Explain investment risks associated with a concentrated position in a single asset and discuss the appropriateness of reducing such risks
Systematic
Company-specific
Property-specific
Concentrated positions can have consequences for return and risk.
- may not be efficiently priced, therefore not generate a fair risk-adjusted return
- illiquid assets can be difficult to exit
- illiquid assets may be non-income producing
The risks:
SYSTEMATIC: the risk that cannot be diversified away through holding a portfolio of risky assets. This is beta in the CAPM model
COMPANY-SPECIFIC RISK: is the nonsystematic risk of an investment that can be diversified away. It would derive from events that affect a specific event but not the overall market. A corporate bankruptcy as a result of financial fraud would be an extreme example of company-specific risk. Nonsystematic risk increases the standard deviation of returns without additional expected return.
PROPERTY-SPECIFIC RISK: for real estate is the direct counterpart to company-specific risk for a company. It is the additional diversifiable risk associated with owning a specific property. e.g. discovery of environmental pollution on the site or the loss of a key tenant and rental income
Describe typical objectives in managing concentrated positions.
Other client specific objectives to consider:
- Reduce the risk
- caused by the wealth concentration - Generate liquidity
- to meet diversification or spending needs - Optimise tax efficiency
- to maximise after-tax ending value
Must also consider:
- restrictions on sale: company expectations or regulatory requirements that the exec hold the stock for a certain length of time
- desire for control: majority ownership brings control over the business
- create wealth: an entrepreneur may assume high specific risk in expectation of building the value of the business and his wealth
- the asset may have other uses: e.g. real estate, could be used as an asset in their business
Discuss 1) tax consequences and 2) illiquidity and/or high transaction costs as considerations affecting the management of concentrated positions in:
- publicly traded common shares
- privately held business
- real estate
- Sale of a concentrated position might trigger a large capital gains tax liability. A plan to defer, reduce, or eliminate the tax may be desirable
- Illiquidity and/or high transaction costs:
e. g. public company trading without sufficient volume may require a discount to sell
e. g. the cost of finding a buyer for a private business or real estate can be substantial. Intended use might affect the price
Discuss capital market and institutional constraints on an investor’s ability to reduce a concentrated position
- Tax law: can significantly affect the costs of selling or monetizing a concentrated position
- Legal issues, depending on how the asset ownership is structured: sole proprietorship, limited partnership, limited company, public stock
- Margin lending rules. Derivative positions can be used to reduce the risk of the asset positions and increase the percentage of value that can be borrowed. Rules-based (rigid, define exact percentage) vs risk-based systems (consider the underlying economics)
- Securities law and regulations. Owner might be defined as an ‘insider’ and impose restrictions, regulations and reporting requirements on the position
- Contractual restrictions and employer mandates: holding periods, blackout periods, beyond those set by securities law and regulation
- Capital market limitations. Indirect consequences. Monetization strategies commonly require OTC derivative trades to hedge security’s risk and increase the LTV ratio. To offer such trades, the dealer must be able to hedge the risks they assume. This may be impossible. Borrowing and shorting the underlying asset is often required and is prohibited in some markets
Discuss psychological considerations that may make an investor reluctant to reduce his or her exposure to a concentrated position
Cognitive biases:
- conservatism in maintaining existing beliefs
- confirmation in seeking support for what is already believed
- illusion of control when the investor believes he can control what will happen to the investment
- anchoring and adjustment in making decisions in reference to the current position held
- availability in making decisions based on ease of recalling information
Emotional biases:
- overconfidence
- familiarity
- illusion of knowledge; all leading the investor to overestimate the probability the investment will produce favourable returns
- status quo bias and a failure to consider making changes
- naive extrapolation of past results
- endowment in expecting to be able to sell the sset for more than the investor would pay for it
- loyalty bias in retaining employer stock or feeling an obligation to retain an inherited position
Describe advisers’ use of goal-based planning in managing concentrated positions
A goal-based decision process modifies traditional mean-variance analysis to accommodate the insights of behavioural theory.
The portfolio is divided into tiers of a pyramid, or risk buckets
- Personal risk bucket: protect client from poverty or a drastic decline in lifestyle. Low-risk assets such as money market funds and bank CDs, personal residence. Safety but below market return
- Market risk bucket: maintain client’s existing standard of living. Stocks and bonds. Expect market return.
- Aspirational bucket: e.g. private business, concentrated stock holdings, real estate investments, other riskier positions
Primary capital = first two buckets
Surplus capital = remaining
If a concentrated holding in the aspirational bucket leaves insufficient funds for the first two primary capital buckets, sale or monetization of the concenrated position must be discussed with the client.
Explain uses of 1) asset location and 2) wealth transfers in managing concentrated positions
Asset location
- Determines the method of taxation that will apply
- Tax-deferred
- Taxable: interest, dividends, capital gains
Wealth transfer
- involves estate planning and gifting to dispose of excess wealth
- key considerations for wealth transfer
1) advisors can have greates impact by working with clients before significant unrealised gains occur.
2) donating unrealised gains to charity is generally tax-free even if there are gains
3) an ESTATE TAX FREEZE: a strategy to transfer future appreciation and tax liability to a future generation. Usually involves a partnership or corporate structure. A gift tax would be due on the value of the asset when the transfer is made; however, the asset (including any future appreciation in value) will be exempt from future estate and gift taxes in the giver’s estate
Five step process can be used to make decisions for managing a concentrated position
- Establish written objectives and constraints for the client
- nonfinancial issues, such as retaining control of the asset and wealth transfer goals should be included in the document - Identify the techniques and strategies that best meet these objectives and constraints
- Consider the tax advantages and disadvantages of each technique
- Consider the other advantages and disadvantages of each technique
- Document the decision made
Three broad techniques can be used to manage concentrated positions
- Sell the asset.
- This will trigger a tax liability and loss of control - Monetise the asset.
- Borrow against its value and use the loan proceeds to accomplish client objectives - Hedge the asset value.
- Often done using derivatives to limit downside risk
Describe strategies for managing concentrated positions in publicly traded common shares
Monetisation
- involves receiving cash for a position without triggering a tax event. Two step process
1. Hedge a large part of the risk in the position (without a tax liability coming due)
2. Borrow using the hedged position as collateral. The more effective the hedge, the higher the LTV
Potential monetisation tools (READ AGAIN AFTER DERIVATIVES CHAPTER)
- short sale against the box. Sells the same stock short so is effectively long and short
- equity forward sale contract
- forward conversion with options. Selling calls and buying puts with the same strike price
- total return on equity swap
Selecting the tool will depend on tax treatment. The goal is to select the tool that will not trigger an existing tax liability
Modified hedging. Minimise downside risk while retaining upside in the underlying positions
- protective puts
There are several ways to lower the cost of the protection:
- out-of-the-money put
- put with shorter time to expiry
- pair of puts. The investor is protected between Xh and Xl. The sale of puts reduces the initial cost
- add exotic features to the option e.g. knock-out put, expires if stock price rises above a specified level
- no cost or zero-premium collars
- Prepaid variable forwards (PVF)
Discuss tax considerations in the choice of hedging strategy
Mismatch in character Yield enhancement with covered calls Two tax-optimisation equity strategies 1) index tracking with active tax management 2) a completeness portfolio Cross hedge Exchange funds
Mismatch in character: strategy that triggers different tax treatments
Yield enhancement with covered calls:
- owner of the stock sells call options
- the premium income can be viewed as either enhancing the income yield of the stock or protecting against the stock price decline
Tax-optimisation equity strategies: combine tax planning with investment strategy:
1) index tracking with active tax management
- cash from a monetised concentrated stock position is invested to track a broad index on a pretax basis and outperform the index on an after-tax basis. e.g. if dividends are taxed at a higher rate than capital gains, the tracking portfolio could be structured with a lower dividend yield and a higher expected price appreciation
2) completeness portfolio
- structures the other portfolio assets for greatest diversification benefit to complement the concentrated position. For example, if the concentrated position is in an auto stock, the rest of the assets are selected to have a low correlation with auto stocks such that the resulting total portfolio better tracks the return of the chosen benchmark
Both of the above allow the investor to retain ownership, provide diversification while deferring the gain
A perfect hedge might be generally inappropriate
- might not exist
- cause the underlying gain to be taxed
Could therefore consider a CROSS HEDGE
e. g. an investor who holds a large position in an auot stock but finds it cannot be shorted could consider
1) short shares of a different auto stock that is highly correlated with the concentrated position. The highly correlated short position will increase (decrease) in value to offset decreases (increases) in the auto stock
2) short an index that is highly correlated with the concentrated position. Shorting a different stock or an index will introduce company-specific risk
3) purchasing puts on the concentrated position is also considered a cross-hedge in that the put and hedge are different types of assets
Exchange funds: Consider 10 investors, each of whom has a concentrated position in a single stock with a low cost basis. Each investor’s position is in a different stock. The investors contribute their holdings into a newly formed exchange fund, and each now owns a pro rata share of the new fund. The investor now participates in a diversified portfolio and defers any tax event until shares of the fund are sold
Describe strategies for managing concentrated positions in privately held businesses
Exit strategy considerations Strategic buyer Financial buyer Recapitalisation Sale to (other) management or key employees
Privately held business:
- standalone and non-systematic risks tend to be high
- asset is generally illiquid
Exit strategy considerations
- value of the business
- tax rate
- availability and terms of credit
- buying power of potential purchasers
- currency values (if considering foreign currencies)
The strategies to consider in managing a private business position
- Strategic buyer: generally highest price. Buy and hold. Complement existing business
- Financial buyer / sponsor: PE -> look to restructure, add value and resell the business
- Recapitalisation. Owner may retain 20 - 40% of the equity capital and sell 60 - 80% back to the company. Could be part of phased exit
- Sale to (other) management or key employees. Disadvantages: buyers want discount, may expect the owner to finance purchase with loan or promissory note (which might contain contingencies on performance of business), negotiation might fail and damage relationship
- Divestiture, sale or disposition of non-core business assets. Company then pays large dividend or repurchases stock from the owner. In either case, the owner receives cash while retaining the rest of the stock and control of the business
- Sale or gift to family members. Downside might be not much cash generation
- Personal line of credit secured by company shares
- IPO
- Employee stock ownership plan (ESOP). Owner sells shares to the ESOP, which in turn sells shares to company employees.
Describe strategies for managing concentrated positions in real estate
Can have a significant unrealised taxable gain.
Strategies:
- Mortgage financing. With a nonrecourse loan, the borrower effectively has a put option on the property
- Donor-advised fund or charitable trust. Can allow the property owner to take a tax deduction, gift more money to the charity, and influence the use of the donation
- Sale and leaseback. Immediate funds while retaining use of the property
