Reading 31: Concentrated Single Asset Position

Question 1

Prepaid Variable Forward Equivalent

Answer 1

A prepaid variable forward is equivalent to hedging the risky asset with a collar (buying a put and selling a call) plus borrowing the value of the hedged position. Owner receives cash at initiation but retains upside if price increases because fewer shares will need to be delivered.

Question 2

Monetisation

Answer 2

Decreasing non-systematic (or asset specific) risk, providing funds for portfolio objectives, and tax efficiency are common objectives in monetisation. Monetising is taking out leverage on the asset and the LVR can be maximised by using derivatives to hedge risk.

Question 3

Single Asset Vs Diversified Portfolio

Answer 3

The median outcome is lower for the single asset portfolio, reflecting its higher probability of suffering a large or total loss. The single asset portfolio has a more extreme positive skew because of a higher average ending value reflecting the benefit of tax deferral (apposed to selling the single stock now with low cost basis and diversifying). Single stock has a much higher probability of a 100% loss. Average ending value looks better for single asset but when downside risk is considered the diversified portfolio is best.

Question 4

Charity Giving of Real Estate

Answer 4

Donating assets to charity is typically tax free (the disposition of the asset is treated as a tax-free transaction), even if the assets have significant unrealized gains. In fact, the donation is likely to also result in a tax credit/deduction in the amount of the donation. The owner will lose control of the asset.

Question 5

Exchange Fund

Answer 5

Involves numerous investors (each with a concentrated position in a single stock with a low cost basis) contributing their holdings into a newly formed exchange fund and then each owning a pro rata share of the new fund. As a result, it involves giving up most of the ownership of the initial concentrated position.

Question 6

Completeness Portfolio

Answer 6

A completeness portfolio structures the other portfolio assets for greatest diversification benefit to complement (complete) the concentrated position. Invests in securities that have very low correlation to the concentrated position. Allows retention of ownership in concentrated asset.

Question 7

Typical Objectives

Answer 7

Reducing the risk of wealth concentration, generating liquidity to diversify and satisfy spending needs, achieving these objectives in a tax efficient manner.

Question 8

Three Tools to Address Concentrated Portfolio

Answer 8

Include outright sale, monetisation, and hedging. Outright sale can result in significant tax liabilities. Monetisation gives the person funds to spend without triggering a taxable event.

Question 9

Downsides of Protective Put

Answer 9

Expenditure to purchase the put options, which can be significant depending on volatility of stock, strike price, and maturity. Another drawback is the counterparty risk of OTC derivatives.

Question 10

Yield Enhancement Strategy

Answer 10

Selling call options to create a covered call. Using a strike price above the current price, and receiving the premium income (yield enhancement) from the sale. A liquidation value is essentially created. Main benefit is that implementing the covered call psychologically prepares the owner to dispose of the shares that may be overly concentrated. However the investor retains full downside exposure to the shares and the upside potential is limited.

Question 11

Leveraged Recapitilization

Answer 11

This is a staged exit strategy, with two liquidity events for the owner, one being upfront and the next in 3-5 years when the private equity firms exits the investment. A private equity firm will invest equity capital and arrange debt. The owner will exchange his stock for cash (typically monetising 60-80%) and retain a significant portion in the newly capitalised entity. He retains upside potential with remaining ownership. If taxes are likely to increase in future, the cash portion will be higher. PE firms are however financial buyers and will pay less than strategic buyers (due to no synergies), and also the owner relinquishes control in the firm.

Question 12

Types of Risk

Answer 12

Systematic risk cannot be avoided or diversified away and includes things like inflation, business cycle risk etc. Company specific risk is non-systematic and includes risks specific to the company like key person risk. Property specific risk is also unsystematic and can be diversified away, similar to company specific but related directly to the property.

Question 13

Reducing Concentrated Positions

Answer 13

It is not always optimal to do this, for example when: there are restrictions on sale, a desire for control, to create wealth, and the asset may have other uses.

Question 14

Institutional & Capital Market Constraints

Answer 14

Margin lending rates: limit the percentage of capital to be borrowed, rules based systems follow specific set rules, risk based would treat two transactions the same that rules based may treat differently as risk based can use derivates to hedge risk and allow 100% LVR lending.
Securities law and regulation: may define the owner as an insider and impose restrictions.
Contractual employer mandates: impose restrictions as minimum holding periods or black outs.
Capital market limitations: monetisation often require OTC derivatives, if the derivatives dealer cannot hedge the risk again that they are hedging for you (due to lack of price history, or prohibited short selling) they will not provide the hedge in the first place.

Question 15

Recap on Biases

Answer 15

Cognitive (easier to be changed): conservatism, confirmation, illusion of control, anchoring and adjustment, availability in making decisions.
Emotional (harder to change): overconfidence, familiarity, illusion of knowledge, status quo bias, naive extrapolation of past results, endowment (getting more than paid for it), and loyalty.

Question 16

Goals Based Decision Process

Answer 16

Portfolio is divided into risk buckets. Personal risk bucket protects from poverty and includes personal residence and cash securities. Market risk bucket maintains clients standard of living and includes stocks and bonds. Aspirational risk bucket increases wealth and includes private business, commercial real estate, concentrated holdings. Primary capital needs include the personal and market risk bucket. Surplus capital goes into the aspirational bucket. If primary capital is insufficient monetisation or sale of concentrated positions needs to be discussed.

Question 17

Estate Tax Freeze: Preferred & Common Shares

Answer 17

Owner can split shares into voting preferred and non voting common. Voting preferred will stay the same value, effectively freezing the value to owner. The common shares will be bought by the recipient (for a low price) and future price appreciation will be transferred to them. The main objective is to transfer future capital appreciation tax. The owner will still have control over the company, the capital gains tax on preferred shares will need to be borne down the track.

Question 18

Estate Tax Freeze: Limited Partnership

Answer 18

The owner can form a limited partnership as the general partner and gift the interests to the limited partners who could be grandchildren. The general partner will still make business decisions. The tax value of the gift to LPs can be reduced through the lack of marketability and control discounts. Further appreciation of the business will be taxed by the LPs not the GP.

Question 19

Monetisation

Answer 19

Involves hedging a large part of the risk without hedging it so perfectly it is considered a sale and creates a tax liability. Then borrow using the hedged portion as collateral. More effective hedge equals higher LVR.

Question 20

Monetisation Tools

Answer 20

Short sale against the box: holding the security and also shorting it for risk-less exposure, can invest short proceeds or use them as collateral to buy diversified portfolio.
Equity forward sale contract: simply buys a forward to sell, shares in no upside or downside of price movement from contract price.
Forward conversion with options: selling call and buying puts with the same strike price giving a hedged ending value of the strike price.
Total return equity swap: pays equity return to receive LIBOR. Return in excess of LIBOR is eliminated and likewise with a decline as LIBOR compensates.
A modified hedge minimises downside while optimising upside like a protective put.

Question 21

Lower Cost of Protection (Premiums on Derivatives)

Answer 21

Purchase an out of the money put, which will have lower premium. Buy a put with shorter time to expiration. Use a pair of puts, for example buy one with a strike of 50 and sell one with strike of 40, any price decrease below 40 will not be hedged but initial cost will be less. Knock out put expires prior to stated maturity if the stock price rises past certain a point. Zero premium collar involves netting the initial cost by buying a put and selling a call so premiums are equal. Upside is reduced, but you can make the strike price higher for the call, but would need to make put strike lower to have costs remain netted.

Question 22

Mismatch in Character

Answer 22

Involves two items in a strategy that trigger different tax treatments. For example a premium received being taxed at a high rate than long term capital gains. Where a negative capital gains tax credit will not offset the premium income tax by the same amount.

Question 23

Cross Hedge

Answer 23

When a perfect hedge is inappropriate as it taxes the underlying gain or the derivatives needed don’t exist. You can short shares of different stocks that are highly correlated with the concentrated position. Short an index that is highly correlated. These introduce company specific risk. Purchasing puts are consider cross hedge as they are different types of assets.

Question 24

Exit Strategy: Sale to Management or Key Employer

Answer 24

Usually only bought at a discount, buyers lack financial resource and may need loan or promissory note with payments contingent on future performance (this is called a management buy out MBO), negotiations may fail and owner could still have to step in to mange firm or could harm the relationships between employees. An MBO does not provide immediate cash flows and there is no assurance that employers are capable of running business and making payments.

Question 25

Exit Strategy: Divesture of Non-Core Business Assets

Answer 25

Owner directs company to sell large asset then issue a large dividends to owner or purchase back his stock. Owner gets cash and retains ownerships.

Question 26

Exit Strategy: Employee Stock Ownership Plan (ESOP)

Answer 26

Owner sells shares to the ESOP that may use leverage to buy then the ESOP sells them to employees. In the US the capital gains tax is not triggered by the owner’s sale of shares.

Question 27

Mortgage Financing & Sale and Leaseback

Answer 27

Similar to buying a protective put on the asset only if the loan in non recourse. If the equity value drops below the loan amount the seller can walk away with the loan and give the asset to the lender. Does not work for recourse loans.
Sale and lease back allows for the sale of the asset at usually 100% fair value, then immediate lease back to the owner, loses ownership but not access.