Ultrawealthy investors face many of the same issues as those with more modest portfolios. They fail to diversify their investments, build emotional attachments to a single stock and let an aversion to taxes dominate investment decisions. It often takes a shake-up in the markets to start a conversation about how to handle the risk inherent in a concentrated stock portfolio.
A concentrated stock position is one that represents more than 20% of the investor's net worth. The typical client holding millions in a single stock may have come into wealth unprepared to deal with the investment issues. Whether it is a case of a highly successful IPO, the receipt of an acquiring company's stock as part of a buyout or an executive compensation package heavily weighted in employee stock options, this investor must tend to the health of his or her golden goose.
There are several ways to handle a concentrated stock portfolio. The initial step is to gauge the client's attachment to the stock. There may be resistance to selling if his or her history is tied to the company's success. Or the client may be bullish on the stock's prospects. It might also be that the stock has appreciated highly, which means an initial tax hit the client doesn't want to face. But this means that the tax tail is wagging the dog.
Some of the common techniques to help clients achieve diversification are discussed below.
Equity Collars As A Hedge
The two most common hedging strategies are the equity collar and the variable prepaid forward sale. Both typically have minimum transaction sizes of $1 million.
The equity collar is probably the easiest to implement. This concept involves buying a put and selling a call. Purchasing the put ensures that if the stock's price drops, the investor could sell it at a predetermined price. At-the-money puts can cost 10% to 20% of the value of the stock annually. At the same time, the investor sells a call, giving someone else the right to buy the stock at a predetermined price if the stock value should rise. A call might sell for 15% to 20% of the current stock price. The premium earned on the call offsets the cost of the put, thus earning the name zero-premium collar.
Buying a put is designed to provide downside protection, while selling the call may allow you to capture at least some upside appreciation (with the added benefit of offsetting the cost of the put). And no taxes are incurred. On the downside, if the price of the stock were to soar, the holder would buy the investor's stock at the agreed-upon price and resell it for an immediate profit. The investor, therefore, has limited his or her participation in the appreciation of the stock.
A collar is only part of the strategy. The second part is to borrow against the hedged position in order to reinvest in a diversified portfolio. If the purpose of the loan, or monetization, is to raise capital to diversify the investor's portfolio, the loan is limited to 50% of the current market value of the shares.
Equity collars have several hurdles to consider. First, when you hedge away too much risk, the IRS considers it a constructive sale. It is as if you had sold and immediately repurchased the same stock, meaning you incur taxes on any gains. There must be some element of possible loss or gain to avoid the constructive sale rule. Second, entering into a hedge transaction puts a pause on the capital gain clock. The one-year holding period for long-term capital gains is interrupted by the duration of the collar. Because there is a possibility that the call will be exercised, it is best to use this technique with stock held longer than one year before you enter into the collar.
Finally, you may experience the whipsaw effect. You cannot deduct the losses until all positions have closed-when the collar expires, is exercised, is bought or is sold out. On the other hand, gains are taxed as soon as the call option expires unexercised. If the call closes before the put, you may recognize capital gains without the benefit of the offsetting loss.
While the term zero-premium collar seems to indicate that the cost has been eliminated, a 1% spread usually goes to the dealer to put the transactions together. In addition, there are borrowing transaction costs and interest.
In the end, while the strategy is designed to protect stock you currently own, there is always the risk that you will be forced to cover the call by liquidating your stock.
The Variable Prepaid Forward
The variable prepaid forward is similar to the monetized collar in that it offers the investor a downside floor and an upside ceiling. It differs in that instead of borrowing money, an institutional counterparty buys the investor's stock, which will be delivered some time in the future. Depending on the nature of the stock and current market conditions, the discounted payment could be as high as 80% or 90% of current stock value. At the end of the term, the client must deliver the stock or a cash equivalent to close out the sale.
The advantage of the variable prepaid forward is that more cash is available to reinvest and diversify the portfolio than could be raised by borrowing on the collar. And if the stock performs well, less stock is needed to close out the transaction than when stock is called away as part of a collar. The more the price of the stock appreciates, the fewer shares will actually be transferred to the counterparty. On the other hand, if the price of the stock were to drop, more shares would have to be delivered. But, like a collar, there is a floor and a ceiling built into the contract.
The institutional counterparty will enter into its own hedging strategy to protect itself in the variable prepaid forward. To do this, it will sell short some of the same stock underlying the variable prepaid forward transaction. The counterparty can borrow stock from the client or from the marketplace. Borrowing from the latter is obviously more expensive and would be reflected in the price of the forward contract. Recently, the IRS issued a technical advice memorandum opining that borrowing the client's shares was the same as a constructive sale and taxes should be recognized immediately rather than deferred to the end of the term.
Like the collar, the holding period time clock is paused as the investor waits to qualify for long-term capital gain treatment. And again, you must have held the stock for more than one year before you can enter into the hedging strategy.
The cost of the variable prepaid forward is the spread between the value of the securities and the amount of the advanced payment. The spread will reflect a discount rate plus the risk that the counterparty assumes by setting a floor and a ceiling. A higher floor translates into more protection for the client, and a higher ceiling translates into more opportunity to participate in the stock's appreciation. The higher the floor and the higher the ceiling, the lower the cash advance. Plus, there are the fees for outside legal and tax advice.
Is it worth it? Both the equity collar and variable prepaid forward transactions should be seen as short-term solutions. Typically, the performance of the underlying stock and the reinvested portfolio must be higher than the borrowing or transaction costs of the hedging strategy.
Hedging Stock Options
Invariably, an executive will ask if there is a way to protect employee stock options before or shortly after they are exercised. You cannot hedge incentive stock options before exercise. Plus, using options during the year after exercise may be a disqualifying disposition and trigger ordinary income taxes. Whether a variable prepaid forward can avoid the same fate is unclear.
It may be possible to hedge the nonqualified stock option. A simple way to hedge the underlying stock is to buy a put for the same price as the option's exercise price. At the same time, the executive sells a call option at a price slightly higher than the current price. To prevent being snagged by the constructive sale rules, the spread between the put and the call is usually 20% of their strike prices.
Once the employee's options are exercised, how does the executive protect his or her concentrated position without violating insider trading rules or sending a signal to the marketplace that he or she is worried about the company's future? One way to work around SEC restrictions and other rules is to set up a 10b5-1 trading plan with a brokerage firm. This written plan includes a formula that will control the trading of the executive's shares over a specific period of time.
Alternatively, the executive can set up a blind trust, giving the trustee full discretion to determine how much will be sold, at what price and when. A trustee working with a professional money manager can maximize the sale price of the stock in the trust. Blind trust managers will often use the same hedging strategies to provide some downside protection during the term of the trust.
Exchange Funds
For the investor who can't bear the risk of selling his or her stock, an exchange fund may be a consideration. In such a fund, the investor commingles his or her stock position with the holdings of other investors to achieve diversification without immediately paying taxes. The trade-off is that the investment lacks liquidity, offers limited or no current income, accrues high fees and gives the investor no control over what is owned within the fund. Because these are highly regulated private placements, they are limited to only the wealthiest investors who can qualify under the SEC rules. An investment in an exchange fund usually carries a $1 million minimum. They carry no guarantee that the diversified portfolio will do better than the single stock, and, as with any technique, tax laws can change.
Charitable Giving
Another vehicle suitable for managing the taxes incurred when diversifying a concentrated stock portfolio is the charitable remainder trust (CRT). A CRT provides income to its beneficiary over the term of the trust, which is usually the lifetime of the beneficiary. In most cases, the donor is also the trust's beneficiary. At his or her death, any remaining assets in the trust are transferred to the donor's choice of charities.
Typically, the donor will create the trust to avoid capital gains taxes on highly appreciated stock, while at the same time making a meaningful donation to charity. Because the trust is tax-exempt, the trustee can sell and reinvest the trust assets without incurring taxes for the trust or the donor. Eventually, any deferred capital gains will be recognized by the beneficiary with each income payment received from the trust.
Besides deferring capital gains and receiving income from a newly diversified portfolio, the donor may receive an immediate charitable income tax deduction for a portion of the gift.
The downside of any hedging strategy is its costs and risks. The CRT is no different. The cost of valuing closely held or thinly traded stock can be as high as $20,000, and some charitable trusts require revaluation annually. Coupled with complex legal and tax issues, the very nature of this irrevocable trust can deter the investor from moving forward.
Tere D'Amato is the vice president of advanced planning at Commonwealth Financial Network in Waltham, Mass. She can be reached at [email protected].