CFA CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA volume 2 finquiz smart summary, study session 5, reading 11

2018 Study Session # 5, Reading # 11 “CONCENTRATED SINGLE-ASSET POSITIONS” CP = Concentrated Position EM = Equity Monetization INTRODUCTION Three major types of concentrated positions in a single asset: Publicly traded stock Privately owned business Commercial or investment real estate Concentrated positions are often illiquid assets CONCENTRATED SINGLE-ASSET POSITIONS: OVERVIEW No universally accepted threshold exists for concentrated position CP is often a long period held position with very low cost basis Publicly traded single-stock positions: Ways an investor can end up owning a concentrated stock position: Part of executive compensation Received a significant amount of stock in share-based sales transaction Came from long term buy-end-hold investing strategy Privately owned business: Usually private businesses with ownership transfer from one generation to next Investment real estate Commercial or industrial real estate typically held for a long-term period 2.1 Investment Risks of Concentrated Positions 2.1.1 Systematic Risk Can’t be eliminated by holding a welldiversified portfolio Multiple sources of systematic risk e.g business cycle, inflation etc 2.1.3 Property-Specific Risk Unsystematic risk of owning a particular piece of real estate 2.1.2 Company-Specific Risk Non-systematic or idiosyncratic risk to a particular company’s operations, reputation & business environment High level of company specific risk exists in a CP the volatility with company specific risks of single-stock holdings, the benefit of higher capital accumulation Copyright © FinQuiz.com All rights reserved 2018 Study Session # 5, Reading # 11 GENERAL PRINCIPLES OF MANAGING CONCENTRATED SINGLE-ASSET POSITIONS 3.1 Objectives in Dealing with Concentrated Positions 3.1.1 Typical Objectives 3.1.2 Client Objectives and Concerns Reduce the risk of wealth accumulation To generate liquidity to diversify & satisfy spending needs To optimize tax efficiency Many objectives that the owner of the CP might wish to achieve including: To maintain effective control To enhance current income 3.2 Considerations Affecting All Concentrated Positions 3.2.1 Tax Consequences of an Outright Sale Significant taxable capital gains possible in CP due to lower cost basis Primary objective ⇒ deferring or eliminating C.G tax if possible 3.2.2 Liquidity CP is generally illiquid Illiquidity generally acts as a constraint with a CP 3.3 Institutional and Capital Market Constraints 3.3.1 Margin-Lending Rules 3.3.2 Securities Laws and Regulations If the purpose of the loan is to buy additional securities, the maximum loan proceeds are usually quite limited Company insiders & executives must often comply with these law’s 3.3.3 Contractual Restrictions and Employer Mandates These generally restrict the flexibility of insider & employees to either sell or hedge their shares & include lockups or blackout periods 3.3.4 Capital Market Limitations Various characteristics of the underlying stock determine the feasibility of hedging different CPs & degree of hedge 3.4 Psychological Considerations2 3.4.1 Emotional Biases Following emotional biases can –vely affect the decision making of holders of CPs: Familiarity & overconfidence bias Status quo bias Endowment effect Careful handling of client to overcome emotional biases 3.4.2 Cognitive Biases These include: Conservatism & confirmation bias Illusion of control, anchoring & adjustment Availability heuristic Copyright © FinQuiz.com All rights reserved 2018 Study Session # 5, Reading # 11 3.5 Goal-Based Planning in the Concentrated-Position Decision-Making Process Goal based planning ⇒ one way to incorporate psychological considerations into allocation & portfolio construction Personal risk bucket: Goal is to protect from poverty or dramatic in life style Yield below market return but limit losses Market risk bucket: Objective is to maintain current living standard Avg risk adjusted market return (stock & bond portfolio) Aspirational risk bucket: Objective is to wealth substantially Above market expected return but with substantial risk of loss of capital Primary capital ⇒ minimum amount to maintain owner’s lifetime spending needs (usually allocated to personal & market risk bucket) Surplus capital ⇒ allocation to aspirational risk bucket 3.6 Asset location and Wealth Transfers Asset location decision ⇒ choice of where to place specific assets (different from asset allocation decision) Usually used to minimize transfer tax Wealth transfers Early planning of wealth transfer enables the owner to shift future wealth with little or no transfer tax Direct gifting is suitable before the concentrated position has appreciated greatly Estate tax freeze ⇒ owners transfer a junior equity interest to the children that will receive most or all of the future appreciation of the enterprise After significant appreciation, technique include: Contribute the CP to an entity such as family limited partnership 3.7 Concentrated Wealth Decision Making: A Five-Step Process Five step process that best satisfy the objectives of holders of CPs Identify & establish objectives & constraints Identify tools that can satisfy these objectives Compare tax advantages & disadvantages Compare non-tax advantage & disadvantages Formulate & document an overall strategy MANAGING THE RISK OF CONCENTRATED SINGLE – STOCK POSITIONS Diversification generally considered prudent to minimize risk from CPs Tools to mitigate the risks of concentrated position Outright sale ⇒ give funds but often incurs significant tax liabilities Monetization strategies ⇒ these provide owners with funds without triggering a taxable event (e.g loan against CPs) Hedging the value of the concentrated asset through derivative Copyright © FinQuiz.com All rights reserved 2018 Study Session # 5, Reading # 11 4.1 Introduction to Key Tax Considerations Internal inconsistency of tax codes provides an opportunity for well diversified investors to reap substantial tax savings 4.2 Introduction to Key Non-Tax Considerations Key non-tax considerations when deciding whether to use an exchange traded or OTC derivative including: Counterparty credit risk Ability to close out transaction prior to stated expiration Price discovery & transparency of fees Flexibility of terms Minimum size constraints 4.3 Strategies Three common strategies that investors use in the case of a CP in a common stock Equity monetization Hedging Yields enhancement 4.3.1 Equity Monetization Equity monetization ⇒ transformation of a CP into cash usually in a way to avoid current taxable event EM entails a two step process To remove a large position of risk inherent in the CP (hedging) To borrow against the hedged positions 4.3.1.1 Equity Monetization Tool Set A Short sale against the box Shorting a security that is held long Any future ∆ in stock price will have no effect on the investor’s economic position Investor will earn money market return Least expensive technique A total return equity SWAP Contract for a series of exchanges of the total return on a specified asset in return for specified fixed or floating payments Investor is fully hedged as in short sale strategy Money market rerun slightly less than what would be on short sale strategy Forward conversion with options Equity forward sale contract Synthetic short forward positions against the asset held long Pay off of a short forward = pay off of a long put & a short call on same asset Money market return Private contract for the forward sale of an equity position Money market returns Copyright © FinQuiz.com All rights reserved 2018 Study Session # 5, Reading # 11 4.3.1.2 Tax Treatment of Equity Monetization Strategies EM eliminates concentration risk & generates cash approximately equal to outright sale Critical question ⇒ whether an EM strategy will be treated as a taxable event for tax purpose in a particular country 4.3.2 Lock-in Unrealized Gains: Hedging 4.3.2.1 Purchase of Puts 4.3.2.2 Cashless (Zero-Premium) Collars Investors of CP can buy put option to Lock in floor price Retain unlimited upside Defer CG tax Investor is fully protected against price risk Long stock + long put position is extremely appealing but costly Knock-out option ⇒ exotic option that can be acquired only through OTC dealer (less expensive option) 4.3.2.3 Prepaid Variable Forwards These are used to: Hedge price risk Retain certain degree of upside Defer CG tax Structure ⇒ buy puts (at or out-of-the money) & sell calls with same maturity Strike price of calls is set at the level exactly to amount required to pay for puts Investment risk is but not eliminated 4.3.2.4 Choosing the Best Hedging Strategy PVF ⇒ an agreement to sell a security at a specific time in the future with the number of shares to be delivered at maturity (varying with the underlying share price at maturity) Tax characteristics of the shares that are being hedged can help determine which strategy will deliver the optimal result for client 4.3.3 Yield Enhancement Investors can enhance the yield of a CP while its volatility by writing covered calls against some or all of the shares Premium income through selling call options Investors retain full downside exposure to the shares Most significant benefit of covered call writing ⇒ to psychologically prepare the owner to dispose of those shares 4.3.4 Other Tools: Tax-Optimized Equity Strategies Combine investment & tax considerations in making investment decisions Index tracking strategy with active tax management ⇒ designed to track a broad based market index on a pretax basis & outperform it on an after tax basis Construction of completeness portfolios ⇒ builds a portfolio such that combination of the two portfolio tracks the broadly diversified market benchmark Copyright © FinQuiz.com All rights reserved 2018 Study Session # 5, Reading # 11 4.3.5 Other Tools: Cross Hedging Cross hedging ⇒ using derivative on a substitute asset with an expected high correlation with the investor’s concentrated position Investor is at least able to hedge market & industry risk (company specific risk retains) 4.3.6 Exchange Funds Exchange fund ⇒ partnership in which the partners have each contributed their low basis CP to the fund Pro-rata holding of diversified pool of securities with minimum period of 7years Pro-rata ownership at redemption MANAGING THE RISK OF PRIVATE BUSINESS EQUITY High percentage of private clients derives their wealth from the ownership of a privately owned business Private business owners are often asset rich but relatively cash poor 5.3 Monetization Strategies for Business Owners 5.3.1 Sale to Strategic Buyers Strategic buyer ⇒ competitors or other companies involved in the same or a similar industry as the seller Highest price due to potential synergies 5.3.3 Recapitalization Leveraged recapitalization ⇒ leveraging of a company’s balance sheet Attractive for owners who would like to the risk of their wealth concentration 5.3.5 Divestiture (Sale or Disposition of Non-Core Assets) Divestiture ⇒ sale of non-core assets Owner continues to run business but generate liquidity through divestiture 5.3.7 Personal Line of Credit Secured by Company Shares 5.3.2 Sale to Financial Buyers These are private equity firms that typically raise funds from institutional investors Pay price which is lower than strategic buyer’s price 5.3.4 Sale to Management or Key Employees Employees or senior managers can acquire control of business through a management buyout Key risk ⇒ employees may not be successful entrepreneurs Failed attempt to an MBO has the potential to –vely affect the dynamics of employeremployee relationship 5.3.6Sale or Gift to Family Member or Next Generation Sell or transfer through a combination of tax advantaged gifting strategies Transfer is typically made to family members or members who actively involved in business Owner might consider arranging a personal loan secured by his/her share in private company Key benefits ⇒ no immediate taxable event Copyright © FinQuiz.com All rights reserved 2018 Study Session # 5, Reading # 11 5.3 Monetization Strategies for Business Owners 5.3.8 Going Public through an Initial Public Offering IPO is possible if the company is in an industry deemed attractive by investors Significant cost of going public but usually price of the deal is very attractive IPO is not a viable exit strategy if owner’s objective is to exit from the company 5.3.9 Employee Stock Ownership Plan Sale of company’s shares to certain type of pension plans Leveraged ESOP ⇒ ESOP borrows funds to finance the purchase of the owner’s shares 5.4 Considerations in Evaluating Different Strategies Objective ⇒ to maximize the after-tax proceeds as opposed to simply maximizing the sale price Different strategies may result in different values for the company that is being sold or monetized Strategic buyers typically pay the highest price for a business MANAGING THE RISK OF INVESTMENT REAL ESTATE Real estate owners are often exposed to significant degree of concentration risk & illiquidity Various forms of debt & equity financing to facilitate monetization 6.1 Monetization Strategies for Real Estate Owners 6.1.1 Mortgage Financing Mortgage financing can be used to generate liquidity to diversify asset portfolios (no taxable event) Non-recourse loan ⇒ lender’s only recourse upon an event of default is to look to the property that was mortgaged to lender 6.1.2 Real Estate Monetization for the Charitably Inclined Asset location is also important for real estate Many tools & techniques can be used by charitably inclined clients under different tax regimes to monetize real estate 6.1.3 Sale and Leaseback 6.1.4 Other Real Estate Monetization Techniques Owner sells the property & then immediately leases it back from the buyer at a rental rate & lease term that is acceptable to new owner Primary goal ⇒ free up the owner’s equity for other uses while retaining use of the facility Other monetization techniques include joint ventures, condominium structures etc These techniques are out of the scope of this reading Copyright © FinQuiz.com All rights reserved  .. .20 18 Study Session # 5, Reading # 11 GENERAL PRINCIPLES OF MANAGING CONCENTRATED SINGLE-ASSET POSITIONS 3. 1 Objectives in Dealing with Concentrated Positions 3. 1.1 Typical Objectives 3. 1 .2. .. possible 3. 2. 2 Liquidity CP is generally illiquid Illiquidity generally acts as a constraint with a CP 3. 3 Institutional and Capital Market Constraints 3. 3.1 Margin-Lending Rules 3. 3 .2 Securities... sale of an equity position Money market returns Copyright © FinQuiz. com All rights reserved 20 18 Study Session # 5, Reading # 11 4 .3. 1 .2 Tax Treatment of Equity Monetization Strategies EM eliminates