THÔNG TIN TÀI LIỆU
Concentrated Single-Asset Positions INTRODUCTION A concentrated position occurs when an investor owns an asset that represents a large percentage of his/her overall portfolio or net worth Concentrated position in an investor’s portfolio reduces portfolio diversification and exposes the investor to significant idiosyncratic (or company-specific) risk and sector-specific risk In addition, sale of a concentrated position may raise substantial concerns about tax and liquidity The objective of managing a concentrated position is to hedge the investor’s portfolio against price declines and diversify it in a tax-effective manner In order to best meet this objective, the investor must match his goals and objectives with different hedging tools and techniques by considering the benefits and drawbacks of each tool/technique CONCENTRATED SINGLE-ASSET POSITIONS: OVERVIEW The three major types of “concentrated position in a single asset” include: 1) Publicly traded single-stock positions: Concentrated positions in publicly traded single-stock may occur as a result of • Stock or stock options received by senior company executives as part of their compensation; • A large position in a single stock inherited by family members; • Stock received by the seller of a privately owned business in lieu of cash when the buyer is a publicly traded company; • A successful long-term buy-and-hold investing strategy; • An IPO of a private company; • A heavy allocation of a pension fund in a sponsor’s company stock; • A significant amount of shares of another publicly traded company held by a publicly traded company for business or investment purposes 2) A privately owned business (including family-owned businesses): It refers to ownership in privately owned businesses that is transferred down from one generation to the next 3) Commercial or investment real estate: Concentrated positions in investment real estate can be derived as a result of • A significant percentage of the value of a private business enterprise represented by commercial or industrial real estate; • A standalone investment of private clients (i.e real estate developers) in commercial real estate; • Inheriting investment real estate or receiving a gift or bequest; • Lack of other investment opportunities in certain jurisdictions; 2.1 Investment Risks of Concentrated Positions The concentrated positions in a single asset expose an investor to systematic risk and non-systematic risk (either company or property-specific risk) Besides risk, concentrated positions also affect return of an investor because holding under-performing company stock or non-income-producing land involve greater opportunity costs and some concentrated positions may not generate fair risk-adjusted returns Concentrated positions cause owners to underestimate the risk of their concentrated position and significantly overestimate the value of that asset 2.1.1) Systematic Risk Systematic risk/non-diversifiable/market risk is the risk that affects the entire market or economy and cannot be reduced through diversification For example, risk associated with interest rates, inflation, economic cycles etc Different sources of systematic risk include: • Equity market risk • Business cycle risk (i.e risk associated with unexpected changes in the level of real business activity) • Inflation risk (i.e risk associated with unexpected changes in inflation rate) etc Note that when the risk of human capital is the same as the systematic risk exposures associated with a concentrated position (e.g founder of a securities firm with a concentrated position in the firm’s shares), then the investor would face portfolio losses and decrease in job earnings at the same time 2.1.2) Company-Specific Risk Company-specific risk is the risk that affects a single company or industry It is also known as non-systematic risk, industry specific or idiosyncratic risk e.g failure of a drug trial A concentrated position in a single stock exposes an investor to a higher level of company- –––––––––––––––––––––––––––––––––––––– Copyright © FinQuiz.com All rights reserved –––––––––––––––––––––––––––––––––––––– FinQuiz Notes Reading 11 Reading 11 Concentrated Single-Asset Positions specific risk The level of company-specific risk is positively related to volatility of returns, all else equal Company-specific risk can be reduced or avoided through diversification i.e investing in different asset classes and/or securities 2.1.3) Property-Specific Risk FinQuiz.com • A potential environment liability associated with a particular property; • Risk associated with renewal of leases and time period involved in finding new tenants; • Credit risk associated with smaller, non-investmentgrade tenants; Property-specific risk is a type of non-systematic risk that affects a particular piece of real estate For example, 3.1 GENERAL PRINCIPLES OF MANAGING CONCENTRATED SINGLEASSET POSITIONS Objectives in Dealing with Concentrated Positions (covering Section 3.1.1-3.1.2) 1) Typical Objectives: Typical objectives include goal • To reduce the concentration risk while minimizing any costs associated with risk reduction • To generate liquidity in order to diversify and to satisfy spending needs • To optimize tax-efficiency, that is, to achieve the above two objectives in the most tax-efficient manner 2) Client Objectives and Concerns: The concentrated position can be used in conjunction with gifting strategies to meet wealth transfer objectives i.e leaving a bequest or giving charity etc other key employees the opportunity to eventually acquire control of the business; • May wish to transfer control of the business to the next generation; Rationale for holding concentrated positions in investment real estate: The investor may prefer to retain concentrated positions in real estate • To maintain control of the property for the successful operation of a business enterprise; • To transfer ownership of the real estate to the next generation; • To generate profit through price appreciation of the property; 3.2 In managing risks of concentrated positions, advisors must also consider rationale for holding such positions Rationale for holding concentrated stock positions: An investor may prefer to retain concentrated stock positions because of • Selling constraints imposed on company executives to hold shares for a long time period in an attempt to encourage them to work hard for the growth of the company; • Emotional attachment to the stock • Concerns about the tax implications of selling i.e to defer capital gains or to eliminate capital gains • Desire to maintain effective voting control of the company • Desire to participate in the stock’s future returns • Lock-up period constraints or insider restrictions on the selling of shares • Illiquidity of the stock Rationale for holding concentrated positions in privately owned businesses: The business owner • May find it premature to sell the company because it has just entered its growth phase; • May have a desire to maintain total control of the company; • May have a desire to give senior management and Considerations Affecting All Concentrated Positions (Covering Section 3.2.1-3.4.2) Various constraints faced by owners of concentrated positions that restrict their flexibility to either sell or hedge their shares are as follows 1) Tax Consequences of an Outright Sale: Simply selling the concentrated positions with highly appreciated current market values compared to their original cost (cost basis) result in an immediate taxable capital gain (selling price – tax cost basis) and associated tax liability for the owner 2) Liquidity: Concentrated position in a publicly traded stock is illiquid when the size of the concentrated position is large relative to the trading volume of the company’s shares or when the owners have legal constraints with regard to the timing and amount of any sales Concentrated position in privately traded shares is illiquid because private company’s shares have no readily available market Similarly, direct ownership of investment in real estate is also illiquid due to large transaction size and lack of availability and timeliness of information 3) Institutional and Capital Market Constraints: They can further be classified as follows: a) Margin-Lending Rules: Margin-lending rules are the rules that determine the maximum amount that a bank or brokerage firm is allowed to lend against Reading 11 Concentrated Single-Asset Positions the securities positions owned by their customers Certain types of secured lending that is reported as “off-balance sheet” debt (i.e prepaid variable forward, discussed below) are considered as “sales” for margin rule purposes (but not for tax purposes; implying that capital gains taxes can be deferred or eliminated) and are therefore NOT subject to margin rules There are two types of Margin Regime i Rule-based system: In a rule-based system, the maximum amount that can be lent against the security owned by the customer (investor) depend on strict rules regarding the purpose of the loan For example, in U.S if the loan proceeds will be used to buy additional securities, then the bank can lend a maximum of 50% of the value of the stock ii Risk-based system: Under a risk-based system if the stock is completely hedged by a long put, then bank or brokerage firm can lend 100% of the put strike to the investor even if the loan proceeds will be used to buy additional securities Portfolio margining is an example of a risk-based margin regime The risk-based rules provide greater flexibility to advisors with regard to obtaining desired economic and tax outcomes b) Securities Laws and Regulations: Company insiders and executives are subject to various regulatory selling constraints i.e prohibition from selling during black-out periods, or when in possession of material nonpublic information; disclosure/reporting requirements; restrictions regarding the timing and volume of sales or hedging transactions c) Contractual Restrictions and Employer Mandates& Policies: Contractual restrictions include IPO “lockup” periods Employer mandates and policies include a prohibition from buying/selling during “blackout period”; “right of first refusal” that require equity-holders of a private company to first give other equity investors the right to buy the interest at the same price and under the same conditions as being offered to a third party before selling their investment to a third party These restrictions and mandates tend to reduce the liquidity of an investment holding d) Capital Market Limitations: Factors that affect dealers’ decision to execute collars or use other hedging techniques include: • Ability to borrow shares: The ability to borrow shares is critically important for the dealer to manage its counterparty risk The investor executing the hedging transaction with the dealer can lend its “long” shares to the dealer (provided that the investor has no restrictions on lending); however, for tax purposes, the transaction is considered as a “sale” • Liquidity of the stock: The liquidity of the stock is also very important for the dealer to periodically adjust its FinQuiz.com hedge • Average daily trading volume: The average daily trading volume of the stock is important for the dealer to analyze shares’ propensity to move in upward or downward direction This implies that dealers prefer to enter into a hedging transaction for the shares of a company with an established trading history/pattern 4) Psychological Considerations: Psychological considerations of clients that negatively affect the decision making of holders of concentrated positions and act as constraints to dealing with concentrated positions include: a) Emotional Biases: For example, • Overconfidence and familiarity (illusion of knowledge) • Status quo bias • Nạve extrapolation of past returns • Endowment effect • Loyalty effects b) Cognitive Biases: For example, • • • • • Conservatism Confirmation Illusion of control Anchoring and adjustment Availability heuristic Emotionally biased clients should be advised differently from the clients with cognitive errors i.e emotionally biased clients should be advised by explaining the effects of investment program on various investment goals and by determining a deceased person’s objective in owning the concentrated position and bequeathing it; whereas clients with cognitive errors should be advised by providing quantitative measures e.g S.D and Sharpe ratios NOTE: Behavioral biases are discussed in detail in Reading and Practice: Example 1, Volume 2, Reading 11 3.5 Goal-Based Planning in the ConcentratedPosition Decision-Making Process Investment advisors can incorporate psychological considerations of their clients holding concentrated positions into asset allocation and portfolio construction decisions using “Goal-based Planning” Goal-based planning involves dividing a portfolio into following three notional “risk buckets” addressing different investment goals and then determining appropriate asset allocation Reading 11 Concentrated Single-Asset Positions consistent with each risk bucket and its corresponding goals 1) Personal Risk Bucket: The goal of personal risk bucket is to protect the client from poverty or significant decrease in standard of living Hence, asset allocations to this bucket focus on investing in low-risk, low-return investments for the purpose of minimizing or eliminating loss These low-risk investments include client’s primary residence, certificates of deposits, Treasury bills, and other “safe haven” investments 2) Market Risk Bucket: The goal of market risk bucket is to maintain the current standard of living Hence, asset allocations to this bucket focus on investing in assets with average risk-adjusted market returns, e.g stocks and bonds 3) Aspirational Risk Bucket: The goal of aspirational risk bucket is to increase wealth substantially Hence, asset allocations to this bucket focus on investing in high-risk, high-return assets e.g client’s concentrated positions (i.e privately owned businesses, investment real estate, concentrated stock positions, stock options etc.) • Owner’s Primary Capital: Owner’s primary capital is the assets owned by the client other than the concentrated position It comprises assets that are allocated to his or her personal and market risk bucket • Primary capital requirement: The capital needed to be allocated to client’s personal and market risk buckets is referred to as primary capital requirement • Owner’s Surplus Capital: It is the capital in excess of the primary capital requirement It comprises assets that are allocated to his or her aspirational risk bucket Goal-based planning approach helps investors in identifying concentration risk and in determining whether a sale or monetization will enable the investor to meet his/her financial goals • For example, if investor’s goal is to maintain its current standard of living after retirement, then he/she should allocate a significant amount of the portfolio to the personal risk and market risk buckets as well as should diversify his/her concentrated position in a single asset • The sale or monetization of the concentrated position should generate sufficient after-tax proceeds to help investor achieve financial independence, i.e meet his/her lifetime spending needs and desires FinQuiz.com Various factors are considered to determine the ability of the sale or monetization of the concentrated position to achieve financial independence for the owner i.e i The lifetime spending needs and desires of the client after the sale or monetization of the concentrated position; ii The primary capital requirement, i.e present value of the capital needed to meet client’s lifetime spending needs with low or zero probability of running out of money iii Current value of the concentrated position The value of concentrated position will vary depending on the type of monetization strategy used by the investor iv Current value of owner’s primary capital v The current value of the concentrated position under one or more of the monetization strategies to determine whether it is sufficient to meet client’s primary and surplus capital requirements Practice: Example 2, Volume 2, Reading 11 3.6 Asset Location and Wealth Transfers Asset location and wealth transfers are the two tools available to investors for addressing their concentrated positions Asset location decision refers to locating/placing investments (different asset classes) in appropriate accounts Asset location decisions primarily depend on the tax regime governing the investor Implications of asset location for the owners of concentrated positions: • Assets that are taxed heavily/annually should be held in tax deferred and tax exempt accounts • Assets that are taxed favorably (i.e at lower rates) and/or tax deferral should be held in taxable accounts Wealth transfer planning refers to determining the most tax-efficient method and timing of wealth transfer • Transfer tax minimization strategies that can be used at the time before substantial appreciation of the value of the concentrated position include: A Direct gifts to family members B Direct gifts to long-term trusts C Ownership transfer estate freeze (or an early of an estate): This strategy seeks to transfer future appreciation (typically of a corporation, partnership, or limited liability company) to the next generation at little or no gift or estate tax cost Under this strategy, only the current market value (not the future appreciation) of the equity Reading 11 FinQuiz.com Concentrated Single-Asset Positions position is subject to gift or wealth transfer tax In a typical corporate estate tax freeze involving a recapitalization of a closely held family-owned corporation, • The older generation owning all of the stock of the company exchanges their existing company’s stock for two newly issued classes of stock i.e i Voting preferred shares: The value of these shares is equal to the current value of 100% of the corporation These shares are held by the older generation These shares pay a fixed rate like bonds; thus, their value does not appreciate greatly ii Non-voting common shares: They have current nominal value and are gifted to the next generation The value of common shares increase with the future appreciation in the value of the corporation However, the appreciation is not subject to any gift or estate tax until the common shares are passed by gift or bequest to the next generation • Due to the voting power attached to preferred shares, the control of the company is retained by the older generation • The preferred shares can be redeemed and voting rights may be provided to common shareholders upon retirement or death of the older generation transfer as well as estate tax savings if the value of concentrated position appreciates by the time the parent dies Example: Suppose the value of concentrated position is $10 million and the combined discount is 30% The parents decide to transfer 25% interest to their children Hence, Value of interest gifted to children = 25% × $10 million × (1 – 30%) = $1.75 million If the value of $10 million concentrated position increases to $35 million by the time the parent dies, Value of interest held by children = 25% × $35 million = $8.75 million Gift tax valuation = $1.75 million Practice: Example 3, Volume 2, Reading 11 3.7 Concentrated Wealth Decision Making: A FiveStep Process NOTE: Step The corporate estate tax freeze is not allowed in all jurisdictions •Identify, establish , & document objectives & constraints of the owner of the concentrated position as well as the impact of those constraints It must be stressed that it is highly important for an advisor to plan the management of an owner’s concentrated positions as early as possible because over time, as the concentrated position appreciates in value, wealth transfer tools (although still useful) tend to be less efficient, more complex, and expensive to implement • After the significant appreciation of the value of the concentrated position, the transfer tax can be minimized by contributing the concentrated position to a limited partnership and gifting the limited partnership interests to the next generation • The value of a limited partnership interest is typically less than the proportionate value of the underlying assets (discount of 10-40%) due to the following two reasons: 1) Lack of marketability: Typically, family limited partnership interests are restricted and difficult to sell outside the family 2) Lack of control: Since the control of the partnership (as represented by general partnership interest) and the concentrated position within it is retained by the parents, the value of limited partner’s non-controlling interest is low • Contributing the concentrated position to a limited partnership generate gift tax savings at the time of Step •Identify tools or strategies that can be used to meet owner's objectives consistent with constraints Step Step •Thoroughly compare tax advantages and disadvantages of each tool or strategy Step •Formulate and document an overall strategy that best meets client's objectives after comparing tax & nontax advantages and disadvanatges of each alternative tool •Thoroughly compare non-tax advantages and disadvantages of each alternative tool or strategy Reading 11 Concentrated Single-Asset Positions FinQuiz.com MANAGING THE RISK OF CONCENTRATED SINGLE-STOCK POSITIONS Common Tools/strategies that can be used to mitigate the risks of any concentrated position are as follows These tools may vary depending on the jurisdiction A Outright sale: It refers to simply selling the security to reduce concentrated position Advantages: • It is the simplest method • It provides investors the maximum flexibility with regard to disposition or reinvestment of sale proceeds • It facilitates the owner to reduce overall portfolio risk and achieve diversification Disadvantages: • It incurs tax liability (i.e capital gains tax) • It is most suitable for publicly traded shares and for positions with no sale restrictions • An outright sale eliminates any upside price potential associated with the concentrated position and also results in loss of dividends and voting power B Monetization strategies: Monetization strategies facilitate owners to mitigate the risks of a concentrated position without incurring tax liabilities Examples of monetization strategy that involve borrowing include: • Margin loan: It is a loan against the value of a concentrated position • Recourse and non-recourse debt • Fixed and floating rate debt • Loans embedded within a derivative (e.g a prepaid variable forward) Other monetization strategies include: • Short sales against the box • Restricted stock sales • Public capital market-based transactions i.e debt exchangeable for common offerings • Rule 10b 5-1 plans and blind trusts (U.S.) • Exchange funds (U.S.) C Hedging: This strategy involves hedging the value of the concentrated asset using derivatives i.e exchange-traded instrument (i.e options or futures) or an over-the-counter (OTC) derivative (i.e OTC options, forward sale or swap) However, such hedging transactions must not be deemed as constructive sale to avoid incurring taxes Transactions that may be deemed as constructive sale of an appreciated stock include: • A short sale of the same or substantially identical property; • An offsetting notional principal contract on the same or substantially identical property; • A futures or forward contract to deliver the same or substantially identical property; 4.1 Introduction to Key Tax Considerations The risk of a concentrated asset (e.g stock) can be mitigated by shorting the stock directly or by using derivatives Either method generates the same economic outcome; but they are taxed differently Most of the tax regimes that govern taxation of financial instruments are comprehensive in nature However, they are not always internally consistent, i.e tax treatment of different tools varies depending on tax regimes The internal inconsistency of tax codes allow investors to reduce their tax risk or generate significant tax savings by selecting the tool that provides the most efficient economic and tax result 4.2 Introduction to Key Non-Tax Considerations (Covering Section 4.2.1-4.2.6) Non-tax considerations that must be considered with regard to selecting the optimal derivative instrument for hedging the concentration risk include: 1) Counterparty Credit Risk: In an OTC derivative the investor is exposed to counterparty credit risk In contrast, exchange-traded derivatives are not subject to credit risk of counterparty or have lower counterparty credit risk 2) Ability to Close Out Transaction Prior to Stated Expiration: Since exchange-traded derivatives are highly liquid, investors can easily close-out the transaction by entering into offsetting transactions before contract’s stated expiration Whereas in OTC derivatives, early termination of a particular contract usually involves a concession in return 3) Price Discovery: Exchange-traded derivatives facilitate price discovery due to their standardized terms and conditions By contrast, in OTC derivatives, price is determined through negotiation by the parties involved in a transaction 4) Transparency of Fees: Fees (commissions) and expenses in exchange-traded transactions are Reading 11 Concentrated Single-Asset Positions relatively more transparent than that of OTC transactions 5) Flexibility of Terms: Due to customized nature of OTC derivatives, they are relatively more flexible to meet the specific needs of counterparties compared to standardized exchange-traded instruments 6) Minimum Size Constraints: Exchange-traded derivatives typically have a smaller minimum size constraint than OTC derivatives 4.3 Strategies Three primary strategies that can be used to mitigate risk of a concentrated position in a common stock are as follows 1) Equity monetization 2) Hedging 3) Yield enhancement 4.3.1) Equity monetization Equity monetization involves borrowing against the value of the concentrated stock position and reinvesting the loan proceeds to achieve diversification It allows an investor to cash out the appreciated value of a concentrated stock position without incurring any tax liability at the time of cashing out When the stock position is hedged, an investor can achieve a high loanto-value (LTV) ratio Advantages of Equity monetization: • It allows an investor to transfer the economic risk and reward of a stock position without actually transferring the legal and beneficial ownership of that asset; implying that they not constitute a sale or disposition of the appreciated concentrated position As a result, the capital gain tax on the appreciated long position can be deferred • It helps the owner to mitigate concentration risk by generating the same amount of cash as that by an outright sale but without incurring an immediate tax liability • This strategy is useful for stock positions with sale restrictions or contractual restrictions • This strategy is preferred to use when the owner (with a large % of share holdings) wants to retain control of the company or not want another investor to acquire a large block of company shares Types of tools/strategies of Equity Monetization (Covering Section 4.3.1.1) A A short sale against the box: A short sale against the box is a transaction in which an investor actually owns the stock and protects its long position by short selling the same stock (i.e settles the sale with borrowed shares) The short sale proceeds can be invested in a diversified portfolio of securities • Due to long and short position in the same number FinQuiz.com of shares of the same stock, any future change in the stock’s price will have no effect on the investor’s economic position Also, any dividends or other distributions received on the long shares are transferred to the lender of shares Advantages: • The short sale against the box enables an investor to lock in a profit without recognizing the related capital gains tax • The short sale against the box creates a riskless position due to simultaneous long and short position in the same stock As a result, the investor can earn a money market rate of return on the stock position and can borrow with a high loan to value (LTV) ratio against the position (e.g up to 99% of the value of the hedged stock) with no restrictions on the use of the loan proceeds • A short sale against the box helps investors to potentially defer the capital gains tax on a concentrated position • It is the least expensive technique as: o It has low net cost of borrowing because the interest earned on the hedged stock position can be used to pay the interest expense of the margin loan o It has low dealer fees compared to synthetic short sales transactions B A total return equity swap: It is a bilateral contract in which an investor agrees to pay out the total return of the equity, including its dividends and capital appreciation or depreciation, to the dealer; and in return, receives a regular fixed or floating cash flow (i.e any loss in the value of the equity + One-month LIBOR - Dealer spread) • Due to derivative dealer spread paid by the investor, the money market rate of return earned by the investor will be slightly less than that of a short sale against the box • Because the stock position is completely hedged, an investor can borrow with a high LTV ratio against the position C Options (forward conversion with options): It involves constructing a synthetic short forward position against the long position in the asset Synthetic short Forward = Long Put + Short Call Where, the long put and short call options are on the same underlying asset with the same strike price and the same termination date • When the stock price falls to zero investor exercises the long put option delivers the stock to the dealer and receives the put strike price • When the stock price increases the counterparty exercises the call option investor delivers the stock to the counterparty and receives the call strike price Reading 11 Concentrated Single-Asset Positions Advantage: • Synthetic short forward position is riskless; as a result, the investor can earn a money market rate of return on the position and can borrow with a high loan to value (LTV) ratio against the position • Capital gains tax on the appreciated long position can be deferred if the long and short (or synthetic short) position is treated separately for tax purposes D An equity forward sale contract or single-stock futures contract: It is a bilateral contract where the investor agrees today to exchange the stock at some future date at a fixed price; and in return, receives the “forward price” from the dealer at some future date Advantage: • An equity forward sale position is riskless; as a result, the investor can earn a money market rate of return on the position (represented by forward price) and can borrow with a high loan to value (LTV) ratio against the position Disadvantage: • If at contract termination, market price of the stock > forward price, investor receives the forward price and loses any upside price potential 4.3.1.2 Tax Treatment of Equity Monetization Strategies The investor should select the most tax-efficient equity monetization strategy Characteristics of a Tax-efficient hedging tool: • Unwinding or cash settlement of the hedging transaction results in a long-term gain rather than short-term gain • Unwinding or cash settlement of the hedging transaction results in a short-term and currently deductible loss • The physical settlement of the contract generates a long-term gain rather than a short-term gain • Monetization strategy has carrying costs that are currently deductible • Hedging transaction has no impact on the taxation of dividends or distributions received on the shares General Income Tax Regimes A Common Progressive Regime: Under this regime, ordinary income is taxed at progressive tax rates whereas all three investment income (i.e dividends, interest, & capital gains) are taxed at favorable tax rates It is the most common tax regime B Heavy Dividend Tax Regime: Under this regime, • Ordinary income is taxed at progressive tax rates • Interest and capital gains are taxed at favorable tax FinQuiz.com rates • Dividends are taxed at ordinary rates C Heavy Capital Gain Tax Regime: Under this regime, • Ordinary income is taxed at progressive tax rates • Interest and dividends are taxed at favorable tax rates • Capital gains are taxed at ordinary rates It is the least common tax regime D Heavy Interest Tax Regime: Under this regime, • Ordinary income is taxed at progressive tax rates • Dividends and capital gains are taxed at favorable tax rates • Interest income is taxed at ordinary rates E Light Capital Gain Tax Regime: Under this regime, • Ordinary income, interest, and dividends are taxed at progressive tax rates • Capital gains are taxed at favorable tax rates It is the second most commonly observed tax regime F Flat and Light Regime: Under this regime, • Ordinary income is taxed at flat tax rates • Interest, dividends, and capital gains are taxed at favorable tax rates G Flat and Heavy Regime: Under this regime, • Ordinary income, dividends and capital gains are taxed at flat tax rates • Interest income is taxed at favorable tax rates 4.3.2) Lock in Unrealized Gains: Hedging Hedging provides protection against downside risk of the concentrated position but without losing the upside price potential associated with the stock Two major hedging approaches (Covering Section 4.3.2.1 – 4.3.2.2): 1) Purchase of puts: This strategy is referred to as “protective put” Protective Put = Long stock position + Long Put position • Purchasing put option requires the payment of cash up front in the form of option premium The put option premium depends on various factors i.e o Volatility of the stock: The more (less) volatile the stock, the higher (lower) the put option premium will be o Strike price of the option: The higher (lower) the strike price of a put option, the higher (lower) put Reading 11 Concentrated Single-Asset Positions option premium but the smaller (greater) the downside risk will be o Maturity: The shorter (longer) the maturity, the lower (higher) the put option premium will be Advantages: • A long put option on the concentrated stock position provides downside protection (by setting a floor price) while retaining the upside potential but without recognizing the related capital gains tax • A long put option on the concentrated stock position enables an investor to retain any dividends received and voting rights Strategies that can be used to reduce the cost of acquiring puts (i.e option premium) are as follows: • Buying at-the-money or slightly out-of-the-money put options with relatively lower option premium • Using “put-spread” strategy that involves buying a put option with a higher exercise price and selling an otherwise identical put option with a lower strike price but with the same maturity as the long puts o Selling put generates some premium income, which can be used to partially finance the cost of long put o However, by selling put option, investor faces downside risk whenever the underlying stock price further declines below the strike price of the short put • Using a “Knock-out” put option in which once the stock price increases to a certain level, the downside protection disappears before its stated expiration date As a result, it has lower option premium than that of “plain vanilla” put It is an “exotic” option and is traded only over-the-counter for fairly large positions • Using a cashless or zero-premium collar (discussed below) 2) Cashless (or zero-premium) Collar: In a cashless collar, an investor purchases an out-of-the-money put option (i.e with a strike price ≤ current stock price) on the underlying position and simultaneously sells a call option with the same maturity but with the same strike price > current stock price Cashless collar = Long Put + Short Call • An investor receives premium income by selling a call option, which can be used to fully finance the purchase of the put option • However, the short call option puts a cap on the opportunity for unlimited capital appreciation by setting a ceiling price established by the covered call* It must be stressed that using a cashless equity collar reduces, not eliminates, the investment risk • When stock price > call strike price, call option is exercised and the investor delivers his long shares and receives Call strike price + Call premium received – Put FinQuiz.com premium paid • When at expiration, stock price lies between strike price of put and call option, both options expire worthless and the investor receives (Call option premium received – Put option premium paid) • When stock price < put strike price, the investor exercises put option and delivers his long shares and receives Put strike price + Call premium received – Put premium paid *The upside potential can be increased using different approaches i.e i By buying put option with a lower put strike price and selling call option with a higher strike price because the lower the put strike price, the lower the put option premium whereas the higher the call strike price, the lower the call option premium ii Using a “put-spread” strategy in conjunction with selling a call option of the same maturity: Selling a put generates some premium income that can be used to partially finance long put option However, investor faces downside risk whenever the underlying stock price further declines below the strike price of the short put but will have more upside potential than with a plain vanilla cashless collar iii Using a Debit collar: It involves paying a portion of put premium “out of pocket” Using debit collar allows investor to sell a call with a higher strike price in order to finance the net cost of the put Important to Note: In Exchange-traded options, the premium received on short call option is taxed as a short-term capital gain in the year of expiration of option 4.3.2.3 Prepaid Variable Forwards A pre-paid variable forward (PVF) is a forward contract in which the investor agrees to sell a specific number of shares in the future at pre-specified future date in return for an upfront cash payment from the counterparty The number of shares to be actually delivered at maturity will be determined by some preset formula e.g based on long put strike price and a short call strike price That is, • If the share price at pre-specified future date is < put strike price: o When PVF is physically settled: An investor has to deliver all of its shares o When PVF is cash settled: An investor has to pay the dealer the then-current value of shares in cash • If the share price at pre-specified future date is greater than put strike price but less than call strike price: o When PVF is physically settled: An investor has to deliver shares worth put strike price o When PVF is cash settled: An investor has to pay the dealer put strike price in cash • If the share price at pre-specified future date is > Reading 11 Concentrated Single-Asset Positions call strike price: o When PVF is physically settled: An investor has to deliver shares worth (put strike price + value of shares in excess of the call strike price) o When PVF is cash settled: An investor has to pay the dealer [put strike price + (then-current price of shares – call strike price)] An investor can enter into another PVF to generate the liquidity to meet its obligations under the original PVF Practice: Example 4, Volume 2, Reading 11 4.3.2.3 Choosing the Best Hedging Strategy The optimal hedging strategy is the one that is most taxefficient Unlike common shares, restricted company shares and employee stock options are taxed similar to other forms of compensation income (salary & bonus) i.e at significantly higher rates than long-term capital gains income Mismatch in Character: When the investor has ordinary income on the concentrated position but capital loss on the hedge, it is referred to as a mismatch in character Due to this mismatch in character, the capital loss on the hedge may not be currently deductible because capital losses are generally deductible against capital gains, not against ordinary income In the U.S., mismatch in character can be avoided by using a swap with an optionality of a collar embedded within it Practice: Example 5, Volume 2, Reading 11 4.3.3) Yield Enhancement In order to enhance the yield of a concentrated stock position while decreasing its volatility, investors can write covered calls against some or all of the shares Covered Call = Long stock position + Short call position (with a strike price > current stock price) • Writing a covered call generates cash up front in the form of option premium but provides limited upside potential (i.e call strike price + premium received) • The downside protection on share price is limited to the option premium received on the front-end of the transaction However, covered call strategy may help in psychologically preparing the owner to dispose off those shares • This strategy is preferred to use when the stock is owned by the investor and when the stock price is expected to move in a trading range for the foreseeable future • Covered call strategy involving short calls with FinQuiz.com staggered maturities and strike prices can be used as an alternative to a structured selling program 4.3.4) Other Tools: Tax-Optimized Equity Strategies With regard to managing risk of a concentrated stock position, 1) Tax-optimized equity strategies can be used as an index-tracking strategy with active tax management: An index-tracking separately managed portfolio is quantitatively designed to closely (not perfectly) track a broad-based market index on a pre-tax basis, and outperform it on an after-tax basis • An index-tracking separately managed portfolio is funded by cash, from the partial sale of the investor’s concentrated stock position, from the monetization proceeds derived from the hedged stock position, or a combination of any of these • These strategies use opportunistic capital loss harvesting and gain deferral techniques that can be used by the investor to sell a commensurate amount of concentrated stock without incurring any capital gains taxes 2) Tax-optimized equity strategies can be used in the construction of completeness portfolios: Constructing a completeness portfolio is a strategy in which an investor “completes” investment in a single security (i.e concentrated stock position) by purchasing a basket of other liquid securities (having low correlation with the concentrated stock) to hold a portfolio that tracks the broadly diversified market benchmark By combining a concentrated stock position with additional liquid securities, the concentration risk is reduced and the portfolio may behave like some desired index • Completeness portfolio uses capital loss harvesting that facilitates the investor to sell a commensurate amount of concentrated stock without incurring any capital gains tax • With the passage of time, the size of the concentrated stock position declines to zero and the investor ends up holding a diversified portfolio of lower-basis (not current) stocks Limitations: • Completeness portfolio strategy is only suitable for investors who have access to other liquid assets besides their concentrated stock position because constructing a completion portfolio requires significant liquidity • Implementing a completeness portfolio strategy tends to require significant time • Liquidation of a diversified market portfolio incurs a capital gain tax Reading 11 4.3.5) Other Tools: Cross Hedging Cross hedge (or indirect hedge) involves hedging a concentrated position by using derivatives on a substitute asset (a security or basket of securities or a broad or target investable index)that has an expected high correlation with the investor’s concentrated stock position Cross hedge is preferred to use when: • Derivatives on the concentrated stock are not available; • Direct hedging involves higher execution costs; or • Investor is restricted from executing a hedging transaction Advantage of cross hedge: Cross hedge helps investors to hedge market and industry risk Disadvantage of cross hedge: Using cross hedge, an investor cannot hedge company-specific risk of the concentrated position • • • • • Valuation level of target companies Tax rate applicable to a particular exit strategy Condition of the credit markets Level of interest rates Degree of buying power in the marketplace (strategic and financial buyers) • Currency valuation Profile of a Typical Business Owned by a Private Client Typically, the business represents the major portion of the owner’s net worth and is owner’s primary source of income It is also a source to meet legacy and charitable objectives NOTE: Business that is privately owned and whose value ranges between $10 million to over $500 million is referred to as “Middle-market” business 5.2 Important to Note: To avoid risk of decline in the value of concentrated stock position associated with companyspecific factors while simultaneous increase in the value of proxy asset or index above the call strike or short-sale price, investors should use long put options rather than cashless collar or short position 4.3.6) Exchange Funds In exchange funds, a number of investors, each with a different concentrated position, pool together their assets and thereby diversify their holdings without incurring immediate capital gains tax because partners’ cost basis in the partnership units is equal to the cost basis of the contributed concentrated stock positions • Each partner then owns a pro rata interest in the partnership • For tax purposes, each partner has a minimum seven year lock up period during which the investor cannot withdraw or sell its investments After the lock-up period, the investor can withdraw a pro rate share of the fund MANAGING THE RISK OF PRIVATE BUSINESS EQUITY From the perspective of the seller of concentrated position, attractiveness of the market depends on various factors, including 5.1 FinQuiz.com Concentrated Single-Asset Positions Profile of a Typical Business Owner • Due to demands of managing and operating the business, the business and personal lives of business owners are usually intertwined, involving both family members and business partners • Additionally, long-term objectives of business owners are non-static in nature • Typically, business owners tend to underestimate their business’ risk and overestimate the value of their business • Besides aging of the owner, business may be exposed to various risks i.e competition, illness of the owner or a family member etc Also, a business owner may have no exit plan and have little knowledge regarding various hedging and monetization strategies 5.3 Monetization Strategies for Business Owners (Covering section 5.3.1 – 5.3.9) The attractiveness of the monetization strategies for business owners depend on the conditions in the capital market and the merger and acquisition deal market Types of Monetization Strategies available to Business Owners: 1) Sale to Strategic Buyers: Strategic buyers are competitors or other companies engaged in the same or similar line of business as the seller Strategic buyers tend to invest in the business with a long-term investment objective They usually pay the highest price for the business to realize potential synergistic benefits (related to revenue, costs etc.) and consider the acquisition of the business as a low-risk and attractive means to enhance revenue and earnings growth, especially in a slow growth environment Reading 11 Concentrated Single-Asset Positions Advantages of sale to a strategic buyer: • This strategy allows the owner to reduce concentration risk and to generate liquidity to diversify • This strategy generates the highest current proceeds for the owner and allows the seller to avoid higher tax rate in future • Selling the business to a strategic buyer relieves the seller from running the business and maintaining its day-to-day operations 2) Sale to Financial Buyers or Financial sponsors: Financial buyers are the investors who make direct investment in mature and stable middle-market businesses Private equity firm is an example of a financial buyer Financial buyers tend to a pay a lower price compared to strategic buyers as they, unlike strategic buyers, lack the opportunity to obtain financial and operational synergistic benefits Financial buyers tend to have a short-term investment objective as they are interested in generating high internal rate of return on their invested capital over a short time period (3-5 years)and the future exit opportunities from the business 3) Recapitalization or a leveraged recapitalization: In a recapitalization strategy, a business owner sells a large portion (60-80%) of its business equity to a seller (i.e private equity firm) for cash and retains a minority ownership interest (20-40%) in that recapitalized entity The investor can invest those after-tax cash proceeds* in other asset classes to create a diversified portfolio The retained minority ownership interest in the business motivates the owner to grow the business • Recapitalization strategy is a type of “staged” exit strategy as it allows the owner to generate liquidity in two stages i.e one up front and another typically within 3-5 years when the private equity seeks to exit the investment • Recapitalization strategy is preferred to use when a business owner wants to reduce concentration risk and generate liquidity without selling the business entirely *After-tax amount monetized by the recapitalization = Sales price × % of equity sold × (1 – Tax rate) For tax purposes, the cash received by the owner is taxed and the owner may usually receive a tax deferral on the stock rolled over into the newly capitalized company In a leveraged recapitalization, besides investing equity, a private equity firm also arranges debt for the business with senior and mezzanine (subordinated) lenders As a result, the owner is no longer required to personally guarantee bank debt and can focus on growing the business and maintaining day-to-day operations FinQuiz.com Advantages of Recapitalization: • Recapitalization strategy allows the owner to reduce concentration risk, to generate liquidity to diversify, to minimize tax liability before expected increase in tax rates, and to sell the business within short time period (3-5 years) • Using recapitalization allows the seller to retain his identity as the CEO of his firm • Capital (equity) obtained through recapitalization can be used to expand the business and enhance earnings and value of the company within a short time period Disadvantages of Recapitalization: • Since private equity firms are financial buyers, they typically pay a lower price relative to strategic buyers • By selling a large ownership interest to private equity firm, the business owner loses control of the company 4) Sale to Management or Key Employees: A management buyout (MBO) is a strategy, which involves transferring control of the business to a group of senior managers or employees Since these key employees may lack skills to successfully run a business, they are not able to raise sufficient funds to buy the company Hence, the business owner may have to finance a portion of a sale price by accepting a significant portion of the purchase price in the form of a promissory note, under which a significant amount of the purchase price is deferred and sometimes conditional on meeting or exceeding certain financial performance targets • It must be stressed that the business should be sold to key employees only if the pricing, terms, and conditions of their purchase offer matches or exceeds that of a third-party buyer • A failed attempt to MBO may have potential negative effects on the employer-employee relationship 5) Divestiture (Sale or Disposition of Non-Core Assets): Divestiture is a strategy that allows the business owner to generate some liquidity to diversify (without losing control of the business) by selling non-core assets i.e assets that are not essential for the continued operation or for the future growth of the business 6) Sale or Gift to Family Member or Next Generation: Business owners can sell or transfer their business to next generation through tax-advantaged gifting strategies • When the business is sold to family members but family members not have the necessary capital to buy the business, the owner may have to accept a significant portion of the purchase price in the form of a promissory note Reading 11 Concentrated Single-Asset Positions • Transferring the business to the next generation through gifting strategies is appropriate to use only if the owner has sufficient capital available outside the business to maintain his/her desired lifestyle 7) Personal Line of Credit Secured by Company Shares: A business owner can generate liquidity to diversify its concentrated position without losing control of the business and without incurring an immediate tax liability (if structured properly) by obtaining a personal loan against its private company shares • The loan gives the lender a “put” option that gives the lender the right to demand repayment of the loan The business owner can meet the put obligation either through its existing credit arrangement or with a standby letter of credit issued for this specific purpose When the put option is exercised, it triggers a taxable event for to the business owner • In addition, in most jurisdictions, the interest expense on the loan is currently deductible for tax purposes 8) Going Public through an Initial Public Offering: A business owner can dispose off its concentrated position by making the company public through an initial public offering (IPO) It is preferred to use if the owner wishes to remain actively involved in the company and does not want to exit from the company in the near future • A private business can use an IPO strategy only if it exhibits steady and significant growth in the past and is considered attractive by the investors • IPO is an expensive strategy but may generate the highest cash proceeds for the owner • By going public, private business owners lose their privacy and authority Also, the management may face pressure to meet short-term quarterly revenue and earnings expectations of the investment community FinQuiz.com • In a leveraged ESOP, the ESOP can borrow capital from a bank to finance the purchase of the owner’s shares, provided that the company has borrowing capacity • An ESOP is a type of “staged” or “phased” exit strategy like recapitalization Advantages of ESOP: • ESOP allows the owner to partially diversify its concentrated position without incurring an immediate capital gains tax liability and without losing control of the company and any upside potential in the retained shares • For tax purposes, the business owner (only shareholders of “Subchapter C” corporation) can defer capital gain tax associated with the sale of stock to an ESOP • ESOP strategy also eliminates capital gains tax by a possible step-up in basis on death Disadvantage of ESOP: ESOP involves significant setup and maintenance costs 5.4 Considerations in Evaluating Different Strategies The capital that the business owner receives after monetizing the business primarily depends on the strategy used by the owner (e.g selling to a strategic buyer generates the highest capital, in an earn-out or MBO, the payout is contingent on the financial performance of the company etc.) As stated previously, the optimal hedging or monetization strategy for the business owner is the one that maximizes the after-tax proceeds, rather than sales price, which the owner can reinvest in other liquid assets Practice: Example & 7, Volume 2, Reading 11 9) Employee Stock Ownership Plan: A business owner can sell some or all of the company’s shares by selling shares to the employees through an employee stock ownership plan (ESOP) MANAGING THE RISK OF INVESTMENT REAL ESTATE Commonly, a substantial portion of the business’s value and assets is comprised of real estate A real estate may also represent a significant portion of a private client’s net worth In addition, a real estate can be held as a standalone investment Like private business owners, real estate owners tend to underestimate risks of their real estate and overestimate their value Risks of Investment Real estate include: • Concentration risk • Illiquidity • Greater tax liability on liquidation of the property as the property may be highly appreciated relative to its original tax cost basis 6.1 Monetization Strategies for Real Estate Owners The monetization strategies used by private businesses and real estate owners should not solely be evaluated for tax purposes; rather, investment advisors should also consider business or investment rationale for the transaction That is, if the business or investment rationale Reading 11 Concentrated Single-Asset Positions FinQuiz.com for the monetization or hedging transaction is justified, then the advisors should select the most tax-efficient strategy for executing that transaction are available that may help charitably inclined investors to achieve their philanthropic goals For example, From the seller’s perspective, attractiveness of the real estate market depends on various factors, including a) Donor-advised fund (DAF): An investor can transfer the asset with potentially greater growth prospects to a DAF in order to grow the asset tax free When the DAF then sells the property to generate liquidity, it does not incur an immediate tax liability because DAF is a charitable organization The accumulated depreciation deductions taken by the investor cannot be “recaptured”, however In addition, the charitable contributions made to DAF are tax deductible • Current valuation of real estate relative to historical levels and future expectations; • Tax rate applicable to a particular property and lending conditions; • Level of interest rates Types of Monetization strategies for Real Estate Owners (Covering Section 6.1.1 – 6.1.4): 1) Outright sale of the property: It is the most common strategy used by investors to reduce a concentrated position in a particular property and to generate liquidity to diversify asset portfolios 2) Mortgage Financing: It refers to obtaining a fixed-rate or floating-rate mortgage against the property It the second most common strategy used by investors to reduce a concentrated position in a particular property and to generate liquidity to diversify asset portfolios BUT without incurring an immediate tax liability The investor can invest the loan proceeds in a liquid, diversified portfolio of securities • The mortgage can be recourse or non-recourse loan In a non-recourse loan, the only resource available to the lender in the event of default is the mortgaged property Advantages of Mortgage financing: • For tax purposes, the loan proceeds not represent “income” and therefore are not taxed In addition, if the value of real estate increases over time, the investor can borrow additional debt against the property without incurring a tax liability • If an investor achieves a cash flow-neutral LTV ratio*, he/she is able to obtain a loan against the property with no limitations on the use of the loan proceeds • *Cash-flow Neutral LTV (loan-to-value) ratio is the ratio where the Net rental income generated from the property = Fixed mortgage payment (composed of interest expense and amortization of the loan principal) • Another benefit to the investor is that he/she can use net rental income on the property to pay servicing cost of the debt and other expenses of the property, leading to zero net income from the real estate Disadvantage of Mortgage financing: Borrowing against the property does not eliminate economic risk of the underlying property 3) Real Estate Monetization for the Charitably Inclined: Charitably inclined investors are investors with philanthropic goals e.g to build an endowment fund etc Different strategies (that involve asset location) b) Tax-exempt charitable trust: The investor can transfer the appreciated property to the taxexempt charitable trust, which is a trust with defined and charitable purpose The charitable contributions to the trust are tax deductible and the trust would not be taxed on property sale proceeds or investment income on the property 4) Sale and Leaseback: It is a transaction in which the owner of the property sells the property to another party (e.g REIT, institutional or private investor) and then immediately leases it back from the buyer at a rental rate and lease term that is feasible for the buyer and on financial terms that are consistent with the marketplace Advantages: • A sale and leaseback strategy helps the investors to generate liquidity to diversify their concentrated position in real estate, to invest in the expansion of the core business, or to use it for other strategic purposes • Unlike traditional mortgage financing where the investor can rarely achieve > 75% LTV ratio (unless tenant is investment grade from a credit perspective), the investor in a sale and leaseback can obtain 100% LTV ratio • A sale and leaseback strategy helps an investor remove any debt associated with the real estate from the balance sheet • Unlike traditional mortgage financing where only the interest expense component is deductible against the company’s taxable income, rental payments under a sale and leaseback structure are 100% tax deductible against the company’s taxable income • Sale and leasebacks have flexible lease terms (usually 10-20 years) with built-in renewal options • Sale and leasebacks facility is available even during periods of tight credit markets Disadvantage: The investor would have to pay the capital gains tax; as a result, the after-tax proceeds will be less than 100% (unless there are capital loss carryforwards) Reading 11 Concentrated Single-Asset Positions Practice: Example 8, Volume 2, Reading 11 6.1.4) Other Real Estate Monetization Techniques Other real estate monetization techniques include: • Joint ventures • Condominium structures • Sale of buildings with the seller retaining control through a long-term ground lease • Mortgage tax-free exchange: It allows the owner of appreciated property to hedge, monetize, defer, and eventually eliminate the capital gains tax It is allowed in the U.S only Practice: End of Chapter Practice Problems for Reading 11 FinQuiz.com ... $35 million by the time the parent dies, Value of interest held by children = 25 % × $35 million = $8.75 million Gift tax valuation = $1.75 million Practice: Example 3, Volume 2, Reading 11 3. 7... the liquidity to meet its obligations under the original PVF Practice: Example 4, Volume 2, Reading 11 4 .3. 2 .3 Choosing the Best Hedging Strategy The optimal hedging strategy is the one that... using a swap with an optionality of a collar embedded within it Practice: Example 5, Volume 2, Reading 11 4 .3. 3) Yield Enhancement In order to enhance the yield of a concentrated stock position
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