Session 13 - Private Wealth Management (2) Flashcards
Explain investment risks associated with a concentrated position in a single asset and discuss the appropriateness of reducing such risks;
- Owners of concentrated positions can face significant investment risks, including systematic, company-specific, and property-specific risk
- Concentrated positions are also typically illiquid
- investment risks
1/ Systematic Risk - market, economic risk
2/ Company-specific risk (non-systematic risk)
3/ Property specific risk (environmental or concentrated tenant positions)
Describe typical objectives in managing concentrated positions;
➀ Reduce the risk of wealth concentration
- Emotional & cognitive biases may cause the investor to underestimate the riskiness of the position and overestimate its value
➁ Generate liquidity in order to diversify and satisfy spending needs
➂ Optimize tax efficiency
Client objectives and concerns in Publicly traded stock, Private business, real estate
a) Publicly traded stock
• Holding may be a requirement
• May wish to maintain effective voting control - Risk-retention vs. risk reduction
b) Private business
• Too early to sell
• May wish to maintain total control
• May wish to keep the business in the family
c) Real estate
• May be necessary as part of a larger business • May wish to keep in the family
Discuss tax consequences and illiquidity as considerations affecting the management of concentrated positions in publicly traded common shares, privately held businesses, and real estate;
⇒ Tax/ – concentrated positions are often highly appreciated versus their original cost
∴ significant embedded cap. gains tax liability
- Deferring or eliminating the tax is a primary objective
⇒ Liquidity/ – publicly traded stock – may be restrictions on amounts & timing of sales
- Private business, real estate – generally illiquid
Discuss capital market and institutional constraints on an investor’s ability to reduce a concentrated position;
• Institutional constraints/
⇒ Margin-lending rules
- Rules-based (Amt. that can be borrowed is limited) vs. risk-based (aka portfolio margining)
e.g./
- large public stock position with a restriction on sale
- buy puts on the position, risk-based margining makes almost 100% of strike price available for diversification
- Unlocks almost 100% margin ability, use funds to diversify, generate income to offset cost of insurance
⇒ Securities laws & regulations – may be restrictions on timing & volume of sales or hedging transactions (company insiders & executives)
⇒ Contractual restrictions & employer mandates
e.g./ (IPO lockup periods, Blackout periods for public stocks or Right-of-first-refusal, Tag-along/drag-along for private stocks)
• Capital market limitations/
- Ability to borrow shares (box traders, dealer hedging)
- Liquidity of the shares - adjusting hedges
Emotional biases for concentrated positions
- Overconfidence & familiarity (illusion of knowledge)
- Status quo bias (preference for no change)
- Naive extrapolation of past returns
- Endowment effect (asking for more than what something is worth)
- Loyalty effects
Cognitive biases for concentrated positions
- Conservatism (reluctant to update beliefs)
- Confirmation (looking for what confirms one’s beliefs)
- Illusion of control
- Anchoring & adjustment
- Availability heuristic (ease of recall & probability of an event)
Describe advisers’ use of goal-based planning in managing concentrated positions;
A) Personal Risk Bucket
- goal = - Protection from poverty or dramatic decrease in lifestyle
- Allocations = yield below-market return, safe investments, home, CDs, T-Bills
B) Market risk bucket
- goal = maintain the current standard of living
- Allocations = avg risk-adjusted returns, stocks, and bonds
C) Aspiration Risk Bucket
- Goal: the opportunity to increase wealth substantially
- allocation = yield above-market returns but with a substantial risk of loss of capital (concentrated position)
- Bucket 1 & Bucket 2 ⇒ primary capital
- Funds sufficient to provide for the owner’s lifetime spending needs
- Bucket 3 – monetizing or sale - support primary capital - provide surplus capital
Determine:
1/ Lifetime spending needs and desires
2/ Primary surplus requirements (PVn)
3/ Current value of assets (non-concentrated positions = CVa)
if CVa < PVn, then a sale of monetization should take place
Explain uses of asset location and wealth transfers in managing concentrated positions;
⇒ Locate the asset in a way that minimizes wealth transfer tax
A) Before the concentrated position has appreciated greatly:
• Direct gifts to family or trusts
• Estate tax freeze (transfer future appreciation)
- Requires a corporation or partnership
- Future estate tax saved if the limited interests appreciate further
B) After the concentrated position has appreciated greatly:
- contribute assets in a manner that does not trigger a taxable event into a family limited partnership
- general partnership interest retained
- limited partnership interests gifted
- valuation of the interest will include valuation discounts
Describe strategies for managing concentrated positions in publicly traded common shares;
➀ Equity monetization ➁ Hedging/ ➂ Yield Enhancement - Covered calls (sets a liquidation value to the shares) - Keep all dividends + voting rights ➃ Others a) Tax optimized equity strategies - Index tracking strategy w/ active tax mgmt. , Completeness fund b) Cross hedging c) Exchange funds
Expand on Equity monetization
- transformation of a concentrated stock position into cash (rather than an outright sale that triggers a current taxable event)
- plus may be restricted from selling, may not wish to cede control by selling, may be subject to the lockout, vesting, etc
Step 1/ remove risk – hedging
Step 2/ borrow against hedged position - Typically, a high LTV ratio can be achieved to reinvest in a diversified portfolio
Methods of Equity monetization
a/ Short sale against the box
b/ Total return swaps
c/ Forward conversion with options
Expand on Short sale against the box - Equity Monetization
- short selling shares of the concentrated positions without closing the actual position
- result in a neutral position where all gains = the losses, and net to 0, funds from the short sale will earn rf, the position is now riskless
- margin rules will allow the investor to borrow with a high LTV ratio, use the borrowed funds to invest in a diversified portfolio
- least expensive technique
Expand on Total return swaps - Equity Monetization
- receive the return on an index or a fixed rate for the return of your concentrated position
- should earn rf (less dealer’s cut)
- then borrow against the hedge position
Expand on Forward conversion with options- Equity Monetization
- Synthetic short position
- Should earn rf
- Now borrow against the hedged position
Summary of Equity Monetization
• Riskless position is created
• Money market rate of return is generated
• Borrow with high LTV ↓ - HNW
• rf earned offsets rm on loan (partially)
• Invest in a diversified portfolio
- If tax authorities respect legal form over economic substance, equity monetization should not trigger a taxable event
Other considerations on Equity Monetization
1) If a gain on the hedge, short or long term?
2) Loss on the hedge ⇒ short or long term
- Currently deductible or does it modify the cost base of the shares
3) Physical settlement – gain short or long term?
4) Interest expense on loan ⇒ deductible or does it modify
the cost base of the shares
5) Does the hedge affect the taxation of dividends?
Expand on Hedging
a) Purchase puts - locks the floor price, retain upside, defer capital gain tax if there is not exercise, retain dividends and voting rights
b) Cashless (zero-premium) collars
- Lock in a floor price, limited upside potential, if no exercise, defer capital gain tax, + retain dividends + voting rights
c) Prepaid variable forwards
- an agreement to sell a security at a specific time in the future with a # of shares varying with the UL share price at maturity
- dealer pays $88M upfront (prepaid), gets the right to receive a variable number of shares in 3 yrs time
Describe strategies for managing concentrated positions in privately held businesses;
1/ Sale to a 3rd party
– Strategic buyers – typically will pay the highest price
– Financial buyers – e.g. PE firms, VC
2/ Sale to insider
a/ Management (MBO) or key employees
- Owner typically holds some portion as a promissory note
3/ Employee stock option plan (ESOP)
- A qualified retirement plan that can be created by the company and is allowed to buy some or all of the owner’s shares
- Maybe a tax deferral benefit
- A staged or phased exit strategy
4/ Recapitalization - staged exit strategy
Expand on Recapitalization
- staged exit strategy
Stage 1 - turn 100% equity into debt, PE equity, and minority equity interest retained via leveraged recapitalization typically via PE firm
- the minority equity interest retained is tax-deferred
Stage 2 (2-5 years later, an IPO or strategic sale) - Diversiture - sale or disposition of non-core assets
- Sale or gift to family members - may be tax-advantaged
- Personal line of credit secured by company shares
– Not a taxable event
– Company backs the personal loan (by a put)
– Funds can then be invested in a diversified portfolio
Describe strategies for managing concentrated positions in real estate;
1/ Mortgage financing
2/ Charitable donation
3/ Sale and leaseback
Expand on mortgage financing
- Fixed-rate mortgage where interest + principal repayment = NOI of the property
- Monetize the LTV amount, invest in the diversified asset portfolio
- Only works if the property is held in the name (inside a corporation – most common – would entail a loan to the shareholder)
- loan Must carry market rates of interest and be paid back
- If the value of the property increases over time, the owner holds the upside
- If the mortgage is non-recourse (rare in commercial lending), the lender holds the downside
Expand on charitable donation
- Earn an income deduction
- If the property is then sold inside the
charitable structure, no tax event is triggered - So ⇒ donate, then sell
Expand on Sale and leaseback
- Sell the property and immediately lease it back from the buyer
- Provides 100% of the value of the property
- Funds distributed to owners for diversification or re-invested
back into the business - Lease payments are now an income deduction (vs. just interest
payments on a mortgage)
**Does trigger a tax event”
Human Capital
- PV of future earnings & wages
- the discount rate used should be consistent with the risk of wage growth and consistency
𝐰𝐭 = 𝐰𝐭,𝟏(𝟏 + 𝐠𝐭) ⇒ wage in time period t = wage in previous period + growth rate
𝐩(𝐬𝐭) – the probability of surviving in year t - discount rate = 𝐫𝐟 + premium for occupational income volatility
