

in various types of accounts are taxed As noted above, holders of a concentrated positions want to achieve diversification and meet their liquidity needs in a tax-efficient manner An advisor’s recommendation with respect to asset location is crucial in meeting these objectives The topic of optimal asset allocation based on how assets are taxed across various types of accounts is covered

extensively in Taxes and Private Wealth Management in a Global Context

Wealth Transfer

An investor can also minimize the tax burden on his or her concentrated position by making effective use of wealth transfer rules A commonly used strategy is the estate tax freeze plan, where the owners transfer a junior equity interest to the children Any gift or wealth transfer tax is based on the current market value of the interest transferred; future appreciation of the equity position transferred is not subject to gift or transfer tax In a classic corporate estate tax freeze, the company is recapitalized, and the older generation gets preferred shares with voting rights and the next generation gets common shares which have a nominal value

Alternatively, if significant appreciation has occurred, the owners can contribute the concentrated position to an entity such as a family limited partnership The parents retain the general partnership interest and therefore retain control Wealth transfers between generations are covered extensively in

Estate Planning in a Global Context

Refer to Example 3 form the curriculum

3.7 Concentrated Wealth Decision Making: A Five-Step Process

Advisors of clients who hold concentrated single-asset positions should use the following five-step process:

1 Identify and establish objectives and constraints

2 Identify tools/strategies that can satisfy these objectives

3 Compare tax advantages and disadvantages

4 Compare non-tax advantages and disadvantages

5 Formulate and document an overall strategy

4 Managing the Risk of Concentrated Single-Stock Positions

This section moves from a discussion of general principles to identifying specific strategies available to investors seeking to diversify out of a concentrated single-stock position and satisfying liquidity needs in

a tax efficient manner In practice, three options are available:

Section 5 and investment real estate is covered in Section 6

4.1 Introduction to Key Tax Considerations

This section addresses LO.i:

LO.i: Discuss tax considerations in the choice of hedging strategy

From a tax efficiency perspective, monetization and hedging are preferable to an outright sale, which will trigger a taxable event However, taxation authorities in various jurisdictions may deem a hedging strategy to be an outright sale (and therefore a taxable event) if the holder of the concentrated position has locked in a sale price and retains no downside risk

4.2 Introduction to Key Non-Tax Considerations

An investor pursuing either a monetization or hedging strategy will likely need to use derivative instruments such as forward, futures or swaps contracts When using derivatives, investors must consider whether exchange-traded or over the counter (OTC) instruments are better suited to meet their objectives Differences between exchange-traded and OTC derivatives include:

Characteristic Exchange-traded derivatives OTC derivatives

Counterparty credit risk Exchange guarantees

settlement, no counterparty credit risk

Full exposure to counterparty credit risk

Ability to close out a transaction

prior to stated expiration

Can be done by taking an identical offsetting position

Can only be done through negotiations with counterparty Price discovery Exchanges provide robust price

discovery

Multiple bids provide only minimal price discovery Transparency of fees Fully transparent and itemized Fees can be hidden in the

overall transaction cost Flexibility of terms Standardized (inflexible) terms Fully customizable terms

Minimum size constraints Smaller minimum size Larger minimum size

4.3 Strategies

This section addresses LO.h:

LO.h: Describe strategies for managing concentrated positions in publicly traded common shares

The owner of an unhedged concentrated single-stock position is both fully exposed to downside risk in the event of a drop in the share price and is able to capture all potential upside, if the share price appreciates The strategies discussed in this section provide investors with the ability to alter the risk exposure and/or return potential of their concentrated position

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

 Strategy 1: Equity monetization

 Strategy 2: Hedging

 Strategy 3: Yield enhancement

Strategy 1: Equity Monetization (no downside risk, no potential upside)

An equity monetization strategy involves two steps:

1 Enter into a hedging transaction that removes all (or substantially all) of the risk associated with holding a concentrated position

2 Borrow against this hedged (and riskless) position

There are four equity monetization tools:

1 Short sale against the box

2 Total return equity swap

3 Forward conversion with options

4 Equity forward sale contract

Short sale against the box

The investor borrows an identical number of shares to offset his or her long position in the underlying asset (the concentrated single-stock position) These shares are sold immediately, which allows the investor to meet liquidity needs Because the long and short positions are exactly offsetting, the net result is that the investor is completely protected against any drop in the share price and unable to benefit from any price appreciation In other words, the transaction creates a riskless position and the investor can only earn the risk-free (money market) rate of return Note that this is the least costly equity monetization technique as it does not involve any dealers and therefore no dealer fees are incurred

Total return equity swap

While retaining ownership of the concentrated position, the investor agrees in advance to pay the return on these shares over a certain period to a dealer In exchange, the dealer will pay the investor the money market rate (less the dealer’s spread) on a notional amount of capital that is equal to the size of the concentrated position If the return on the concentrated position is negative, the dealer will compensate the investor for the loss and pay the money market rate In other words, this is a riskless transaction that results in the investor receiving the risk-free (money market) rate (less the dealer’s spread) regardless of how the concentrated position performs

Forward conversion with options (Long put, short call)

This strategy involves the creation of a synthetic short forward position with the concentrated asset as the underlying The synthetic short forward position is constructed by combining a long put with a short call

When an investor holds an asset, taking a long put position is like buying home insurance The investor pays a premium in order to be protected in the event that the value of the underlying asset drops below

a certain value In the case of a concentrated single-stock position, the counterparty (the put writer) has the obligation to pay the investor an agreed price (the strike price) if the investor chooses to exercise his option So downside risk has been eliminated With a short call, the investor will receive premium payments from the counterparty, but foregoes any benefit if the underlying shares appreciates above the call strike price If the strike prices for both the long put and short call positions are equal, the investor has eliminated both downside risk and potential upside to create a riskless position Consider the following example from the curriculum:

“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.”

Equity forward sale contract

The holder of a concentrated position can enter into a forward contract to sell his or her shares to a counterparty for a fixed price at a future date Any change in the value of the underlying in the time between the contract being signed and the shares being delivered is irrelevant to the price that is paid The position is therefore riskless and the pricing of the forward contract will be set so that the seller earns the risk-free (money market) rate over the duration of the contract

While each of these tools involves a different set of transactions, they all leave the investor in the same position Specifically:

- All the downside risk of the concentrated position has been eliminated

- All of the potential gains from holding the concentrated position have been eliminated

- With no downside risk or potential gains, the position is now referred to as riskless

- As with any riskless position, the investor will earn the money market rate of return

- Because the position is riskless, the investor can borrow against it with a very high loan to value (LTV) ratio

- The borrowed funds are then used to meet the investor’s liquidity needs and invested in a diversified portfolio

Note that no actual sale occurs immediately, so any capital gains liability is deferred

Tax Treatment of Equity Monetization Strategies

The primary advantage of an equity monetization strategy is that it does not trigger a taxable event, as would be the case with an outright sale However, given that all downside risk and potential upside has been eliminated, tax authorities may eventually deem these strategies to be the equivalent of a sale and tax them accordingly

Strategy 2: Hedging (limited downside risk, some or all potential upside retained)

Equity monetization techniques such as those covered in the preceding section create riskless positions, which means that the investor is protected against a decline in the value of his or her concentrated

position, but also foregoes any potential upside The two strategies discussed below also eliminate downside risk while allowing the investor to retain the concentrated position’s potential upside

There are three tools that will achieve this objective:

1 Purchase of Puts

2 Cashless (Zero-Premium) Collars

3 Prepaid Variable Forwards (PVF)

Purchase of Puts

As noted in the discussion of the forward conversion with options technique, a long put position is like

an insurance policy on the shares in investor’s concentrated position So downside risk has been eliminated If the stock rises in value, the put option goes unused and the investor captures this (potentially unlimited) price appreciation This technique is known as a protective put, which is covered

in Execution of Portfolio Decisions

Cashless (Zero-Premium) Collars

Like the forward conversion with options technique, a collar is established by establishing long put position to eliminate downside risk and a short call position, which foregoes potential upside The difference with a cashless collar is that the strike price for the put is set below the current price of the

underlying shares, so some downside risk exists Similarly, the strike price for the call is set above the current share price of the underlying, so not all potential upside has been foregone If the price of the

calls sold is equal to the price of the puts purchased, these premiums offset and the net transaction cost

is zero (or cashless) The investor’s payoff for the shares cannot be less than the put strike price or higher than the call strike price In other words, it will be within a range known as a collar

Prepaid Variable Forwards (PVF)

Like an equity forward sale (discussed above), a PVF is an agreement to sell a position to a counterparty

at a future date Unlike an equity forward sale, which is a riskless transaction, a PVF exposes the seller to some downside risk, but allows for the retention of some potential upside The seller receives a partial payment upfront (this is the “prepaid” part) The number of shares delivered at the future date is determined by a formula and is based on how the shares have performed in the interim (this is the

“variable” part) The details of the formula are not important, but the net result is like a collar in the sense that the seller has eliminated some downside risk by setting a floor price and given away some potential upside The primary advantage offered by the PVF is the upfront payment, which allows the seller to meet his or her immediate liquidity needs

Refer to Example 4 from the curriculum

Refer to Example 5 from the curriculum

Strategy 3: Yield Enhancement (full exposure to downside risk, potential upside limited)

Using the cashless collar technique discussed above, investors purchase put options to establish a floor price for their shares and sell call options, which provides option premium payments as compensation

for limiting potential upside A yield enhancement technique involves only the sale of call options, which establishes a liquidation price for the shares The investor keeps the revenue generated from selling calls which enhances the return (or yield) on the shares

Consider the following example from the curriculum “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).”

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

In certain circumstances, it may not be possible for an investor to directly hedge a position In such a case, the investor might wish to consider an indirect or cross hedge by using derivatives on a substitute asset which has a high correlation with the investor’s concentrated stock position

Finally, investors may consider participating in an exchange fund which 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

5 Managing the Risk of Private Business Equity

This section addresses LO.j:

LO.j: Describe strategies for managing concentrated positions in privately held businesses

5.1 Profile of a Typical Business Owned by a Private Client

Businesses owned and managed by private clients are generally called as “middle-market” businesses These businesses can be worth anywhere from $10 million to over $500 million Real estate can be a significant portion of the firm’s assets Typically such a business would be the primary source of the owner’s income

5.2 Profile of a Typical Business Owner

For most business owners, personal life and business life are closely linked Owners often underestimate

risks associated with their business and overestimate the value of their business

5.3 Monetization Strategies for Business Owners

Monetization strategies available to private business owners fall into three categories:

Sale to third-party - Strategic buyer

- Financial buyer

Sale to insider - Management Buyout

- Employee Stock Ownership Plan (ESOP)

- Sale or transfer to next generation of family

- Divestiture of non-core assets

- Personal line of credit against company shares

- Initial public offering

Sale to Strategic Buyers

A competitor may purchase a company in pursuit of its own strategic objectives Strategic buyers have in depth knowledge of the company’s position in its industry as well as its strengths and weaknesses Because they can generate synergies by merging the company into its existing operations, a strategic buyer will typically offer the highest price

Sale to Financial Buyers

For practical purposes, financial buyers can be thought of as private equity firms Their objective is to invest in the company and improve its operations over a three to five year periods before selling it to a strategic buyer (typically a competitor) or taking it public in an initial public offering (IPO)

Sale to Management or Key Employees (Management Buyout)

Like strategic buyers, a company’s managers and key employees have in depth knowledge of its operations Unlike strategic (and financial) buyers, managers and employees have difficulty raising sufficient capital As a result, their purchase offer is typically composed of only a small amount of cash

up front and a large promissory note

Employee Stock Ownership Plan (ESOP)

Implementing an ESOP can (eventually) produce the same result as the management buyout technique discussed above Additionally, ESOPs can provide a tax-efficient vehicle for the owner of a private company to monetize his or her equity position in stages However, not every company is eligible to

make use of an ESOP

Sale or Gift to Family or Next Generation

Transferring ownership of a company to a family member using a combination of gifting and estate planning can be the most tax-efficient technique Unfortunately, as with managers and employees, family members will have difficulty raising sufficient funds and are unlikely to offer much in the way of

an upfront cash payment

Recapitalization

Rather than purchase a company outright, a financial buyer can carry out a recapitalization From the owner’s perspective, this is a two-stage transaction in which he or she sells a large portion of the company’s equity (generally 70% or more) up front, but continues to manage the company for a period

of three to five years At that point, the (now minority) owner retires and sells his or remaining equity stake to the private equity firm or in an IPO

Divestiture of Non-Core Assets

The owner of a private business seeking to monetize his or her equity can do so by selling off one or more of the company’s non-core assets In practice, the divested asset is often real estate The advantage of this technique is that the owner relinquishes no equity and can continue to run the company

Personal Line of Credit Secured by Company Shares

A private business owner can take out a bank loan or line of credit using his or her company shares as security The borrowed funds, which could be invested in a diverse portfolio, would not generate a taxable event as they are neither income nor the proceeds of a sale The owner relinquishes no equity and can continue to operate the company The disadvantages of this technique are that the funds must

be repaid and the bank could take ownership of the company in the event of a default

Initial Public Offering

An IPO is a good way for a company to raise capital to finance its expansion, but it is not a good exit strategy for the company’s owner Investors are unlikely to put their money into a company whose most important employee is about to leave and retains no stake in its future operations In the event that the owner stays with the company and continues to hold a (smaller) equity position post-IPO, he or she may not enjoy the increased scrutiny and decreased control that come with having shares listed on a public exchange

5.4 Considerations in Evaluating Different Strategies

There are a variety of techniques available to private business owners who wish to monetize their equity position As an advisor, you must consider factors such as the timing of payments, terms, conditions, and tax implications of each alternative as well as the owner’s objectives and constraints For example,

is a one-time fixed payment that lets the owner walk away immediately desirable? Or would the owner

rather continue to operate the company and increase the purchase price by meeting certain performance targets Ultimately, the objective is to realize the maximum amount of total compensation

on an after-tax basis

Refer to Example 6 from the curriculum

Refer to Example 7 from the curriculum

6 Managing the Risk of Investment Real Estate

This section addresses LO.k:

LO.k: Describe strategies for managing concentrated positions in real estate

Real estate is an illiquid asset and can often represent a disproportionately large share of an investor’s portfolio Just like owners of concentrated positions in publicly-traded equity or private businesses, holders of significant positions in investment real estate seek to meet their diversification and liquidity objectives in a tax efficient manner

6.1 Monetization Strategies for Real Estate Owners

The equity monetization technique available to real estate owners include the following:

Sale and Leaseback

This transaction is structured such that the investor sells a property (often a financial buyer) and continues to use it in exchange for rent payments to the new owner Unlike a mortgage financing, the owner receives 100% of the property’s value, which can be invested in a diversified portfolio or, in the case of a business, allocated to potentially more profitable ventures The sale will trigger a taxable event, but any liability incurred may be avoided if the seller has an offsetting capital loss

Charitable Transfer

When a piece of real estate is donated to charity, ownership is transferred without triggering a taxable

event Furthermore, the donor can deduct the value of the property for tax purposes

Refer to Example 8 from the curriculum

Overview

Note: LO.l asks you to apply what you have covered in this reading’s other Learning Objectives

LO.l: Evaluate and recommend techniques for tax efficiently managing the risks of concentrated positions in publicly traded common stock, privately held businesses, and real estate

Below is a summary of the important points discussed in this reading:

 Monetization strategies available to investors with concentrated positions in publically traded common stock include:

o Equity Monetization

 Short sale against the box

 Total return equity swap

 Forward conversion with options

 Forward sale contract or single-stock futures contract

 Employee Stock Ownership Plan (ESOP)

 Sale or transfer to next generation of family

o Other Monetization Strategies

 Recapitalization

 Divestiture of non-core assets

 Personal line of credit against company shares

 Initial public offering

 Monetization technique available to real estate owners include the following:

o Mortgage Financing

o Sale and Leaseback