A Private Equity Management Strategy for Concentrated Positions

Staged Diversification and Completion Portfolios

Staged diversification refers to selling the concentrated position, paying the tax, and reinvesting the proceeds in a diversified portfolio. This is often done over several years and has the advantage of spreading out the tax burden over multiple years, rather than incurring it all at once. The disadvantage of this approach is that it leaves the client exposed to the concentrated position risk longer than an immediate sale would.

Completion portfolios involve developing an index-based portfolio that when added to the concentrated position creates an overall portfolio with exposures similar to the investor's benchmark. The completion portfolio is funded with a partial sale of the concentrated position, making it somewhat similar to a staged diversification strategy. This is often a quantitative process involving the use of software and modern portfolio theory, with the goal of creating the optimal completion portfolio. For this reason, the completion portfolio can often be complemented by the quantitative tax management process mentioned earlier in Reading 22.

Equity Monetization, Collars, and Call Writing

An equity monetization strategy is designed to avoid triggering an outright sale of the concentrated position, and thus the capital gains taxes that would go with that. Factors to consider when choosing equity monetization include:

• The possibility of restrictions from the sale of the stock.
• Avoiding the ceding of control of the voting rights.
• Wanting to keep the position but create short-term liquidity.

Two-Steps in Monetization

1. First, the investor will hedge a large portion of the risk inherent in the concentrated position using a short sale, a total return swap, options, futures, or a forward sale contract. This is likely to be more difficult or expensive for a smaller company with a thin derivatives market.
2. Next, the investor will borrow against the hedged position. In most instances, favorable loan provisions can be achieved since the position is hedged. The loan proceeds are then invested in a diversified portfolio of other investments, thus reducing the stock-specific risk of the portfolio without triggering the infamous capital gains tax.

A position can be hedged in a number of ways. Investors could:

• Sell the security short.
• Sell a forward contract.
• Enter into a total return equity swap.

The use of options on publicly-traded instruments however is not applicable to privately held companies and real estate. This would include the zero-cost collar strategy or the buying of protective puts.

The following are other tax considerations:

In unwinding a position, how are gains and losses treated? Structures that result in long-term gains with a lower tax rate are preferred in jurisdictions that favor long-term gains with a lower tax rate.

What effect does the hedge have on the taxation of dividends received? The taxation of stock dividends varies by jurisdiction. When call options are in-the-money or have expiration periods of less than 30 days, dividends on the stock in the United States are taxed at the regular income tax rate instead of at the more favorable qualified dividend tax rate.

Tax-Free Exchanges

In some tax jurisdictions, a method exists for accomplishing a tax-free exchange of a concentrated single asset position. One way, in the United States, for example, is an exchange fund – a partnership where each partner contributes low-cost stocks. The partners then own a portion of the total interest in the fund depending on the size of their original contribution. Investors who previously held a large concentrated position in a single asset will be able to diversify into the fund’s diversified pool of low-cost basis securities.

Charitable Remainder Trust

If the investor has philanthropic goals, estate planning techniques can be implemented to mitigate the risk associated with a concentrated position. A charitable remainder trust is one such possibility. Investors would donate assets irrevocably to a trust in this structure and receive a tax deduction for the gift. They would no longer own the assets. The assets could be sold and reinvested in a diversified portfolio within the trust without triggering a capital gains tax since the trust is exempt from taxes. Trust beneficiaries would receive a lifetime of income from the trust. After the death of the last-named beneficiary, assets remaining in the trust are distributed to the charity of choice.

Question

Which of the following methods most correctly describes a charitable remainder trust?

1. Beneficiaries receive income during the investment horizon, the charity receives a lump-sum distribution at the end of the investment horizon.
2. Beneficiaries receive a lump-sum distribution at the end of the investment horizon, the charity receives income the investment horizon.
3. Both beneficiaries and the charity receive income during the investment horizon and a lump-sum distribution at the end of the investment horizon.

Solution

The correct answer is C.

A charitable remainder trust is a type of trust arrangement where both beneficiaries (typically individuals or non-charitable entities) and a designated charity receive income during the trust’s investment horizon, and a lump-sum distribution is made to the charity at the end of that horizon. This arrangement allows the donor to provide income to beneficiaries while also benefiting a charitable organization.

A is incorrect. It incorrectly states that beneficiaries receive income during the investment horizon, but the charity receives a lump-sum distribution at the end. In a charitable remainder trust, both beneficiaries and the charity receive income during the investment horizon.

B is incorrect. It incorrectly states that beneficiaries receive a lump-sum distribution at the end of the investment horizon, while the charity receives income during the investment horizon. This does not accurately describe how a charitable remainder trust typically works.

Reading 8: Topics in Private Wealth Management

Los 8 (h) Describe strategies for managing concentrated positions in privately owned businesses and real estate