R13 Concentrated Single-Asset Positions

Question 1

R13

Single Asset Position Overview

3 Main assets classes and risks

Answer 1

3 Main asset classes effected:

1. publicly traded single-stock positions,
2. privately held businesses (including family-owned businesses), and
3. investment real estate.

3 Main Risks:

1. Systematic risk
2. Company specfic risk
3. Property Specfic risk

Question 2

R13

3 Main objectives when dealing with concentrated positions

Answer 2

1. Reduce the risk of wealth concentration
2. Generate liquidity in order to diversify and satisfy spending needs
3. Optimise Tax effiency

Question 3

R13

Goal Based Planning

Answer 3

1. Personal Risk Bucket
2. Market Risk Bucket
3. Aspirational Risk Bucket

Personal Risk Bucket + Market Risk Bucket = Primary Captial

Aspiration Risk Bucket = Surplus Capital

Question 4

R13

Concentrated Wealth Decision Making: A Five-Step Process

Answer 4

1. Identify and establish objectives and constraints
2. Identify tools/strategies that can satisfy these objectives
3. Compare tax advantages and disadvantages.
4. Compare non-tax advantages and disadvantages.
5. Formulate and document an overall strategy.

Question 5

R13

3 primary strategies in the case of a concentrated position in a common stock

Answer 5

• Equity monetization
• Hedging
• Yield enhancement

Question 6

R13

Equity Monetization Tool Set (4)

Answer 6

1. Short sale against the box - Shorting a security that is held long. Long and short positions together constitute a riskless position. The least expensive technique that is available to hedge, monetize, and potentially defer the capital gains tax on a concentrated position. Will earn a money market rate of return.
2. Total return equity swap - A swap contract that involves a series of exchanges of the total return on a specified asset or equity index in return for specified fixed or floating rate payments. a very high LTV ratio should be possible.Money market return slightly less than short sale against the box.
3. Forward conversion with options -The construction of a synthetic short forward position against the asset held long. Position created is riskless, should a money market rate of return.
4. Equity forward sale contract - A private contract for the forward sale of an equity position. If the market price is above the forward price at the termination of the contract, the investor will receive the forward price and will not participate in any market increase above that price.

Question 7

R13

Hedging concentrated stock position

Answer 7

1. Purchase of Puts - can purchase put options to (1) lock in a floor price, (2) retain unlimited upside potential, and (3) defer the capital gains tax. Downside protection with unlimited upside price participation.But has a permium cost. Reduce premium:

• Further out of money put
• Shorter maturity put
• Put spread
• Knock out option
• Cashless collar

1. Zero Premium Collar - (1) hedge against a decline in the price of a stock, (2) retain a certain degree of upside potential with respect to the stock, and (3) defer the capital gains tax while avoiding any out-of-pocket expenditure. The investor retains any dividend income and voting rights.

Question 8

R13

Prepaid Variable Forwards

Answer 8

• Where the hedge (e.g.collar) and the margin loan are combined in one instrument that achieves an identical economic result

Question 10

R13

Mismatch in character

Answer 10

• The potential tax inefficiency that can result if the instrument being hedged, and the tool that is being used to hedge it, produce income and loss of a different character.
• 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

Question 11

R13

Yield Enhancement of concentrated stock positions

Answer 11

• Writing covered calls against some or all of the shares.
• Allows the investor to establish a liquidation value
• Psychologically prepare the owner to dispose of those shares.
• Attractive if the holder believes the stock will be stuck in a trading range for the foreseeable future

Question 12

R13

Tax-Optimized Equity Strategies (4)

Answer 12

1. Index-tracking strategy - Funded by cash, from a partial sale of the investor’s concentrated stock position. Track benchmark closely.
2. Completeness portfolio - build a portfolio such that the combination of the two portfolios tracks the broadly diversified market benchmark to the best extent possible. Capital loss harvesting in the completeness portfolio allows a concurrent sale of the concentrated stock position without a tax liability. Over time, the size of the concentrated stock position is whittled down to zero, whereas the completeness portfolio becomes an index-tracking one. This strategy is intended to be implemented over time.
3. Cross Hedging - A hedge involving a hedging instrument that is imperfectly correlated with the asset being hedged. By using derivatives on a substitute asset with an expected high correlation with the investor’s concentrated stock position. using a cross hedge. The investor is at least able to hedge market and industry risk.Investor retains all of the company-specific risk of the concentrated position.
4. Exchange Fund - an investment fund structured as a partnership in which the partners have each contributed their low-basis concentrated stock positions to the fund. Participating in the exchange fund is not considered a taxable event. For tax purposes, each partner must remain in the fund for a minimum of seven years.

Question 13

R13

Managing Private Equity Concentration

Sale to third-party investor

Answer 13

• Sale to third-party investor:

1. Strategic buyer- Will typically pay the highest price for a business because of potential revenue, cost, and other potential synergies
2. Financial buyer - look for companies that they can create significant value. They target earning a high internal rate of return on their invested capital over a fairly short period of time, typically three to five years, at which time the company will ideally either be sold to a strategic buyer or go public.

Question 14

R13

Managing Private Equity Concentration

Sale to insider

Answer 14

• Sale to insider:

1. Management (management buyout, or MBO) - key employees may not, in fact, be successful entrepreneurs. Owner is often asked to finance a substantial amount of the purchase price in the form of a promissory note. Failed attempt to do an MBO has the potential to negatively affect the dynamics of the employer–employee relationship.
2. Employees (employee stock ownership plan, or ESOP, in the United States)-

By using an ESOP, the owner can partially diversify his or her holdings, in a tax-advantaged manner, and diversify while retaining control of the company and maintaining upside potential in the retained shares. Disadvantages, include setup and maintenance costs.

3. Sale or transfer to next generation of family - Gifting strategies are often used to transfer ownership to the next generation.Family members may not have the necessary capital to buy the business.

Question 15

R13

Managing Private Equity Concentration

Other strategies (4)

Answer 15

1. Recapitalization - leveraged recapitalization. A leveraging of a company’s balance sheet, usually accomplished by working with a private equity firm. Owner transfers a portion of her stock for cash and retains a minority ownership interest in the freshly capitalized entity. An example of a “staged” exit strategy in that it allows the owner to have two liquidity events, one up front and another typically within three to five years, when the private equity firm seeks to cash out its investment (which could be an IPO, a sale to a strategic or financial buyer, or another recapitalization).
2. Divestiture - Sale or Disposition of Non-Core Assets.Exiting a certain line of business or closing a division that does not fit in with the future growth plans of the company, yet this business line or division may have value to a competitor.
3. Personal Line of Credit Secured by Company Shares - a personal loan secured by his or her shares in the private company. Owner maintains full ownership and control of the company, has access to cash to diversify his or her concentration risk, and avoids triggering a taxable event. At some point the debt will need to be repaid.
4. IPO - costs are significant. if the owner’s objective is to exit from the company in the near term, an IPO is not a viable exit strategy.

Question 16

R13

Monetization Strategies for Real Estate Owners

Answer 16

1. Mortgage Financing - proceeds could be invested in a liquid, diversified portfolio of securities. Net rental income derived from the property exactly covers the cost of servicing the debt and other expenses of the property. Non-recourse loan (meaning that the lender’s only recourse upon an event of default is to look to the property that was mortgaged to the lender), the investor has economically acquired the equivalent of a put issued by the lender.
2. Real Estate Monetization for the Charitably Inclined - use of tax-exempt charitable trust e.g. DAF.he trust would have a defined and charitable purpose, the contributor would receive a tax deduction from the donation to trust, and the trust would not be taxed on property sale proceeds or investment income emanating from the property.
3. Sale and Leaseback - a transaction wherein the owner of a property sells that property and then immediately leases it back from the buyer at a rental rate. ny debt that was associated with the real estate is removed from the balance sheet.There is typically complete rental payment deductibility for tax purposes. Provides 100% of the value of the asset compared with traditional mortgage debt financing, which rarely exceeds 75%