Unit 5. Concentrated Single-Asset Positions

Question 1

A _________________ is one that makes up a significant portion of a private client’s net worth.

Answer 1

concentrated position

Question 2

A concentrated position occurs when an investor owns shares of a stock (or other security type) that represent a ________ percentage of his or her overall portfolio. The investor’s wealth becomes concentrated in the _________ position.

Answer 2

large; single

Question 3

The ___________________ was a period of speculative frenzy that occurred in the 17th century in the Netherlands, during which tulip bulb prices soared to unsustainable levels, and then abruptly collapsed, resulting in a financial bubble and subsequent economic crisis.

Answer 3

Dutch Tulip Mania

Question 4

(T or F) Dutch Tulip Mania is often considered one of the most famous and extreme examples of speculative bubbles in history.

Answer 4

True

Question 5

(T or F) Dutch Tulip Mania is not considered as a famous and an extreme example of speculative bubble.

Answer 5

False

Question 6

The _______, which was a relatively new and exotic flower in Europe at the time, became a popular status symbol among the Dutch elite.

Answer 6

tulip

Question 7

(T or F) Demand for tulip bulbs grew rapidly, and prices skyrocketed, driven by speculation and a fervor for tulip bulb trading.

Answer 7

True

Question 8

Demand for tulip bulbs grew rapidly, and prices skyrocketed, driven by ____________ and a fervor for tulip bulb trading.

Answer 8

speculation

Question 9

Tulip bulbs were bought and sold in ________________, where buyers would purchase the right to receive tulip bulbs at a future date, even before the bulbs were harvested or bloomed.

Answer 9

futures contracts

Question 10

Tulip bulbs were often used as ____________ for loans, further driving up their prices.

Answer 10

collateral

Question 11

At the height of the tulip mania, which is believed to have peaked in early _____, tulip bulbs were traded for astronomical prices, sometimes reaching the equivalent of several years’ worth of a skilled craftsman’s salary.

Answer 11

1637

Question 12

However, the bubble burst suddenly in ___________, and tulip bulb prices collapsed dramatically, causing panic selling and widespread financial losses.

Many investors and speculators were left bankrupt, and the Dutch economy suffered a severe downturn as a result.

Answer 12

February 1637

Question 13

(T or F) The Dutch Tulip Mania serves as a cautionary tale of the dangers of speculative bubbles and irrational exuberance in financial markets.

It has been studied by economists, historians, and investors as an example of the risks associated with speculative trading and the importance of prudent investing practices.

Answer 13

True

Question 14

(T or F) The Dutch Sunflower Mania serves as a cautionary tale of the dangers of speculative bubbles and irrational exuberance in financial markets.

It has been studied by economists, historians, and investors as an example of the risks associated with speculative trading and the importance of prudent investing practices.

Answer 14

False

Question 15

The (1) ___________________________ is a widely used measure of U.S. residential real estate prices.

It is a composite index that tracks changes in the prices of existing (2) _______________ homes in 20 major metropolitan areas across the United States.

The index is published on a (3) __________ basis and provides insight into the overall trend and performance of the U.S. housing market.

Answer 15

(1) S&P CoreLogic Case-Shiller Home Price Index
(2) single-family
(3) monthly

Question 16

The ______________________, also known as the _____________________, was a major financial crisis that originated in the United States and had far-reaching global repercussions.

The crisis was characterized by a speculative housing market boom followed by a severe collapse, leading to a financial meltdown and economic recession.

Answer 16

2008 U.S. real estate bubble; subprime mortgage crisis

Question 17

In the early 2000s, there was a rapid expansion of the U.S. housing market, driven by a combination of factors including low interest rates, relaxed lending standards, and the proliferation of subprime mortgages. Home prices soared, and there was a surge in demand for homes, with many people taking on mortgages they could not afford.

Answer 17

Housing Market Boom

Question 18

_________________ were high-risk loans offered to borrowers with poor credit histories or limited income documentation.

These mortgages often had adjustable interest rates, and many borrowers were unable to afford the higher payments once rates increased, leading to widespread mortgage defaults.

Answer 18

Subprime Mortgages

Question 19

A _______________ individual is somebody with at least $1 million in liquid financial assets.

Answer 19

high-net-worth

Question 20

A _________________ individual has a net worth of at least $5 million while an _________________ individual is defined as having at least $30 million in assets.

Answer 20

very-high-net-worth; ultra-high-net-worth

Question 21

Three major types of “concentrated position in a single asset” (3)

Answer 21

1. publicly traded stock
2. a privately owned business
3. commercial or investment real estate

Question 22

Risks Associated in Concentrated Positions (3)

Answer 22

• Systematic risk
• Company-specific risk
• Property-specific risk

Question 23

Typical Objectives in Dealing with Concentrated Positions (3)

Answer 23

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

Question 24

Constraints to consider when managing a concentrated position (4)

Answer 24

• Restrictions on sale
• A desire of control
• To create wealth
• The asset may have other uses

Question 25

Beginning March 1, 2023, mergers and acquisitions that breach a Size of Party (SoP) of P7 billion and a Size of Transaction (SoT) of P2.9 billion will have to be notified to the ____________________ for mandatory merger review.

Answer 25

Philippine Competition Commission

Question 26

Are all M&As prohibited?

Answer 26

No. Only mergers and acquisitions that substantially prevent, restrict or lessen competition in the relevant market or in the market for goods or services as determined by the PCC are prohibited (Section 20, PCA).

Question 27

Are there any exemptions from prohibited M&As?

Answer 27

Yes. Prohibited M&As may be allowed under the following conditions:
a. The concentration has brought about or is likely to bring about gains in efficiencies that are greater than the effects of any limitation on competition that result or are likely to result from the merger or acquisition agreement; or
b. A party to the merger or acquisition agreement is faced with actual or imminent financial failure, and the agreement represents the least anti-competitive arrangement among the known alternative uses for the failing entity’s assets. (Section 21, PCA)

Question 28

Considerations Affecting All Concentrated Positions (2)

Answer 28

1. TAX CONSEQUENCES OF AN OUTRIGHT SALE
2. LIQUIDITY

Question 29

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

Answer 29

tax law

Question 30

Legal issues depend on the form of asset ownership: ____________________, ___________________, ______________, or _______________.

Answer 30

sole proprietorship; limited partnership; limited company; public stock

Question 31

Other specific issue that may exist include: (4)

Answer 31

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

Question 32

_________________ refer to those instances enumerated in Section 40(C)(2) of the NIRC of 1997, as amended, that are not subject to Income Tax, Capital Gains Tax, Documentary Stamp Tax and/or Value-added Tax, as the case may be.

Answer 32

Tax-free exchanges

Question 33

In general, there are two kinds of tax-free exchange: (2)

Answer 33

(1) reorganization; and
(2) transfer to a controlled corporation.

Question 34

(1) reorganization – read

Answer 34

In the first instance, no gain or loss shall be recognized on a corporation or on its stock or securities if such corporation is a party to a reorganization and exchanges property in pursuance of a plan of reorganization solely for stock or securities in another corporation that is a party to the reorganization. A reorganization is defined as:

• (a) A corporation, which is a party to a merger or consolidation, exchanges property solely for stock in a corporation, which is a party to the merger or consolidation; or
• (b) The acquisition by one corporation, in exchange solely for all or a part of its voting stock, or in exchange solely for all or part of the voting stock of a corporation which is in control of the acquiring corporation, of stock of another corporation if, immediately after the acquisition, the acquiring corporation has control of such other corporation whether or not such acquiring corporation had control immediately before the acquisition; or
• (c) The acquisition by one corporation, in exchange solely for all or a part of its voting stock or in exchange solely for all or part of the voting stock of a corporation which is in control of the acquiring corporation, of substantially all of the properties of another corporation. In determining whether the exchange is solely for stock, the assumption by the acquiring corporation of a liability of the others shall be disregarded; or
• (d) A recapitalization, which shall mean an arrangement whereby the stock and bonds of a corporation are readjusted as to amount, income, or priority or an agreement of all stockholders and creditors to change and increase or decrease the capitalization or debts of the corporation or both; or
• (e) A reincorporation, which shall mean the formation of the same corporate business with the same assets and the same stockholders surviving under a new charter.

Question 35

(2) transfer to a controlled corporation. – read

Answer 35

In the second instance, no gain or loss shall be recognized if property is transferred to a corporation by a person, alone or together with others, not exceeding four (4) persons, in exchange for stock or unit of participation in such a corporation of which as a result of such exchange the transferor or transferors, collectively, gains or maintains control of said corporation.

Question 36

Karlito, a Filipino businessman, is engaged in the business of metal fabrication and repair of LPG cylinder tanks. He conducts business under the name and style of “Karlito’s Enterprises,” a single proprietorship. Started only five (5) years ago, the business has grown so enormously that Karlito decided to incorporate it by transferring all the assets of the business, particularly the inventory of goods on hand, machineries and equipment, supplies, parts, raw materials, office furniture and furnishings, delivery trucks and other vehicles, buildings, and tools to the new corporation, Karlito’s Enterprises, Inc., In exchange for 100% of the capital stock of the new corporation, the stock subscription to which shall be deemed fully paid in the form of the assets transferred to the corporation by Karlito.

As a result, Karlito’s Enterprises, the sole proprietorship, ceased to do business and applied for cancellation of its BIR Certificate of Registration. The BIR, however, assessed Karlito VAT on account of the cessation of business based on the current market price of the assets transferred to Karlito’s Enterprises, Inc.

Is the transfer subject to Income tax?

Answer 36

The transfer is not subject to income tax. The Tax Code states that no gain is recognized when property is transferred to a corporation by a person in exchange for stock, the result of which Is that said person, alone or together with others, not exceeding four (4) persons, gains control of said corporation. This is exactly what happened in this case. Karlito transferred all his assets in exchange for all the shares in a corporation. It is a tax-free exchange.

Question 37

B transferred his ownership over a 1,000-square meter commercial land and three-door apartment to ABC Corp., a family corporation of which B is a stockholder. The transfer was in exchange of 10,000 shares of stock of ABC Corp. As a result, B acquired 51 % ownership of ABC Corp., with all the shares of stock having the right to vote. B paid no tax on the exchange, maintaining that it is a tax avoidance scheme allowed under the law. The Bureau of Internal Revenue, on the other hand, insisted that B’s alleged scheme amounted to tax evasion.

Should B pay taxes on the exchange? Explain.

Answer 37

B shouldn’t pay taxes on the exchange. The Tax Code states that no gain is recognized when property is transferred to a corporation by a person in exchange for stock, the result of which is that said person, alone or together with others, not exceeding four (4) persons, gains control of said corporation. This is exactly what happened in this case. B transferred all his assets in exchange for all the shares in a corporation. It is a tax-free exchange.

Question 38

Emotional Biases (5)

Answer 38

• Status quo bias (preference for no change)
• Loyalty effects
• Overconfidence and familiarity (illusion of knowledge)
• Naïve extrapolation of past returns
• Endowment effect (a tendency to ask for much more money to sell something than one would be willing to pay to buy it)

Question 39

This bias refers to the tendency of individuals to prefer maintaining the current state of affairs, even when changing the situation may be objectively beneficial.

Answer 39

Status quo bias (preference for no change)

Question 40

__________________ refer to the emotional attachment and loyalty that individuals may feel towards their investments, even when objective analysis indicates that it may be prudent to sell or divest from those investments.

Answer 40

Loyalty effects

Question 41

____________________ bias refers to the tendency of individuals to overestimate their own abilities and knowledge in making investment decisions, especially when they are familiar with a particular investment or industry.

Answer 41

Overconfidence and familiarity (illusion of knowledge)

Question 42

This bias refers to the tendency of individuals to assume that past performance of an investment will continue indefinitely into the future, without considering other relevant factors.

Answer 42

Naïve extrapolation of past returns

Question 43

The ________________ refers to the tendency of individuals to attach a higher value to something they own compared to its objective market value.

Answer 43

endowment effect (a tendency to ask for much more money to sell something than one would be willing to pay to buy it)

Question 44

Cognitive Biases (5)

Answer 44

• Conservatism (in the sense of reluctance to update beliefs)
• Anchoring and adjustment (the tendency to reach a decision by making adjustments from an initial position, or “anchor”)
• Illusion of control (the tendency to overestimate one’s control over events)
• Availability heuristic (the probability of events is influenced by the ease with which examples of the event can be recalled)
• Confirmation (looking for what confirms one’s beliefs)

Question 45

In private wealth management, conservatism bias can manifest when investors are resistant to updating their beliefs or changing their investment strategies, even when new information becomes available.

Answer 45

Conservatism (reluctance to update beliefs)

Question 46

This bias can influence private wealth management decisions when investors base their investment decisions on an initial anchor, such as the purchase price of an investment, without fully considering current market conditions or updated information.

Answer 46

Anchoring and adjustment (reaching a decision based on an initial position)

Question 47

This bias can impact private wealth management decisions when investors overestimate their ability to control or predict investment outcomes.

Answer 47

Illusion of control (overestimating one’s control over events)

Question 48

This bias can impact private wealth management decisions when investors rely on the ease with which examples or information comes to mind, rather than considering a broad range of relevant information.

Answer 48

Availability heuristic (influenced by ease of recalling examples)

Question 49

This bias can impact private wealth management decisions when investors seek out information or opinions that confirm their preexisting beliefs or opinions, while ignoring or dismissing information that challenges their views.

Answer 49

Confirmation bias (looking for what confirms one’s beliefs)

Question 50

___________ Risk Bucket:

• Protect the client from poverty
• Low-risk assets such as money market and bank CDs & personal residence

Answer 50

Personal

Question 51

___________ Risk Bucket:

• to maintain the client’s existing standard of living
• stocks and bonds earning an expected market return
• This bucket is where the client would allocate his or her stock and bond portfolio

Answer 51

Market

Question 52

___________ Risk Bucket:

• high-risk investments could substantially improve the client’s standard of living
• private business, concentrated stock holdings, real estate investments, and other riskier positions

Answer 52

Aspirational

Question 53

Concentrated Wealth Decision Making: A Five-Step Process (5)

Answer 53

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 54

Three broad techniques can be used to manage concentrated positions: (3)

Answer 54

• Outright sale
• Monetization strategies
• Hedging the value of the concentrated asset

Question 55

___________ generally involves receiving cash for a position without triggering a tax event.

Answer 55

Monetization

Question 56

Monetization is a _______ process:

• _______ a large part of the risk in the position. This is often complicated by tax regulations.
• Borrow using the hedged position as a ________. The more effective the hedge, the higher the loan to value (LTV) ratio for the loan.

Answer 56

two-way; Hedge; collateral

Question 57

In addition to avoiding an immediate tax liability associated with an outright sale, there are other factors that might make the use of an equity monetization strategy attractive to a holder of a concentrated position, such as the following: (3) – Familiarize only

Answer 57

• The investor may be subject to a diverse array of securities law restrictions that are applicable to a sale of stock.
• The investor might own a large percentage of outstanding shares of the company and may not wish to cede control of the company or give the opportunity to another investor to acquire a large block of company shares.
• The investor may be subject to contractual provisions, such as an IPO lockup or an employment agreement or policy, that prohibit the sale of shares.

Question 58

Non-investment psychological issues of owners of private businesses: (3)

Answer 58

1. The owner may derive a large part of his sense of self-worth as well as his income from the business
2. Business and personal life are often intermixed
3. If the concentrated position was received from a family member, there can be a strong sense of attachment to the holding.

Question 59

Exit strategy analysis should consider:

Answer 59

• 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 60

________________ take a buy and hold perspective and generally offer the highest price to the seller.

Answer 60

Strategic buyers

Question 61

________________ or a ________________ is often a private equity fund planning to restructure the business, add value, and resell the business (typically in a 3 to 5 year period).

Answer 61

Financial buyer; financial sponsor

Question 62

_______________ is generally used for established but less mature (middle market) companies.

Answer 62

Recapitalization

Question 63

A _________________ is a strategy that is especially attractive to middle-market business owners who would like to reduce the risk of their wealth concentration and generate liquidity to diversify but who are not yet ready to exit entirely and have the desire to continue to grow their businesses.

Answer 63

leveraged recapitalization

Question 64

____________________________, the owner sells his position to existing employees of the company.

Answer 64

Sale to (other) management or key employees

Question 65

________________________________________, the owner sells nonessential business assets and then directs the company to use the proceeds to pay a large dividend to, or repurchase stock from, the owner.

Answer 65

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

Question 66

____________________ could be structured with tax advantages such as the estate tax freeze or limited partnership valuation discounts discussed earlier.

Answer 66

Sale or gift to family members

Question 67

A _____________________ secured by company shares. The owner can borrow from the company and pledge her company stock as collateral.

Answer 67

personal line of credit

Question 68

___________________ the owner sells a portion of his shares to the public and transforms the remaining shares into liquid public shares.

Answer 68

Initial public offering (IPO)

Question 69

_______________________, the owner sells stock to the ESOP, which in turn sells the shares to company employees.

Answer 69

Employee stock ownership plan (ESOP)

Question 70

Managing Risk of Investment Real Estate (4)

Answer 70

• Mortgage financing
• Non-recourse loan
• Sale and lease back
• Donor-advised fund or charitable trust