Managing Concentrated Positions in Public Equities

The three main types of concentrated positions include:

• Public company shares.
• Private company ownership.
• Real estate.

This learning outcome statement focuses on public equity ownership. There is no singular definition for a concentrated position in public equities. Anything that inhibits the building of a diversified and optimal portfolio, as defined by modern portfolio theory could be considered concentrated. These positions are typically accumulated through employment with a publicly traded firm.

Main Concerns of Concentrated Positions in Public Equities

• Concentrated positions carry company-specific risks.
• Due to a lack of diversification, portfolio efficiency is reduced.
• The liquidity risk in a privately-held or large grouping of publicly-held security.
• The risk of incurring a large tax bill that reduces return upon selling part of the concentrated position.

Typically, a concentrated position in a family-owned company is riskier than a similar-sized position in a publicly-traded company. This is due to a number of factors including lack of access to talent, funding, or earnings shortfall potential being higher in smaller firms. Private firms also carry a higher liquidity premium.

Methods to Manage Concentrated Positions

1. Sell and diversify: Involves selling the concentrated position, paying the capital gains taxes, and reinvesting those proceeds into a diversified portfolio. This is often the best approach due to its completeness and simplicity, but it can often be difficult to get clients on board with this approach.
2. Staged diversification: This method involves selling the firm in multiple tranches, which can at least partially mitigate the risk of inconvenient timing.
3. Hedging and monetization strategies: These strategies use derivatives to hedge the risk of a concentrated position. When the position is hedged, monetization – such as a loan against the value of the concentrated position – enables owners to spend or reinvest without triggering a taxable event.
4. Tax-free exchanges: Oftentimes an investor may be able to exchange assets, replacing an illiquid private company position with publicly traded stock, without creating tax consequences. Some exchange funds allow investors to pool their public stock positions with others to achieve diversification without triggering a tax event.
5. Strategies for charitable giving: Charitable trusts, private foundations, and donor-advised funds allow the assets to be transferred to a tax-exempt account where they can be sold tax-free. In contrast to private foundations and donor-advised funds, charitable trusts can be structured to provide income to the client in the present while the assets will fulfill the philanthropic purpose in the future.
6. Tax-avoidance and tax-deferral strategies: Oftentimes, holding the position until death allows a step-up in basis (a new tax basis based on the value at the date of death) which can be used to diversify the position and avoid capital gains taxes. A staged diversification strategy is another way to match gains and losses in a diversified equity portfolio. Tax-loss harvesting strategies invest in diversified portfolios to harvest losses and generate extra capital gains. As a result, the client is able to defer some of the tax burden.

Question

Which of the following methods most notably seeks to liquidate a concentrated position slowly, and overtime?

1. Tax-free exchanges.
2. Staged diversification.
3. Hedge and monetize.

Solution

The correct answer is B.

Staged diversification refers to selling a company or concentrated position in stages, and then using the proceeds to invest in a diversified (or completeness portfolio). This is covered in a little more detail in the next summary reading.

A and C are incorrect. Tax-free exchanges generally occur at one point in time. Hedging and monetization involve using derivatives to ensure the value of a concentrated portfolio will not fall in value and then borrowing against that minimum guaranteed portfolio value. Nothing in the reading mentions that this normally happens over the course of many years, or in many years.

Reading 8: Topics in Private Wealth Management

Los 8 (g) Describe strategies for managing concentrated positions in public equities