CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r11 concentrated single asset positions IFT notes

Concentrated Single-Asset Positions IFT Notes Concentrated Single-Asset Positions Introduction Concentrated Single-Asset Positions: Overview 2.1 Investment Risks of Concentrated Positions General Principles of Managing Concentrated Single-Asset Positions 3.1 Objectives in Dealing with Concentrated Positions 3.2 Considerations Affecting All Concentrated Positions 3.3 Institutional and Capital Market Constraints 3.4 Psychological Considerations 3.5 Goal-Based Planning in Concentrated-Position Decision-Making Process 3.6 Asset Location and Wealth Transfers 3.7 Concentrated Wealth Decision Making: A Five-Step Process Managing the Risk of Concentrated Single-Stock Positions 4.1 Introduction to Key Tax Considerations 4.2 Introduction to Key Non-Tax Considerations 4.3 Strategies Managing the Risk of Private Business Equity 12 5.1 Profile of a Typical Business Owned by a Private Client 12 5.2 Profile of a Typical Business Owner 12 5.3 Monetization Strategies for Business Owners 13 5.4 Considerations in Evaluating Different Strategies 14 Managing the Risk of Investment Real Estate 15 6.1 Monetization Strategies for Real Estate Owners 15 Overview 16 Summary 17 Examples from the Curriculum 22 Example Constraints and the Concentrated Position Decision-Making Process 22 Example A Business Owner and the Concentrated-Position Decision-Making Process (1) 24 Example A Corporate Estate Tax Freeze 25 Example Hedging a Concentrated Position 26 Example Mismatch in Character 28 Example A Business Owner and the Concentrated-Position Decision-Making Process (2) 29 Example Short Sale against the Box 31 Example Refinancing or Sale Leaseback? 33 This document should be read in conjunction with the corresponding reading in the 2018 Level III CFA® Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright 2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute IFT Notes for the Level III Exam www.ift.world Page Concentrated Single-Asset Positions IFT Notes Introduction Often, the wealth of individuals and families is concentrated in an asset or group of assets that has played a part in their accumulation of wealth If a holding represents more than 25% of an investor’s wealth it is generally considered ‘concentrated’ As private wealth managers, we need to advise our clients on whether to hold on to concentrated positions or to monetize and reinvest Concentrated Single-Asset Positions: Overview Defining a concentrated position Because we are discussing individual investors, it is difficult to give broadly-applicable advice on the subject of concentrated positions Indeed, there is no specific definition of a “concentrated” position The curriculum tells us that, for practical purposes, a single asset that makes of 25% or more of an individual’s net worth can be considered to be a concentrated position Common concentrated positions Examples of concentrated single-asset positions and individuals who hold these types of positions include: Concentrated position Publicly-traded single-stock Investor example - An executive of a publicly-traded company who has received sharebased compensation - The owner of a company who has been paid in shares by a listed company (non-cash merger) - An investor who has pursued a long-term buy-and-hold strategy - The owner of a company that started out private and went public in an IPO Privately held business - An entrepreneur - An entrepreneur’s family Investment real estate - A real estate developer - An entrepreneur who has sold his or her business but still owns the property where the business operates - An investor who has inherited real estate 2.1 Investment Risks of Concentrated Positions This section addresses LO.a: LO.a: Explain investment risks associated with a concentrated position in a single asset and discuss the appropriateness of reducing such risks IFT Notes for the Level III Exam www.ift.world Page Concentrated Single-Asset Positions IFT Notes Investors who hold concentrated positions are exposed to three specific types of risk: Systematic Risk    This is the market risk that comes from holding equities and is quantified by market beta Systematic risk cannot be eliminated by holding a well-diversified portfolio Having human capital risk exposure similar to systematic market risk can be dangerous Company-specific (Unsystematic) Risk    Unlike overall market risk, this is the specific risk faced by a single company Company-specific risk can be eliminated by holding a broadly diversified portfolio A concentrated position has higher expected return and higher risk (higher probability of low/negative returns) relative to a diversified portfolio Property-specific Risk   Similar to company-specific risk, this is the risk that an event will affect the value of a specific property without affecting the overall real estate market Example: a major tenant may break its lease As you have learned at Levels I and II, a well-diversified portfolio is desirable because it eliminates unsystematic risk, which for the purposes of this reading can be considered both company-specific risk as well as property-specific risk General Principles of Managing Concentrated Single-Asset Positions 3.1 Objectives in Dealing with Concentrated Positions This section addresses LO.b: LO.b: Describe typical objectives in managing concentrated positions Regardless of the form of the concentrated position, there are three objectives that are normally considered in discussions with the client: Reducing the risks (discussed above) associated with holding a concentrated position Generating liquidity to satisfy spending needs Accomplishing and in a tax efficient manner While diversification is desirable, investors may have reasons to maintain their concentrated position: Concentrated Position IFT Notes for the Level III Exam Reasons to Maintain Concentrated Position www.ift.world Page Concentrated Single-Asset Positions IFT Notes Publicly-traded single-stock - An executive who has received share-based compensation may not be allowed to sell these shares until a later date - Maintain control of company - Retain upside potential Privately held business - Maintain control of company - Retain upside potential - Give management/employees opportunity to buy-out company - Transfer ownership to the next generation Real Estate - Property is an integral asset to the owner’s company - Transfer ownership to the next generation - Retain upside potential 3.2 Considerations Affecting All Concentrated Positions This section addresses LO.c: LO.c: Discuss tax consequences and illiquidity as considerations affecting the management of concentrated positions in publicly traded common shares, privately held businesses, and real estate As noted above, it is difficult to make general conclusions about concentrated single-asset positions However, the tax consequences triggered by an outright sale of a concentrated position and an owner’s ability to meet his or her liquidity needs will be important considerations in all cases Tax Considerations With concentrated single-asset positions, the primary tax consideration is the capital gains liability that will be incurred when the position is sold Concentrated positions are often characterized by low cost basis, which means that the vast majority (if not all) of the position’s value will be subject to capital gains tax at the time of sale It is therefore desirable to take steps to defer, reduce or even eliminate this liability Liquidity Considerations Owners of privately held companies and real estate investments cannot convert their positions into cash The process of selling either of these positions is time-consuming and the number of potential buyers is limited Concentrated positions in publicly-traded shares are more liquid as shares listed on a public exchange can be traded relatively quickly and the number of potential buyers is relatively large However, there may be institutional and capital market constraints that reduce the liquidity of these positions These limitations are discussed in Section 3.3 Illiquidity acts as a constraint on the choice of strategies for dealing with a concentrated position IFT Notes for the Level III Exam www.ift.world Page Concentrated Single-Asset Positions IFT Notes 3.3 Institutional and Capital Market Constraints This section addresses LO.d: LO.d: Discuss capital market and institutional constraints on an investor’s ability to reduce a concentrated position Constraint Margin-Lending Rules Securities Laws and Regulations Contractual Restrictions and Employer Mandates Capital Market Limitations Description Holders of concentrated positions often cover their short-term liquidity needs by borrowing against the value of their asset Margin lending rules establish the maximum amount (as a percentage of the asset’s value) that a financial institution is allowed to lend in such cases Borrowers may be able to increase the amount of the loan by employing a hedging strategy to protect against a decline in the value of the asset that they are borrowing against In most countries, executives of publicly-listed firms are considered “insiders” and must comply with various rules and regulations before they can trade in their company’s shares In addition to laws and regulations imposed by governments, shareholders who work for a company may be subject to trading restrictions imposed by contractual agreements For example, a company may grant share-based compensation to executives on the condition that these shares cannot be sold for several years In the case of a private company, the owner may be obligated to give a potential buyer the opportunity to buy before receiving offers from other potential buyers This is known as the “right of first refusal” As mentioned in Section 3.2, concentrated positions in publicly-traded shares are generally more liquid than those in private companies or real estate However, someone who wants to sell a position that is several times larger than a share’s average daily trading volume will likely need to accept a discount from the quoted share price Additionally, dealers may be unwilling to act as a counterparty in hedging transactions for certain shares 3.4 Psychological Considerations This section addresses LO.e: LO.e: Discuss psychological considerations that may make an investor reluctant to reduce his or her exposure to a concentrated position The holder of a concentrated position (or his or her heir) often has psychological concerns about selling these shares These concerns generally emerge as a result of the investor’s long-time attachment to the company These psychological biases can be classified as either emotional or cognitive The emotional biases that holders of concentrated positions may exhibit include: Bias Description IFT Notes for the Level III Exam www.ift.world Page Concentrated Single-Asset Positions Overconfidence and familiarity Status quo bias Naive extrapolation of past results Endowment effect Loyalty effects IFT Notes Also known as illusion of knowledge, this bias can be observed when an investor believes that he or she has superior knowledge about an investment This can be a particular concern in the case of retired top executives (or even founders) who no longer have access to inside information about their former company Investors, including holders of concentrated positions, are often unwilling to change their holdings and prefer to stick with the status quo A holder of a concentrated single-asset position that has generated good returns in the past may be unwilling to sell it because of a belief that it will continue to generate these returns This belief may be based on a naïve extrapolation of past results rather than rational analysis This bias occurs when an investor’s selling price for an asset is higher than what he or she would be willing to pay to acquire it (or an investment with an identical risk/return profile) Entrepreneurs who have founded a company (or their heirs who have inherited this position) can be particularly susceptible to this bias Employees of publicly-traded companies are often encouraged (and even given financial incentives) to purchase shares This act can be seen as showing confidence in their firm and even protecting it against a takeover, which makes the decision to sell these shares seem disloyal Holders of concentrated positions may also display the following cognitive biases: Bias Conservatism Confirmation Illusion of control Anchoring and adjustment Availability heuristic Description Someone who maintains his or her beliefs about an investment and fails to incorporate new information as it becomes available is exhibiting conservatism bias This bias is evident when an investor seeks out information that confirms his or her established beliefs and discounts or ignores information that contradicts these beliefs An investor who believes (incorrectly) that he or she can influence a company’s results is exhibiting illusion of control bias A retired executives who had previously been influential in shaping a company’s direction, may find it difficult to accept that his influence no longer exists The tendency to stick closely to an investment forecast and inadequately adjusting it as new information becomes available Note that this is very closely related to confirmation bias Giving a greater probability to a possible event based on how easily other examples of this event can be recalled As discussed in The Behavioral Biases of Individuals, cognitive biases are easier for a financial advisor to moderate than emotional biases, which are bases in an individual’s attitudes and feelings Refer to Example from the curriculum IFT Notes for the Level III Exam www.ift.world Page Concentrated Single-Asset Positions IFT Notes 3.5 Goal-Based Planning in Concentrated-Position Decision-Making Process This section addresses LO.f: LO.f: Describe advisers’ use of goal-based planning in managing concentrated positions A financial advisor working with the holder of a concentrated position who exhibits one or more of the psychological biases discussed in Section 3.4 may wish to use goals-based planning Rather than using the traditional mean-variance optimal diversified portfolio, goals-based planning considers asset allocation within the context of three “risk buckets”, each of which has a distinct investment objective (or goal) and asset allocation Risk Bucket Personal Investment Objective Protect against poverty or a dramatic decrease in income Typical Asset Allocation  Primary residence (can be sold)  Government securities  Other low-risk investments Market Maintain current standard of living  Well-diversified portfolio of assets offering average risk-adjusted returns Aspirational Increase standard of living  Riskier assets with above-average expected return The investor’s concentrated position is allocated into this risk bucket  Using this framework, an advisor can show a client if he or she has failed to make a sufficient allocation to the personal and market risk buckets If such a case, it may be possible to convince the investor to sell a portion of his or her concentrated position (or otherwise reallocate assets) in order to set aside sufficient funds to meet the objectives of the personal and market risk buckets This allocation is referred to as primary capital By contrast, the funds allocated to the aspiration risk bucket are referred to as surplus capital In Example 2, we see that the goals-based planning framework is used to help the founder and CEO of a private company come to the rational decision of moving assets out of his aspiration risk bucket and into his personal and market risk buckets in order to meet his primary capital objectives Refer to Example from the curriculum 3.6 Asset Location and Wealth Transfers This section addresses LO.g: LO.g: Explain uses of asset location and wealth transfers in managing concentrated positions IFT Notes for the Level III Exam www.ift.world Page Concentrated Single-Asset Positions IFT Notes Asset Location Asset location refers to the type of account in which an asset is held and, in particular, how assets held in various types of accounts are taxed As noted above, holders of a concentrated positions want to achieve diversification and meet their liquidity needs in a tax-efficient manner An advisor’s recommendation with respect to asset location is crucial in meeting these objectives The topic of optimal asset allocation based on how assets are taxed across various types of accounts is covered extensively in Taxes and Private Wealth Management in a Global Context Wealth Transfer An investor can also minimize the tax burden on his or her concentrated position by making effective use of wealth transfer rules A commonly used strategy is the estate tax freeze plan, where the owners transfer a junior equity interest to the children Any gift or wealth transfer tax is based on the current market value of the interest transferred; future appreciation of the equity position transferred is not subject to gift or transfer tax In a classic corporate estate tax freeze, the company is recapitalized, and the older generation gets preferred shares with voting rights and the next generation gets common shares which have a nominal value Alternatively, if significant appreciation has occurred, the owners can contribute the concentrated position to an entity such as a family limited partnership The parents retain the general partnership interest and therefore retain control Wealth transfers between generations are covered extensively in Estate Planning in a Global Context Refer to Example form the curriculum 3.7 Concentrated Wealth Decision Making: A Five-Step Process Advisors of clients who hold concentrated single-asset positions should use the following five-step process: Identify and establish objectives and constraints Identify tools/strategies that can satisfy these objectives Compare tax advantages and disadvantages Compare non-tax advantages and disadvantages Formulate and document an overall strategy Managing the Risk of Concentrated Single-Stock Positions This section moves from a discussion of general principles to identifying specific strategies available to investors seeking to diversify out of a concentrated single-stock position and satisfying liquidity needs in a tax efficient manner In practice, three options are available: Outright sale Monetization Hedging Note that the strategies for managing a concentrated position in a private company are covered in IFT Notes for the Level III Exam www.ift.world Page Concentrated Single-Asset Positions IFT Notes Section and investment real estate is covered in Section 4.1 Introduction to Key Tax Considerations This section addresses LO.i: LO.i: Discuss tax considerations in the choice of hedging strategy From a tax efficiency perspective, monetization and hedging are preferable to an outright sale, which will trigger a taxable event However, taxation authorities in various jurisdictions may deem a hedging strategy to be an outright sale (and therefore a taxable event) if the holder of the concentrated position has locked in a sale price and retains no downside risk 4.2 Introduction to Key Non-Tax Considerations An investor pursuing either a monetization or hedging strategy will likely need to use derivative instruments such as forward, futures or swaps contracts When using derivatives, investors must consider whether exchange-traded or over the counter (OTC) instruments are better suited to meet their objectives Differences between exchange-traded and OTC derivatives include: Characteristic Counterparty credit risk Transparency of fees Exchange-traded derivatives Exchange guarantees settlement, no counterparty credit risk Can be done by taking an identical offsetting position Exchanges provide robust price discovery Fully transparent and itemized Flexibility of terms Minimum size constraints Standardized (inflexible) terms Smaller minimum size Ability to close out a transaction prior to stated expiration Price discovery OTC derivatives Full exposure to counterparty credit risk Can only be done through negotiations with counterparty Multiple bids provide only minimal price discovery Fees can be hidden in the overall transaction cost Fully customizable terms Larger minimum size 4.3 Strategies This section addresses LO.h: LO.h: Describe strategies for managing concentrated positions in publicly traded common shares The owner of an unhedged concentrated single-stock position is both fully exposed to downside risk in the event of a drop in the share price and is able to capture all potential upside, if the share price appreciates The strategies discussed in this section provide investors with the ability to alter the risk exposure and/or return potential of their concentrated position There are three primary strategies that investors use in the case of a concentrated position in a common stock: IFT Notes for the Level III Exam www.ift.world Page Concentrated Single-Asset Positions    IFT Notes Strategy 1: Equity monetization Strategy 2: Hedging Strategy 3: Yield enhancement Strategy 1: Equity Monetization (no downside risk, no potential upside) An equity monetization strategy involves two steps: Enter into a hedging transaction that removes all (or substantially all) of the risk associated with holding a concentrated position Borrow against this hedged (and riskless) position There are four equity monetization tools: Short sale against the box Total return equity swap Forward conversion with options Equity forward sale contract Short sale against the box The investor borrows an identical number of shares to offset his or her long position in the underlying asset (the concentrated single-stock position) These shares are sold immediately, which allows the investor to meet liquidity needs Because the long and short positions are exactly offsetting, the net result is that the investor is completely protected against any drop in the share price and unable to benefit from any price appreciation In other words, the transaction creates a riskless position and the investor can only earn the risk-free (money market) rate of return Note that this is the least costly equity monetization technique as it does not involve any dealers and therefore no dealer fees are incurred Total return equity swap While retaining ownership of the concentrated position, the investor agrees in advance to pay the return on these shares over a certain period to a dealer In exchange, the dealer will pay the investor the money market rate (less the dealer’s spread) on a notional amount of capital that is equal to the size of the concentrated position If the return on the concentrated position is negative, the dealer will compensate the investor for the loss and pay the money market rate In other words, this is a riskless transaction that results in the investor receiving the risk-free (money market) rate (less the dealer’s spread) regardless of how the concentrated position performs Forward conversion with options (Long put, short call) This strategy involves the creation of a synthetic short forward position with the concentrated asset as the underlying The synthetic short forward position is constructed by combining a long put with a short call When an investor holds an asset, taking a long put position is like buying home insurance The investor pays a premium in order to be protected in the event that the value of the underlying asset drops below IFT Notes for the Level III Exam www.ift.world Page Concentrated Single-Asset Positions IFT Notes A Index-tracking strategy with active tax management: Track a broad-based market index on a pre-tax basis and outperform it on an after-tax basis B Completeness portfolio: Concentrated holdings + other liquid securities C Cross/indirect hedge: Using derivatives on a substitute asset that has an expected high correlation with the investor’s concentrated stock position D Exchange fund: Investment fund structured as a partnership, each partner owns a pro rata interest in the partnership Mismatch in character: When instrument being hedged and the tool that is being used to hedge it produce income and loss of a different character Example: Having ordinary income on the concentrated position but capital loss on the hedge i discuss tax considerations in the choice of hedging strategy; Characteristics of a Tax-efficient hedging tools:  Long term gain generated by the hedge is preferable  Short term and currently deductible losses are preferable  Long term gain in physically settled contracts is preferable  Currently deductible monetization carrying costs are preferable  Hedging transaction having no impact on the taxation of dividends or distributions received on the shares is preferable j describe strategies for managing concentrated positions in privately held businesses; Strategy Pros Cons  Strategic buyers pay the highest price  Seller can avoid higher tax rate in future  Relieves the seller from running the business  Strategic buyers are difficult to find Recapitalization: Sell a large portion of business equity while retaining a minority ownership interest This is considered as “staged” exit strategy  Reduce concentration risk and generate liquidity without selling the business entirely  Investor can invest after-tax cash proceeds in other asset classes  Receive lower price compared with strategic buyer  Cede control of the company Sale to financial buyers  Easier to find compared with strategic buyers  Financial buyers pay lower Sale to management or key employees  Like strategic buyers, a company’s managers Sale or disposition of non-core assets  Generate some liquidity to diversify without losing control of the business Sale to strategic buyers IFT Notes for the Level III Exam price compared to strategic buyer and key employees have in depth knowledge of its operations www.ift.world  Significant amount of the purchase price is deferred  Does not eliminate entire concentration risk Page 20 Concentrated Single-Asset Positions IFT Notes Personal line of credit secured against company shares  Generate liquidity without losing control of the business and without incurring an immediate tax liability (if structured properly)  Interest expense on the loan is tax deductible  The loan gives the lender a “put” option, which if exercised, triggers a taxable event to the business owner  Bank could take ownership of the company in the event of a default Going public through an IPO  Suitable to use if owner wishes to remain actively involved in the company for near future  May generate the highest cash proceeds for the owner  Expensive strategy  Owners lose their privacy and authority  Face higher scrutiny Employee stock ownership plan  Do not incur immediate capital gains tax liability  Retain control of the company and any upside potential  May eliminate capital gains tax by a possible step-up in basis at death  Involves significant setup and maintenance costs k describe strategies for managing concentrated positions in real estate; Strategy Pros Cons Outright sale  Relatively easy and common strategy  Triggers a taxable event Mortgage financing  Loan proceeds not represent “taxable income”  If an investor achieves a cash flow-neutral LTV ratio, there are no limitations on the use of the loan proceeds  Potential upside is retained  Does not eliminate economic risk of underlying property Donate  Ownership is transferred without triggering a taxable event  Tax deductible  Only suitable to those who are charitably inclined IFT Notes for the Level III Exam www.ift.world Page 21 Concentrated Single-Asset Positions Sale and leaseback     Investor can obtain 100% LTV ratio Rental payments are 100% tax deductible Remove debt from the balance sheet Available even during periods of tight credit markets IFT Notes  Investor has to pay capital gain tax due to which the after-tax proceeds will be