“When you come to a fork in the road, take it.” - Yogi Berra
A fair proportion of individual income in the San Francisco Bay Area can be attributed to deferred compensation packages. As many readers are aware, this type of compensation scheme is very popular with both technology and biotechnology companies. Deferred compensation often comes in the form of restricted stock and/or incentivize stock options, with vesting schedules usually in the ballpark of three to five years.
Over the past few years of running Pacificus, we have been asked on various occasions to advise on strategies to help realize some of these windfall gains for clients. Although each situation is unique in and of itself, there is one golden rule we like to get across to the lucky beneficiary. That is – “Your stock award is not an investment, rather it is compensation and should be treated as such.”
I grabbed the below reading from the CFA Institutes curriculum on portfolio management, in which the topic of concentrated investments and private wealth management are becoming more important subjects. Although the below text is geared more towards the professional, I feel the descriptive nature of the subject will likely benefit most of my readers who have skin in the game.
MANAGING CONCENTRATED POSITIONS
by Paul Bouchey, CFA, Helena Eaton, PhD, CFA, and Philip Marcovici
Frequently, individuals’ and families’ wealth are concentrated in an asset or group of assets that has played a pivotal role in the creation of their wealth. Three major types of concentrated positions commonly encountered in managing private client assets are: (1) publicly traded stocks, (2) a privately-owned business, and (3) commercial or investment real estate.
Concentrated positions in public equity may derive from an initial public offering or the sale of a privately-owned business to a public company. Or, individuals may have worked at a publicly traded company, perhaps for many years, and received company stock as part of their compensation.
There is no universal agreement as to what constitutes a concentrated position; it frequently depends on the nature of the position. A 10% position in a small-cap stock might be considered a concentrated position. A 10% position in a liquid large-cap stock might be considered risky, but it likely doesn’t meet the threshold of a “concentrated position” for the purposes of this discussion. In this reading, the term “concentrated position” is used to describe a holding that due to its low tax basis or personal association with the client inhibits the development of an efficient, diversified portfolio.
Advisers must be able to assist clients with decisions concerning such positions, including the risk and tax consequences associated with managing them. This section will discuss approaches to managing those concentrated positions.
Risk and Tax Considerations in Managing Concentrated Single-Asset Positions
We have identified four risk and tax-related considerations relevant to concentrated single-asset positions:
1. The company-specific risk inherent in the concentrated position
2. The reduction in portfolio efficiency resulting from the lack of diversification
3. The liquidity risk inherent in a privately-held or outsized publicly-held security
4. The risk of incurring an outsized tax bill that diminishes return if one were to sell part of the concentrated position in an attempt to reduce the other risks
Private companies tend to be smaller than public companies with all of the attendant risks of being a small company. They may have a more limited operating history or an undiversified business mix. They may have difficulty attracting high-quality management personnel due to the family ownership. Or, their access to financing may be more constrained than that of a public company. These risks, alone or in combination, typically make a concentrated position in a family-owned company much riskier than a similar-sized position in a publicly-traded company.
Whether the position is publicly-traded or privately-held, however, a concentrated position subjects the portfolio to a higher level of risk. A significant proportion of the client’s wealth is exposed to the risk of adverse events affecting this company—either a company-specific event, such as an earnings shortfall, or an industry-specific event, such as changes in tariffs on imported materials. In the course of building wealth, adverse events pose unavoidable risk. However, once a certain level of wealth has been attained, the wealth owner’s focus tends to shift toward maintaining that status. Private wealth managers must be able to counsel clients through this changing view of risk.
A portfolio with a concentrated position may also be subject to liquidity risk. Shares in a private company cannot be readily sold to meet unexpected expenses. If not subject to regulatory restrictions, a large position in a public company can be sold, although the sale is likely to incur higher transaction costs than a position of more moderate size. This lack of liquidity complicates the management of the remaining portfolio.
Lastly, concentrated positions frequently have a very low tax basis, having been held by the investor for a long time. Sale of all or a part of the position can trigger a significant tax liability.
While these and other considerations (notably, a client’s emotional attachment to an asset that has been the foundation for financial success) make a simple sale problematic, the risk inherent in the position may outweigh the tax and liquidity issues.
Approaches to Managing the Risk of Concentrated Positions
Given the risks associated with holding a concentrated position, well-informed investors will seek to diversify these risks. Several different strategies might be considered depending on the facts and circumstance of the client’s situation. The key factors to consider when selecting a strategy include the following:
· Degree of concentration—The larger the concentrated position is relative to the total portfolio, the more concerned an investor should be about the risks and the more urgent the need to address those risks.
· Volatility and downside risk of the position—The higher the risk associated with the position, the greater the benefit of diversification.
· Tax basis —The lower the tax basis, the higher the tax liability.
· Liquidity —The lower the liquidity, the more costly it will be to achieve the risk reduction goal.
· Tax rate of the investor—The higher the tax rate, the higher the tax liability.
· Time horizon of the investor—A longer investment horizon gives the portfolio a better chance to offset any tax impact of a sale.
· Restrictions on the investor—If the investor is restricted from selling the asset through an employment or acquisition agreement, then a strategy other than an outright sale must be developed.
· Emotional attachment and other non-financial considerations—Often the concentrated position is the original source of wealth for the individual and/or family, so there is an emotional attachment that makes them reluctant to sell. Alternatively, an owner might wish to maintain voting control of the company or retain shares to signal a continued association with the company.
Several approaches can be used to mitigate the risks of a concentrated position. Each has different tax consequences:
1. Sell and diversify—The simplest (and often best) approach is to sell the concentrated position, pay the capital gains taxes, and re-invest the proceeds into a diversified portfolio.
2. Staged diversification—In some cases, timing risk is a concern. Selling in multiple tranches can at least partially mitigate the risk of inconvenient timing.
3. Hedging and monetization strategies—Several strategies using derivatives can be used to hedge the risk of a concentrated position. Once the position is hedged, monetization—such as a loan against the value of the concentrated position— provides owners with funds to spend or re-invest without triggering a taxable event.
4. Tax-free exchanges—In some jurisdictions, an investor may be able to exchange assets, replacing an illiquid private company position with publicly traded stock, without creating a taxable event. In the United States, a 1031 exchange allows you to sell a real estate asset and transfer the tax basis to another property purchased within a few months of the sale. Some exchange funds allow investors to pool their public stock positions with others to achieve diversification without triggering a tax event.
5. Charitable giving strategies—Charitable trusts, private foundations, and donor advised funds (an investment account established for the sole purpose of supporting the donor’s charitable giving) allow the asset to be transferred to a tax exempt account in which it can be sold without incurring capital gains taxes. While the assets of private foundations and donor-advised funds can be used to fund only the client’s philanthropic goals, the charitable trust can be structured to provide income to the client in the present with the assets fulfilling the philanthropic purpose in the future.
6. Tax-avoidance and tax-deferral strategies—In some jurisdictions, holding the position until death allows heirs to receive a step-up in basis (a new tax basis based on the value at the date of death) that will allow them to diversify the position and avoid capital gains taxes. Tax loss harvesting strategies that invest in a diversified equity portfolio and generate extra capital losses can be paired with a staged diversification strategy that matches gains with losses. This allows the client to spread out the tax burden over time, creating flexibility to defer some portion of the tax.
A variety of financial tools can be used to implement these approaches. For example, an investor can synthetically sell a stock by shorting the stock or using options, swaps, forwards, or futures. Although these actions produce a similar economic result, they may not be taxed similarly.
To our clients and friends – if you hold a significant proportion of assets that are concentrated in company stock and would like to discuss ideas of minimizing risk and/or realizing gains, feel free to reach out to us anytime for an unbiased opinion.
The latest good news on COVID-19 vaccines have put modest upward pressure on interest rates and alternatively provided a bid to the forgotten stocks (companies in sectors which lagged during the market rebound from the Spring onward). Nevertheless, my view hasn’t shifted much at this point, aside from my interest in small capitalization companies, which have outperformed their peers recently.
I believe money will remain cheap and policy will continue to benefit asset holders. Although many investors have now come around to looking for a melt-up in asset prices, I still believe a decent amount of cash remains on the sidelines with incentive for those that are willing to give it a go, to take on some added risk. Our portfolios are broadly positioned for continued equity market gains with overweight’s in large capitalization technology and real estate related sectors.
The death of the bond market has been greatly exaggerated. I do see interest rates continuing their long term trend lower, which in this environment is mainly supportive to equity holders.
Justin Kobe, CFA
Founder, Portfolio Manager & Adviser
Pacificus Capital Management
Advisory services through Cambridge Investment Research Advisors, Inc., a Registered Investment Adviser. Securities offered through Registered Representatives of Cambridge Investment Research, Inc., a broker-dealer, member FINRA/SIPC. Cambridge and Pacificus Capital Management are not affiliated. Material discussed is meant for general illustration and/or informational purposes only, and it is not to be construed as investment, tax, or legal advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon when coordinated with individual professional advice. These are the opinions of Justin Kobe and not necessarily those of Cambridge Investment Research, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Investing in the bond market is subject to risks, including market, interest rate, issuer credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies is impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counter-party capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Diversification and asset allocation strategies do not assure profit or protect against loss.