Reading 11 Concentrated Single Asset Positions

Question 1

Monetization

Answer 1

Monetization generally involves receiving cash for a position without triggering a tax event. It is a two-way process:

1. Hedge a large part of the risk in the position. This is ofter complicated by tax regulations.
2. Borrow using the hedged position as a collateral. The more effective the hedge, the higher the loan to value (LTV) ratio for the loan.

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

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

Selecting the tool will depend on tax treatment. The goal is to select tool that will not trigger an existing tax liability.

Question 2

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

Answer 2

A goal-based decision process modifies traditional mean-variance analysis to accomodate the insights of BFT. The portfolio is divided into tiers of a pyramid, or risk buckets, with each tier or bucket designed to meet progressive levels of client goals.

1. Allocate fundes to a personal risk bucket to protect the client from poverty or a drastic decline in lifestyle. Low-risk assets such as money and bank CDs, as well as personal residence, are held in this bucket. Safety is emphasized, but below-market return is likely.
2. Next, allocate funds to a market risk bucket to maintain the client`s existing standard of living. Portfolio assets in this bucket would be allocated to stocks and bonds earning an expected market return.
3. Remaining portfolio are allocated to an aspirational risk bucket holding positions such as private business, concentrated stock holdings, real estate investments, and other riskier positions. If succesful, these high-risk investments could substantially improve the client`s standard of living.

To implement a goal-based plan, the manager and the client must determine the primary capital neccessary to meet the goals of the first two risk buckets and the amount of any remaining surplus capital to meet aspirational goals. If a concentrated holding in the aspirational bucket leaves insufficient funds for the fist two primary capital buckets, sale or monetization of the concentrated postion must be discussed with the client.

Question 3

Protective puts

Answer 3

Protective puts (sometimes called portfolio insurance): the investor purchase puts on 100,00 shares of PBL.

There are several ways to lower the cost of the protection:

• purchase an out-of-money put
• use a pair of puts, buying a put with a higher strike price of X_H and selling a put with a lower strike price of X_L
• add exotic features to the option (not found in standard options). For example, a knock-out put expires to its stated expiration if the stock price rises above a specified level. This may reduce the protection, and the option will cost less.
• No-cost or zero-premium collars are a common way to lower initial cost, in this case to zero, by giving up some stock upside. A put purchased and a call is sold with different strike prices selected so the premiums are equal.

Question 4

Sale to management or key employees

Answer 4

In a sale to management or key employees, the owner sells his position to existing employees of the company. There are drawbacks:

• generally the buyers will only purchase at a discount price
• the buyers may lack financial resources and expect the existing owner to finance a significant portion of the purchase with a loan or a promissory note
• the promissory note is often contingent on future performance of the business with no assurance current employees or managers are capable of running the business and making the payments. This structure may be called a management buyout obligation (MBO) because existing managers buy the business in exchange for am obligation to pay for the business in the future.
• negotiation with employees to sell the business to them may fail and damage the continuing employer/employee relationship neede to continue operating the business.

Question 5

Use of modified hedging

Answer 5

It is also possible to use modified hedging to minimize downside risk while retaining upside in the underlying position:

• protective puts
• prepaid variable forwards (PVF)
• cashless, or zero-premium, collar

Question 6

Margin lending rules

Answer 6

Margin lending rules limit the percentage of the asset`s value that can be borrowed. Derivative positions can be used to reduce the risk of the asset position and increase the percentage of value that can be borrowed.

Rule-based systems tend to be rigid and define the exact percentage that can be borrowed, while risk-based systems consider the inderlying economics of the transaction.

Question 7

Constraints to consider when managing a concentrated position

Answer 7

Reducing the concentrated position is not appropriate for all clients. There are other specific objectives and constraints to consider:

• Restrictions on sale. Stock ownership in a public company may be received by a company executive as part of a compensation package, with company expectations or regulatory requirements that the executive will hold the stock for a certain lenght of time.
• A desire of control. Majority ownership brings control over the business.
• To create wealth. An entrepreneur may assume high specific risk in expectation of building the value of the business and his wealth.
• The asset may have other uses. Real estate owned personally could also be a key asset used in another business of the owner.

Question 8

Three common objectives when managing a concentrated position

Answer 8

There are three common objectives when managing a concentrated position:

• Reduce the risk caused by the wealth concentration
• Generate liquidity to meet diversification of spending needs
• Optimize tax efficiency to maximize after-tax ending vaule

Question 9

What should be considered when implementing exit strategy

Answer 9

Privately held businesses may be more concentrated (the owner could own 100% of the business and it may be close to 100% of his asset), the standalone and nonsystematic risk tends to be very high, and the asset is generally illiquid.

Exit strategies for the business must be condidered. Exit strategy ananlysis should consider:

• the value of the business
• tax rates that would apply to the potential exit strategies
• availability and terms of credit, as borrowing may be involved in financing any transaction
• the buying power of potential purchasers
• currency values if the transaction involves foreign currencies

Question 10

Recapitalization

Answer 10

Recapitalization is generally used for established but less mature (middle market) companies. In a leveraged recapitalization the owner may retain 20% to 40% of the equity capital and sell 60% to 80% of his shares back to the company. The owner continues to manage the business with a significant financial stake. A private equity firm could arrange the financing for the company to purchase the owner`s stock. In exchange, the private equity firm receives equity in the company. This could be part of a phased exit strategy for the owner; sell and receive cash for a portion of his equity in the initial transaction, then participate in and sell his remaining shares when the private equity firm resells their position in a few years.

Question 11

Sale to Financial Buyers

Answer 11

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.

Plan to restructure the business, add value, and resell the business typically in a 3 to 5 year period.

Question 12

Strategies for managing concentrated positions in real estate

Answer 12

A single investment in a real estate asset can be large and constitute a significant portion of an investor`s assets, bringing a high level of concentrated, property-specific risk. Real estate is generally illiquid and, if held for a long time, may have a significant unrealized taxable gain. A seller considering sale or monetization of a property should consider its current value relative to historical and expected value in the future. Strategies to consider include:

• Mortgage financing can be an attractive strategy to raise funds without loss of control of the property. With a nonrecourse loan the lender`s only recourse is to seize the property if the loan is not paid. The borrower effectively has a put option on the property. If the property value falls below the loan amount, the borrower can default on the loan, keep the loan proceeds, and “put” property to the lender.
• A donor-advised fund or charitable trust can allow the property owner to take a tax deduction, gift more money to the charity, and influence the use of the donation.
• A sale and leaseback can provide immediate funds while retaining use of the property.

Question 13

Capital market limitations

Answer 13

Capital market limitations in the form of market structure can have indirect consequences. Monetization strategies commonly require over-the-counter derivative trades with a dealer to hedge the security`s risk and increase the LTV ratio. To offer such trades, dealers must be able to hedge the risks they assume. This may be impossible. For example, if the asset is an initial public offering (IPO) or trades infrequently, there will NOT be a price history on which the dealer can base a hedge. Borrowing and shorting the underlying asset is often required for the dealer to hedge their risks. This is prohibited in some markets. Without sufficiaent price history and liquidity in the underlying instruments, monetization techniques may be unavailiable.

Question 14

Exchange funds

Answer 14

Exchange funds are another possibility. Consider 10 investors, each of whom has a concentrated position in a single stock with a low cost basis. Each investor`s position is in a different stock. The investors contribute their holdngs into a newly formed exchange fund, and each now owns a pro rata share of the new fund. The investor now participates in a diversified portfolio and defers any tax event until shares of the fund are sold.

Question 15

Personal line of credit secured by company shares

Answer 15

A personal line of credit secured by company shares. The owner can borrow from the company and pledge the company stock as collateral.

Question 16

Concentrated positions and risks associated with them

Answer 16

Concentrated positions can have consequences for return and risk. The assets may no be efficiently priced and, therefore, not generate a fair risk-adjusted return. Illiquid assets can be difficult and costly to exit or non-income producing.

The risks in such assets is both systematic and company- or property- specific.

• Systematic risk is the risk that cannot be diversified away holding a portfolio of risky assets. In the single factor CAPM, this would be beta. In multifactor models there will be more than one systematic risk.
• Company-specific risk is the nonsystematic risk of an investment that can be diversified away. It would derive from events that affect a specific investment but not the overall market. A corporate bankruptcy as a result of financial fraud would be an extreme example of company-specific risk. Nonsystematic risk increases the standard deviation of returns without additional expected return.
• Property-specific risk for real estate is the direct countrerpart to company-specific risk for a company. It is additional, deiversifiable risk associated with owning a specific property.

Question 17

Institutional and capital market constraints

Answer 17

Institutional and capital market constraints such as tax law can significantly affect the costs of selling or monetizing a concentrated position.

Legal issues depend on the form of asset ownership: sole proprietorship, limited partnership, limited company, or public stock.

Other specific issue that may exist include:

• Margin lending rules
• Securities law and regulations
• Contractual restrictions and employer mandates
• Capital market limitations

Question 18

Strategies to consider in managing a private business position include

Answer 18

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

1. Sale to third-party investor:

• Strategic buyer
• Financial buyer
• Other investor

2. 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

3. Recapitalization
4. Divestiture of non-core assets (often real estate)
5. Personal line of credit against company shares
6. 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

Question 19

Contractual restrictions and employer mandates

Answer 19

Contractual restrictions and employer mandates may impose restrictions (such as minimum holding periods or blackout periods when sales may not be made) beyond those of securities law and regulation.

Question 20

Sale to Strategic Buyers

Answer 20

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.

Question 21

A five-step process for managing a concentrated position

Answer 21

A five-step process can be used to make decisions for managing a concentrated position:

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

Question 22

Illustrate potential monetization tools

Answer 22

To illustrate potential monetization tools, consider an investor with 100,000 shares of PBL, which is trading for $50 per share. Four tools can be considered four hedging the asset:

1. Short sale against the box. The investor borrows 100,000 shares of PBL and sells them short. The investor is long and short the stock, a “riskless position” that is expected to earn the risk-free rate of return. The investor can use the short sale proceeds to meet portfolio objectives.
2. **Forward sale contract or single-stock futures contract. **The investor enters a forward contract to sell 100,000 shares of PBL. The investor has a known sale price and does not share in any upside or downside price movement of PBL from that contract price.
3. Options (forward conversion). A pair of options is used to hedge the stock position, selling calls and buying puts with the same strike price. A hedged ending value of $50 is established.
4. **Total return equity swap. **The investr enters a swap to pay the total return on the $5,000,000 of PBL and receives LIBOR

Question 23

Sale or gift to family members

Answer 23

Sale or gift to family members could be structured with tax advantages such as the estate tax freeze or limited partnership valuation discounts. The existing owner could do an MBO. Unfortunatelly, neither a gift nor MBO sale provides the existing owner much immediate cash flow.

Question 24

Considerations affecting all concentrated positions

Answer 24

1. Sale of a concentrated position may trigger a large capital gain tax liability. A large concentrated position is often accumulated and held for many years, resulting in a zero or low tax basis. A plan to defer, reduce, or eliminate the tax may be desirable.
2. Illiquidity and/or high transaction costs can be a factor even if there is no tax due. A public company trading with insufficient volume may require a price discount to sell. The expense of finding a buyer for a private business of real estate can be substantial. The intended use by the prospective buyer may affect the price.

Question 25

Securities law and regulations

Answer 25

**Securities law** **and regulations** may define the owner as an "insider" (who is presumed to have material, nonpublic information) and *impose* restrictions, regulations, and reporting requirements on the position

Question 26

IPO and ESOP

Answer 26

* with an **initial public offering (IPO)** the owner sells a portion of his shares to the public and transforms the remaining shares into liquid public shares * with an **employee stock ownership plan (ESOP)**, the owner sellls stock to the ESOP, which in turn sells the shares to company employees. In a leveraged ESOP, the company borrows the money to finance the stock purchase.

Question 27

Cross hedge

Answer 27

A perfect hedge is generally inappropriate if it causes the underlying gain to be taxed or if the neccesary derivatives do not exist. A **cross hedge** may be used instead. The investor who holds a large position in an auto stock but finds it cannot be shorted to create a hedge could consider three cross hedge possibilities: 1. Short shares of a different auto stock or another stock that is highly correlated with the concentrated position. The highly correlated short position will increase (decrease) in value to offset decreases (increses) in the auto stock. 2. Short an index that is highly correlated with the concentrated position. Shorting a different stock or an index will introduce company specific risk. A negative event could affect the concentrated position but have no offsetting effect on the value of the short position. 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. 3. Purchasing puts on the concentrated position is also considered a cross-hedge in that the put and stock are different types of assets.

Question 28

Asset Location

Answer 28

**Asset location** determines the method of taxation that will apply. Location in a tax-deferred account would defer all taxes to a future date. In a taxable account, interest, dividends, and capital gains may be subject to different tax rates (or deferral possibilities in the case of when to realize capital gains).

Question 29

Three broad techniquies to manage concentrated positions

Answer 29

Three broad techniquies can be used to manage concentrated positions: * **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. Hedging techniques often utilize over-the-counter (OTC) or exchange-traded derivatives.

Question 30

Divestiture, sale, or disposition of non-core business assets

Answer 30

In a **divestiture, sale, or disposition of non-core business assets**, the owner sells nonessential business assets and then directs the company to use proceeds to pay a large dividend to, ior repurchase stock from, the owner. In either case, the owner receives cash while retaining the rest of the stock and control of the business.

Question 31

Yield enhancement with covered calls

Answer 31

**Yield enhancement with covered** calls is another potential strategy. The owner of shares could sell call options. The premium income received can be viewed as either enhancing the income yield of the stock or protecting against the stock price decline.

Question 32

Wealth transfer

Answer 32

**Wealth transfer** involves estate planning and gifting to dispose of excess wealth. The specific strategies used depend on the tax laws of the country and the owner`s situation. Key considerations include: 1. Advisors can have the greatest impact by working with clients before significant unrealized gains occur. If there are no unrealized gains, there are generally no financial limitations on disposing of the concentrated position. 2. Donating assets with unrealized gains to charity is generally tax-free even if there are gains. 3. An **estate tax freeze** is a strategy to transfer future appreciation and tax liability to a future generation. This strategy usually involves a partnership or corporate structure. A gift tax would be due on the value of the asset when transfer is made; however, the asset (including any future appreciation in value) will be exepmt from future estate and gift taxes in the giver`s estate. Any tax owned is "frozen", meaning paid or fixed near an initial value. *Estatate tax freeze is usually done through recapitalization and issue of 2 classes of shares: preferred voting (bond like) for the owner and common non-voting (for the next generation)*

Question 33

Prepaid Variable Forwards

Answer 33

**Prepaid Variable Forwards (PVF**) are economically similiar to a collar and loan in one transaction. 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.

Question 34

Psychological Considerations

Answer 34

A number of *emotional biases* can combine to negatively affect the decision making of holders of concentrated positions, including the following: * **_S_**tatus quo bias (preference for no change) * **_L_**oyalty effects * **_O_**verconfidence and familiarity (illusion of knowledge) * **_N_**aïve extrapolation of past returns * **_E_**ndowment effect (a tendency to ask for much more money to sell something than one would be willing to pay to buy it) A number of *cognitive biases* can combine to negatively affect the decision making of holders of concentrated positions, including the following: * **_C_**onservatism (in the sense of reluctance to update beliefs) * **_A_**nchoring and adjustment (the tendency to reach a decision by making adjustments from an initial position, or “anchor”) * **_I_**llusion of control (the tendency to overestimate one’s control over events) * **_A_**vailability heuristic (the probability of events is influenced by the ease with which examples of the event can be recalled) * **_C_**onfirmation (looking for what confirms one’s beliefs)

Question 35

Two tax-optimization equity strategies

Answer 35

Two **tax-optimization equity strategies** combine tax planning with investment strategy: 1. **Index tracking with active tax management.** Cash from a monetized concentrated stock position is invested to track a broad market index on a pretax basis and outperform the index on an after-tax basis. For example, if dividends are taxed at a higher rate than capital gains, the tracking portfolio could be structured with a lower dividend yield but higher expected price appreciation. 2. **A completeness portfolio** structures the other portfolio assets for greatest diversification benefit to complement (complete) the concentrated position. For example, if the concentrated position is an auto stocks such that the resultin total portfolio better tracks the return of the chosen benchmark. Both tax-optimization strategies allow the investor to retain ownership of the concentrated position but may take time and sufficient other assets and funds to implement. Both strategies provide diversification while deferring the gain.

Question 36

Mismatch in character

Answer 36

A **mismatch in character,** two items in a strategy that trigger different tax treatments. A hedging strategy needs to consider any mismatch and select the tool or a strategy that maximizes after-tax value to investor. 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.