2.1 Investment Risks of Concentrated Positions 2.1.1 Systematic Risk Can’t be eliminated by holding a well-diversified portfolio.. GENERAL PRINCIPLES OF MANAGING CONCENTRATED SINGLE-ASS
Trang 1“CONCENTRATED SINGLE-ASSET POSITIONS”
1 INTRODUCTION
Three major types of concentrated positions in a single asset:
Publicly traded stock
Privately owned business
Commercial or investment real estate
Concentrated positions are often illiquid assets
CP = Concentrated Position
EM = Equity Monetization
2 CONCENTRATED SINGLE-ASSET POSITIONS: OVERVIEW
No universally accepted threshold exists for concentrated position
CP is often a long period held position with very low cost basis
Publicly traded single-stock positions:
Ways an investor can end up owning a concentrated stock position:
Part of executive compensation
Received a significant amount of stock in share-based sales transaction
Came from long term buy-end-hold investing strategy
Privately owned business:
Usually private businesses with ownership transfer from one generation
to next
Investment real estate
Commercial or industrial real estate typically held for a long-term period
2.1 Investment Risks of Concentrated Positions
2.1.1 Systematic Risk
Can’t be eliminated by holding a well-diversified portfolio
Multiple sources of systematic risk e.g business cycle, inflation etc
2.1.2 Company-Specific Risk
Non-systematic or idiosyncratic risk
to a particular company’s operations, reputation & business environment
High level of company specific risk exists in a CP
the volatility with company specific risks of single-stock holdings,
the benefit of higher capital accumulation
2.1.3 Property-Specific Risk
Unsystematic risk of owning a particular piece of real estate
Trang 23 GENERAL PRINCIPLES OF MANAGING CONCENTRATED SINGLE-ASSET POSITIONS
3.1 Objectives in Dealing with Concentrated Positions
3.1.1 Typical Objectives
Reduce the risk of wealth accumulation
To generate liquidity to diversify &
satisfy spending needs
To optimize tax efficiency
3.1.2 Client Objectives and Concerns
Many objectives that the owner of the CP might wish to achieve including:
To maintain effective control
To enhance current income
3.2 Considerations Affecting All Concentrated Positions
3.2.1 Tax Consequences of an Outright Sale
Significant taxable capital gains possible in
CP due to lower cost basis
Primary objective ⇒ deferring or eliminating C.G tax if possible
3.2.2 Liquidity
CP is generally illiquid
Illiquidity generally acts as a constraint with a CP
3.3 Institutional and Capital Market Constraints
3.3.1 Margin-Lending Rules
If the purpose of the loan is to buy additional securities, the maximum loan proceeds are usually quite limited
3.3.2 Securities Laws and Regulations
Company insiders & executives must often comply with these law’s
3.3.3 Contractual Restrictions and Employer Mandates
These generally restrict the flexibility of insider &
employees to either sell or hedge their shares & include lockups or blackout periods
3.3.4 Capital Market Limitations
Various characteristics of the underlying stock determine the feasibility of hedging different CPs &
degree of hedge
3.4 Psychological Considerations2
3.4.1 Emotional Biases
Following emotional biases can –vely affect the decision making of holders of CPs:
Familiarity & overconfidence bias
Status quo bias
3.4.2 Cognitive Biases
These include:
Conservatism & confirmation bias
Illusion of control, anchoring & adjustment
Availability heuristic
Trang 33.5 Goal-Based Planning in the Concentrated-Position Decision-Making Process
Goal based planning ⇒ one way to incorporate psychological considerations into allocation & portfolio construction
Personal risk bucket:
Goal is to protect from poverty or dramatic in life style
Yield below market return but limit losses
Market risk bucket:
Objective is to maintain current living standard
Avg risk adjusted market return (stock & bond portfolio)
Aspirational risk bucket:
Objective is to wealth substantially
Above market expected return but with substantial risk of loss of capital
Primary capital ⇒ minimum amount to maintain owner’s lifetime spending needs (usually allocated to personal & market risk bucket)
Surplus capital ⇒ allocation to aspirational risk bucket
3.6 Asset location and Wealth Transfers
Asset location decision ⇒ choice of where to place specific assets (different from asset allocation decision)
Usually used to minimize transfer tax
Wealth transfers
Early planning of wealth transfer enables the owner to shift future wealth with little or no transfer tax
Direct gifting is suitable before the concentrated position has appreciated greatly
Estate tax freeze ⇒ owners transfer a junior equity interest to the children that will receive most or all of the future appreciation of the enterprise
After significant appreciation, technique include:
Contribute the CP to an entity such as family limited partnership
3.7 Concentrated Wealth Decision Making: A Five-Step Process
Five step process that best satisfy the objectives of holders of CPs
Identify & establish objectives & constraints
Identify tools that can satisfy these objectives
Compare tax advantages & disadvantages
Compare non-tax advantage & disadvantages
Formulate & document an overall strategy
4 MANAGING THE RISK OF CONCENTRATED SINGLE – STOCK POSITIONS
Diversification generally considered prudent to minimize risk from CPs
Tools to mitigate the risks of concentrated position
Outright sale ⇒ give funds but often incurs significant tax liabilities
Monetization strategies ⇒ these provide owners with funds without triggering a taxable event (e.g loan against CPs)
Hedging the value of the concentrated asset through derivative
Trang 44.1 Introduction to Key Tax Considerations
Internal inconsistency of tax codes provides an opportunity for well diversified investors to reap substantial tax savings
4.2 Introduction to Key Non-Tax Considerations
Key non-tax considerations when deciding whether to use an exchange traded or OTC derivative including:
Counterparty credit risk
Ability to close out transaction prior to stated expiration
Price discovery & transparency of fees
Flexibility of terms
Minimum size constraints
4.3 Strategies
Three common strategies that investors use in the case of a CP in a common stock
Equity monetization
Hedging
Yields enhancement
4.3.1 Equity Monetization
Equity monetization ⇒ transformation of a CP into cash usually in a way to avoid current taxable event
EM entails a two step process
To remove a large position of risk inherent in the CP (hedging)
To borrow against the hedged positions
4.3.1.1 Equity Monetization Tool Set
A Short sale against the box
Shorting a security that is held long
Any future ∆ in stock price will have no effect on the investor’s economic position
Investor will earn money market return
Least expensive technique
A total return equity SWAP
Contract for a series of exchanges of the total return
on a specified asset in return for specified fixed or floating payments
Investor is fully hedged as in short sale strategy
Money market rerun slightly less than what would be
on short sale strategy
Forward conversion with options
Synthetic short forward positions against the asset held long
Pay off of a short forward = pay off of a long put & a short call on same asset
Money market return
Equity forward sale contract
Private contract for the forward sale
of an equity position
Money market returns
Trang 54.3.1.2 Tax Treatment of Equity Monetization Strategies
EM eliminates concentration risk & generates cash approximately equal to outright sale
Critical question ⇒ whether an EM strategy will be treated as a taxable event for tax purpose in a particular country
4.3.2 Lock-in Unrealized Gains: Hedging
4.3.2.1 Purchase of Puts
Investors of CP can buy put option to
Lock in floor price
Retain unlimited upside
Defer CG tax
Investor is fully protected against price risk
Long stock + long put position is extremely appealing but costly
Knock-out option ⇒ exotic option that can be acquired only through OTC dealer (less expensive option)
4.3.2.2 Cashless (Zero-Premium) Collars
These are used to:
Hedge price risk
Retain certain degree of upside
Defer CG tax
Structure ⇒ buy puts (at or out-of-the money) &
sell calls with same maturity
Strike price of calls is set at the level exactly to amount required to pay for puts
Investment risk is but not eliminated
4.3.2.3 Prepaid Variable Forwards
PVF ⇒ 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)
4.3.2.4 Choosing the Best Hedging Strategy
Tax characteristics of the shares that are being hedged can help determine which strategy will deliver the optimal result for client
4.3.3 Yield Enhancement
Investors can enhance the yield of a CP while its volatility by writing covered calls against some or all of the shares
Premium income through selling call options
Investors retain full downside exposure to the shares
Most significant benefit of covered call writing ⇒ to psychologically prepare the owner to dispose of those shares
4.3.4 Other Tools: Tax-Optimized Equity Strategies
Combine investment & tax considerations in making investment decisions
Index tracking strategy with active tax management ⇒ designed to track a broad based market index on a pretax basis & outperform it on an after tax basis
Construction of completeness portfolios ⇒ builds a portfolio such that combination of the two portfolio tracks the broadly diversified market benchmark
Trang 64.3.5 Other Tools: Cross Hedging
Cross hedging ⇒ using derivative on a substitute asset with an expected high correlation with the investor’s concentrated position
Investor is at least able to hedge market & industry risk (company specific risk retains)
4.3.6 Exchange Funds
Exchange fund ⇒ partnership in which the partners have each contributed their low basis CP to the fund
Pro-rata holding of diversified pool of securities with minimum period of 7years
Pro-rata ownership at redemption
5 MANAGING THE RISK OF PRIVATE BUSINESS EQUITY
High percentage of private clients derives their wealth from the ownership
of a privately owned business
Private business owners are often asset rich but relatively cash poor
5.3 Monetization Strategies for Business Owners
5.3.1 Sale to Strategic Buyers
Strategic buyer ⇒ competitors or other companies involved in the same or a similar industry as the seller
Highest price due to potential synergies
5.3.2 Sale to Financial Buyers
These are private equity firms that typically raise funds from institutional investors
Pay price which is lower than strategic buyer’s price
5.3.3 Recapitalization
Leveraged recapitalization ⇒ leveraging of a company’s balance sheet
Attractive for owners who would like to the risk of their wealth concentration
5.3.4 Sale to Management or Key Employees
Employees or senior managers can acquire control of business through a management buyout
Key risk ⇒ employees may not be successful entrepreneurs
Failed attempt to do an MBO has the potential
to –vely affect the dynamics of employer- employee relationship
5.3.5 Divestiture (Sale or Disposition of Non-Core Assets)
Divestiture ⇒ sale of non-core assets
Owner continues to run business but generate liquidity through divestiture
5.3.6Sale or Gift to Family Member or Next Generation
Sell or transfer through a combination of tax advantaged gifting strategies
Transfer is typically made to family members or members who actively involved in business
5.3.7 Personal Line of Credit Secured by Company Shares
Trang 75.3 Monetization Strategies for Business Owners
5.3.8 Going Public through an Initial Public Offering
IPO is possible if the company is in an industry deemed attractive by investors
Significant cost of going public but usually price of the deal is very attractive
IPO is not a viable exit strategy if owner’s objective is
to exit from the company
5.3.9 Employee Stock Ownership Plan
Sale of company’s shares to certain type of pension plans
Leveraged ESOP ⇒ ESOP borrows funds to finance the purchase of the owner’s shares
5.4 Considerations in Evaluating Different Strategies
Objective ⇒ to maximize the after-tax proceeds as opposed to simply maximizing the sale price
Different strategies may result in different values for the company that is being sold or monetized
Strategic buyers typically pay the highest price for a business
6.1 Monetization Strategies for Real Estate Owners
6.1.1 Mortgage Financing
Mortgage financing can be used to generate liquidity
to diversify asset portfolios (no taxable event)
Non-recourse loan ⇒ lender’s only recourse upon an event of default is to look to the property that was mortgaged to lender
6.1.2 Real Estate Monetization for the Charitably Inclined
Asset location is also important for real estate
Many tools & techniques can be used by charitably inclined clients under different tax regimes to monetize real estate
6 MANAGING THE RISK OF INVESTMENT REAL ESTATE
Real estate owners are often exposed to significant degree of concentration risk & illiquidity
Various forms of debt & equity financing to facilitate monetization
6.1.3 Sale and Leaseback
Owner sells the property & then immediately leases
it back from the buyer at a rental rate & lease term that is acceptable to new owner
Primary goal ⇒ free up the owner’s equity for other uses while retaining use of the facility
6.1.4 Other Real Estate Monetization Techniques
Other monetization techniques include joint ventures, condominium structures etc
These techniques are out of the scope of this reading