Private Wealth Mgt (2) Flashcards
Concentrated Positions
Typical Objectives
Common objectives in managing the concentrated position are:
(1) reduce non-systematic risk (diversify)
(2) increase liquidity (especially for retirement)
(3) optimize taxes
(x) other – gifiting strategies, retain voting control, maintain control
Goal-based planning (Concentrated-Position)
Buckets and weaknesses
Primary Capital = Personal risk bucket + market risk bucket
Surplus capital = Aspirational risk bucket (w/ concentrated position)
Weaknesses = “You miss correlation between buckets when you don’t look the portfolio as a hole”
(0) Asset Location and Wealth Transfer - Asset location ≠ Asset allocation (e.g. Holding asset in a TDA or TEA can reduce taxation).
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Estate tax freeze: Limit gift/estate tax by basing the liability in current market value, instead of future appreciated market value
- Example: Recapitalize the company and keep two shares classes (1) preferred stock with most of the initial value and (2) voting shares. Owner retain control and is able to transfer future appreciation.
- Family Limited Partnership (FLP’s): Owner retain control as general partner and gifts limited partnership interests (LPS) to others.
Mitigating risk with a concentrated position
- Outright sale (then reinvest, large tax liability)
- Monetize strategies (perfectly hedge position that creates liquidity and does not generate a tax liability)
- Hedging the value of the concentrated asset (using derivatives)
Monetization
(1) Concentrated Stock Position
(1) Concentrated Stock Position – executive who works for the firm, sells firm or a successful long-term investor
- Sell the asset: Losing control of the asset and triggering any tax liability.
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Equity monetization:
- Perfect hedge, high loan-to-value ratio, proceeds from borrowing used to diversify, increase liquidity, inexpensive, risk free earned on long position
- Short sale against the box: Borrow and then short the asset owned to obtain funds for spending or diversification.
- Total return equity swap: Pay the return of the asset and receive LIBOR or a desired index return.
- Forward sale: Similar result as short sale.
- Forward conversion with options: Sell a call and buy a put with the same strike price. Similar results as short sale.
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Hedging Strategies – protect downside while preserving upside potential in the asset
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Protective Puts: long stock + long put
- ATM (expensive, but ideal protection), OTM (cheaper, but less protection), exotic (knock-in/knock-out)
- Cash-less collar: long stock + long OTM put + short OTM call
- Prepaid variable forward: “Sell” the asset forward, receiving cash at initiation.
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Protective Puts: long stock + long put
- Other Strategies
- Covered Calls = Long stock + short OTM call
- Index tracking with active tax management: partial sale of position reinvested in an index
- A completion portfolio: complement the concentrate position in a way that approximates to a diversified mkt index.
- Gift the asset to charity: tax deduction for full market value.
- Exchange fund: Owners of different concentrated positions each contribute their asset to a fund.
Exchange-traded instrument vs OTC position
Exchange traded
the good
i. no counterparty risk
ii. ability to close our transaction before expiry w/ reverse trade
iii. price efficiency (bid vs ask puts price where it should be)
iv. transparency of fees and expenses
v. smaller minimum size contract sizes
the bad
i. do not have same degree of flexibility
ii. tax may treat each instrument of a single stregy separetly (ie. a gain will not be neted and as consequence, would be taxed). OTC may group instruments in a single contract, and only the net amount would be taxed
Tax considerations:
Tax considerations:
- A perfect hedge is not always appropriate because it will be deemed equivalent to sale and trigger any tax liability.
X. Mismatch in character: when hedge is subject to a different tax treatment than the concentrated position (liab.)Tax considerations: X A perfect hedge is not always appropriate because it will be deemed equivalent to sale and trigger any tax liability. X Mismatch in character: when hedge is subject to a different tax treatment than the concentrated position (liab.)
Monetization Strategies for Private Business Owners
(2) Privately Held Businesses – Entrepreneur. Usually underestimate risk, overestimate value of their business, face emotional bias.
- Sale to a strategic or financial buyer
- Recapitalization: staged exit. 1 - Partial sell to PE, 2 - PE raises low-cost debt, 3 - grows company, 4 - Total exit @ higher price
- Management buyout or sale to employees
- Divestiture or sale of noncore business assets
- Sale or gift to family members
- Personal loan shares as collateral: company directly make the loan or a 3rd party uses shares as guarantee
- IPO
- Sale to an ESOP: sell stocks to employees
ometimes levered)
vii. IPO (expensive, less privacy, used when owner wishes to remain actively involved in the company)
Monetization Strategies for Real Estate
(3) Real Estate
- Property specific risk – environmental liabilities, large tenants do not renew lease, credit risk of new or smaller tenants
- High loan-to-value mortgage financing: non-recourse loan, equivalent to a protective put. If the value of the property declines below the loan amount, the borrower can default on the loan and allow the lender to seize the property.
- Sale and lease back: Rental are tax deductible, continue to use the asset and cash can be redeployed to the core business
- Donor-advised fund or charitable trust (asset location strategy)
Human Capital vs Financial Capital
Human Capital + Financial Capital = Total Wealth
Human Capital
NPV of investor’s future expected labor income weighted by the probability of surviving to each future age
Financial Capital
Tangible and intangible assets owned by the investor
Include personal assets (used to be consumed, not appreciate in value), mixed assets (such as wine, that is consumed but can also appreciate), defined benefit plan, personal home, annuities, government pension, etc.
Traditional vs Economic Balance Sheet
Traditional Balance Sheet
Assets + Liabilities that are generally easy to quantify
Economic Balance Sheet
Traditional BS + Human Capital and Pension Wealth (assets) + Consumption and Bequests Goals (liabilities)
Individual Risk Exposures & Hedges
Net payment cost index vs Surrender cost index
Net payment cost index
A. FV of premiums (pmts), BEG, n years, i rate
B. FV of dividends (pmts), END, n years, i rate
C = A - B (“insurance cost”)
D. Find pmt of C, BEG, n years, i rate
E. Divide by 100 for cost per thousand
Surrender cost index
A. FV of premiums (pmts), BEG, n years, i rate
B. FV of dividends (pmts), END, n years, i rate
C. Cash value (surrended with end of policy)
D = A - B - C (“insurance cost”)
E. Find pmt of D, BEG, n years, i rate
F. Divide by 100 for cost per thousand
Annuity Types
Deferred Variable Annuities - Income starts in the future, similar to a mutual fund
Deferred Fixed Annuities - Income starts in the future, annuity payout
Immediate Variable Annuities - Exchange lump-sum for annuities, based on performance of port
Immediate Fixed Annuities - Exchange lump-sum for annuities, income for life
— / —
“Period certain” - annuity guaranteed for a specific period of time to beneficiary
Efforts of Loss Control
- Risk Avoidance = Not engage in high-risk activities (remove the possibility of occuring)
- Loss Prevention = Reduce likelihood of a risky event
- Loss Reduction = Minimize impact if a risky event does occur
— / –
High severity + Low Frequency Risks = Risk transfer (through insurance / contract)
Low severity + Low Frequency Risks = Risk Retention
