R11 Flashcards
Investment objectives
Reduce risk
Liquidity
Tax efficiency
Investment objective obstacles
Insider trading laws
Company restrictions
Wants to retain control
Asset has other uses
Considerations affecting all concentrated positions
Sale triggers tax bills
Asset illiquid
Transaction costs
Alternatives like hedging or borrowing
Constraints on dealing with concentration: Institutional and Capital market constraints
Margin lending rules
Regulations
Employer restrictions
Market limitations: needs liquidity, ability to borrow shares, brokers want observable trading history, instruments must exist
Psychological considerations: Emotional biases
- Overconfidence/familiarity
- Status quo
- Naïve extrapolation of past results
- Endowment effect
- Loyalty effects
Psychological considerations: Cognitive biases
- Conservatism
- Confirmation
- Illusion of control
- Anchoring and adjustment
- Availability heuristic
Goal-based planning: Personal risk bucket - goal and types of investments?
Goal: prevent big declines
Types: safe haven investments like home, money market, treasury bills
Goal-based planning: Market risk bucket - goal and types of investments?
Goal: Maintain current standard of living
Types: normal stocks/bonds
Goal-based planning: Aspirational risk bucket - goal and types of investments?
Goal: Grow wealth strongly
Types: high risk investments, concentrated positions
Primary capital: Definition + Source buckets
Def: provides lifetime spending needs
Buckets: Market/personal risk buckets
Surplus Capital: Definition + Source buckets
Def: excess capital above primary
Buckets: aspirational bucket
Monetize concentrated position: 5 questions that need to be answered
- Lifetime spending needs/desires after sale
- Primary/surplus capital requirements?
- Current value of concentrated position?
- Value of assets other than concentrated positions?
- Is value of concentrated position sufficient to meet primary/surplus capital need?
Wealth Transfer Strategies: 3 strategies
- Gift to charity
- Estate tax freeze
- Combine limited partnership, gifting, valuation discount
Wealth Transfer Strategies: Gift to charity
-tax deduction for full value
Wealth Transfer Strategies: Estate tax freeze definition + example
Def: transfer future appreciation that does not get taxed
Ex: transfer junior equity to kids. current market value taxed, but not future appreciation.
Family Limited Partnership: Why does using this to transfer assets reduce taxes?
Value of limited partnership is less than sum of assets. Discount applied because of LP non-controlling stake and lack of marketability due to difficulty of selling
Equity monetization:
What are 4 basic types?
- Short sale against the box
- Total return equity swap
- Forward conversion with options
- Forward sale or single stock futures
Equity monetization:
explain a “short sale against the box”
short a security you already hold
Equity monetization:
explain a “forward sale”
sell for delayed delivery
Equity monetization:
explain a “forward conversion with options”
synthetic short forward position. Buy put, sell call at same strike. Riskless.
Equity monetization:
explain a “Total return equity swap”
contract to pay return of stock (capital gains and dividends) in exchange for return on index, LIBOR, or other
Two major hedging approaches
- Purchase a put
2. Cashless (zero premium) collar
Cashless (zero-premium) collar
Buy a put slightly below market price, sell a call above market price to finance put premium
Prepaid Variable Forward
Combines economics of a collar and a borrowing against underlying stock into a single instrument.
Get paid upfront and deliver shares (or cash) in the future based on terms of underlying collar.
Choosing best hedging strategy: main considerations
- minimal initial cost
- max upside potential
- max downside protection
- minimum tax
- other
Tax Issue: mismatch in character
instrument hedged and tool used to do the hedge produce income and loss of different character.
E.g.: Stock options gains are “ordinary income”; hedging produces losses taxed at capital gains rate, but not deductible against ordinary income
Tax optimization equity strategies: Index tracking with active tax management
make portfolio that tracks the market closely, not perfectly, and use opportunistic tax loss harvesting and other strategies to outperform on an after-tax basis
Tax optimization equity strategies: completeness portfolio
Invest funds other than the concentrated stock position such that the combined portfolio is as diversified as possible. Whittle down concentrated piece over time.
Tax considerations: what is a perfect hedge?
perfect hedge (hedge item and vehicle perfectly correlated; no systematic/non-systematic risk), if too perfect, could be equivalent to a sale, triggering tax due immediately
Tax considerations: what is a cross hedge and what is a downside of using it?
If instruments to hedge asset directly do not exist, hedge a substitute asset with high correlation with primary asset.
Downside: don’t eliminate company-specific (non-systematic) risk
Tax considerations: what is an exchange fund? How long must partner remain in fund?
An investment fund where partners each contribute their concentrated positions and gain pro-rata share of total fund.
How long: must remain in fund 7 years
Managing risk of privately held business: what are three considerations?
- owner psychologically attached
- Owner has financial reasons to maintain control
- Complexity in determining exit strategy and value
Business monetization: Strategic buyer
Pay more than financial buyers, because long term view.
Usually very active.
Business monetization: Financial buyer
typically invest in mature/stable businesses.
Don’t pay as much as strategic buyer
Business monetization: Recapitalization
Company issues debt to finance purchase of owner’s shares
Business monetization: Management Buy Out
group of employees buy the business.
Most of the time owners acts as creditor for small cash component and large promissory note, because employees cannot raise enough cash.
Business monetization: Divestiture
sell some assets
Business monetization: Sale or gift to family member
self explanatory
Business monetization: Line of credit secured by company shares
personal loan secured by shares.
Business monetization: Employee stock ownership plan
An ESOP. Tax advantaged for Subchapter C companies.
Real-estate monetization: Mortgage financing
Get a mortgage where payments equal to rent (if income generating property)
Non-recourse loan means could only go after property in case of default
Real-estate monetization: Sale-leaseback
sell property for cash and lease back to retain use
Real-estate monetization: Donor-advised fund or charitable trust
give asset to charity or fund set up for charitable gift. Full tax deduction on gift.
