Wealth Creation

Entrepreneurship and Wealth Creation

Entrepreneurship plays a pivotal role in wealth creation. A study by Altrata, a global wealth management firm, reveals that a significant majority of the ultra-high-net-worth individuals have amassed their wealth through entrepreneurship. The statistics are as follows:

• Approximately 73% of the ultra-high-net-worth population have entirely self-made wealth, such as Bill Gates, the co-founder of Microsoft.
• About 21% possess wealth that is partially self-made and partially inherited, like Rupert Murdoch, the media mogul.
• Roughly 7% count inheritance as their primary source of wealth, like Paris Hilton, the heiress of Hilton Hotels.

Distinction in Wealth Levels

Altrata’s research also underscores a distinction in wealth levels between entirely self-made entrepreneurs and inheritors of wealth among those with an ultra-high net worth. The findings are as follows:

• Entrepreneurs have the highest median wealth, amounting to approximately USD78 million.
• The mean inherited wealth is USD52 million.

This suggests that entrepreneurship can lead to higher levels of wealth compared to inheritance.

Entrepreneur’s Extended Family Balance Sheet

The extended family balance sheet for entrepreneurs and private business owners is significantly different from that of typical wage earners. This difference is primarily due to the unique nature of an entrepreneur’s human capital, which is an implicit asset and is closely tied to the success of their business.

Human Capital

Human capital refers to the skills, knowledge, and experience possessed by an individual or population, viewed in terms of their value or cost to an organization or country. For entrepreneurs, this is closely linked to the success of their business.

• During the startup phase of a business, the value of the business and the entrepreneur’s human capital is usually low. However, both can increase rapidly if the business grows successfully. For example, Mark Zuckerberg’s human capital was low during the early days of Facebook, but as the company grew, so did his human capital.
• The increase in human capital mimics equity due to its close linkage to business value. This is in contrast to wage earners whose human capital is more bond-like due to their stable earnings.
• Entrepreneurs face greater non-systematic, idiosyncratic risk in their human capital. This is due to heavy investments and often undiversified investment in their specialized human capital. For instance, Elon Musk invested heavily in Tesla and SpaceX, putting his human capital at risk.

Entrepreneur’s Wealth

Entrepreneur’s wealth refers to the total value of all physical and intangible assets owned by an entrepreneur, minus any liabilities.

• The wealth of entrepreneurs and their families is often concentrated in key assets that have been instrumental in generating their wealth. For example, Jeff Bezos’ wealth is largely concentrated in Amazon stocks.
• These concentrated positions typically fall into three categories: wholly owned or closely held private businesses, publicly traded stocks, and commercial or investment real estate.
• For private businesses, the concentration can result from pre-IPO holdings or long-term family-owned operations, often involving shares held by multiple family members or generations. The Walton family, for instance, holds a significant portion of Walmart shares.
• Real estate positions usually show similar concentration patterns. Often, real estate holdings are linked directly to closely held private businesses. Donald Trump’s wealth, for example, is largely tied to his real estate holdings.
• Public equity concentration can arise from IPOs, from sales of private businesses to public firms, or as stock-based compensation from long-term employment at publicly traded companies.

Concentrated Positions

Concentrated positions refer to a significant portion of an investor’s portfolio being invested in a single asset. The definition of a concentrated position can vary depending on the nature of the asset. For instance, owning 10% of a small-cap stock might be considered a concentrated position, while the same percentage in a large-cap stock might not. This reading defines a concentrated position as a holding that, due to its low tax basis and large potential capital gains or personal association with the client, hinders the development of an efficient, diversified portfolio.

Key Aspects of Concentrated Positions

When advising clients on concentrated positions, wealth managers evaluate both associated risks and tax implications, focusing on three key aspects:

• Wealth Concentration: A significant portion of a client’s net worth is tied up in a single asset or business. For example, consider a tech entrepreneur in Silicon Valley whose net worth of $100 million, with $80 million tied up in his startup.
• Low Cost Basis and High Unrealized Capital Gains: The low cost basis and high unrealized capital gains make diversification expensive. If the startup’s value has risen significantly from its initial value, selling shares could incur substantial capital gains tax, decreasing the entrepreneur’s net worth significantly.
• Risk Management Complexities: The complexities associated with managing risk make it crucial to strategize carefully to maintain both wealth and tax efficiency.

Risks of Concentrated Positions

Concentrated positions, particularly in private companies, carry both systematic and non-systematic risks. Systematic risks, which are unavoidable, impact the entire market, while non-systematic risks are unique to a specific company or property. For instance, a significant investment in a family-owned business like Walmart Inc. can be riskier than a similar investment in a publicly traded company like Amazon Inc.

Impact of Concentrated Positions on Portfolio Efficiency

Concentrated positions can compromise portfolio efficiency by limiting diversification. They introduce non-systematic risk specific to a company’s operations and business environment. When combined with systematic risk, this contributes to the total risk of the portfolio. Concentrated positions are inherently more volatile than otherwise equivalent diversified positions with similar betas, reducing median ending wealth over time.

Tax Minimization Strategy and Non-Systematic Risks

While a tax minimization strategy may seem attractive, it is not always the best approach due to the potential for higher volatility leading to larger losses. Despite the higher positive skew creating a higher expected value for a single stock, the median outcome is significantly higher for a diversified portfolio. This analysis is influenced by various factors, including psychology and legacy.

Property-Specific Risk

Consider the case of a real estate investment in a commercial building. If an environmental hazard like asbestos is discovered in the building, the value of this specific property could significantly decrease, even while the general real estate market and similar assets appreciate. This is an example of property-specific risk, a unique form of non-systematic risk associated with a particular real estate investment.

Liquidity Challenges in Private Businesses and Investment Real Estate

Imagine owning a significant stake in a privately-owned tech startup or a piece of investment real estate. Unlike publicly traded stocks, these assets do not have an easily accessible market. The sale price largely depends on how the position is exited, the selling strategy, and the identity of the buyer. Therefore, quickly liquidating private company shares to pay unforeseen expenses can be challenging. Similarly, direct ownership in investment real estate is illiquid. Finding a buyer may require effort, and different classes of potential buyers may assign divergent values to a given property.

Risk Management in Concentrated Positions

Wealth managers are instrumental in aiding clients to navigate the risks associated with concentrated positions in private businesses, public stocks, or real estate. They assist in formulating targeted risk management objectives that aim to avoid, mitigate, transfer, or accept these risks.

The objectives associated with managing these risks typically fall into five categories.

Reduce Total Risk

For instance, a family’s significant investment in a private business often constitutes a large portion of their extended balance sheet. The primary goal is to mitigate both systematic (market-related) and non-systematic (company-specific) risks that influence the total risk to the portfolio.

Address Idiosyncratic Risk

While the intent may be to reduce total risk, psychological factors may discourage clients from reducing idiosyncratic and investment-specific risk, such as divesting a poorly performing family business. It is the wealth manager’s responsibility to identify and communicate the implications of retaining idiosyncratic risk.

Generate Liquidity

For example, wealth owners often face spending requirements that surpass their liquid cash income. Generating supplemental income becomes crucial when holding illiquid assets like private company shares that are difficult to convert into cash for unplanned expenses.

Manage Tax Obligations

Tax considerations, often arising from low-cost cost-basis assets with large unrealized gains, can be so significant that managing them can become an investment objective. Various structures, transactions, and strategies can manage these tax liabilities.

Transfer Wealth

For privately owned businesses that define a family’s identity, the goal is often to transfer ownership within the family or create a legacy for future generations. In more detached ownership scenarios, the focus may shift to fulfilling philanthropic objectives.

Goals-Based Planning with Concentrated Positions

Goals-based planning is a strategy that integrates psychological elements into asset allocation. This method is especially beneficial when advising clients on the potential risks associated with portfolios that have concentrated asset positions. This approach, advocated by Chhabra (2015), organizes investment objectives and corresponding assets into distinct “risk buckets”.

• Personal Risk Bucket: This bucket is dedicated to maintaining essential lifestyle spending and safeguarding against lifestyle degradation. It primarily invests in low-risk assets, such as bank deposits or government bonds, yielding below equity market returns. An example of this could be a primary residence as it contributes to lifestyle preservation.
• Market Risk Bucket: This bucket aims to maintain the client’s current lifestyle with a high probability. It allocates to stocks and bonds, targeting average risk-adjusted market returns. For instance, investing in a diversified portfolio of S&P 500 stocks.
• Aspirational Risk Bucket: This bucket targets significant wealth growth but comes with a higher risk of capital loss. It includes investments in privately owned businesses, concentrated stock positions, real estate, and alternative assets. An example could be investing in a start-up company or buying a rental property.

This framework allows wealth managers to discuss investment risks with clients, specifically those with concentrated assets. It serves as a reference for decisions on selling or monetizing positions. One metric to consider in the goal-based framework is whether the after-tax proceeds from monetization, combined with other personal risk bucket assets, will cover lifetime spending needs. This amount is the owner’s primary capital and comprises allocations to his or her personal and market risk buckets.

Optimal Timing for Selling or Monetizing a Concentrated Asset Position

When it comes to the optimal timing for selling or monetizing a concentrated asset position, such as a privately held business, wealth managers need to consider five key questions with the owner. These questions are crucial in determining the financial feasibility and timing of the sale or monetization.

1. Projected Lifetime Expenditures and Aspirations

For instance, if the owner is Jeff Bezos, what are his projected lifetime expenditures and aspirations after selling or monetizing Amazon?

2. Immediate Capital Requirement

How much immediate capital, say $10 billion, is needed to confidently fund these lifetime expenditures without risk of financial shortfall?

3. Current Market Value of the Concentrated Position

What is the current market value of Amazon? It’s important to note that different valuation approaches may yield significantly different values.

4. Value of the Concentrated Asset

Does the value of Amazon, under any available monetization strategies, sufficiently bridge the gap between Bezos’s existing capital and the required primary capital?

5. Current Market Value of All Liquid and Other Assets

What is the current market value of all liquid and other assets that Bezos holds outside of Amazon?

For owners of concentrated assets, a sale or monetization should at least meet their primary capital requirements. Goals-based planning is equally effective for clients with businesses, real estate, or concentrated stock holdings. This strategy allows wealth managers to first identify each client’s concentration risk and then develop a framework to evaluate if a sale or monetization will achieve financial objectives. Successfully doing so may incentivize the owner to confront the emotional hurdles of selling or monetizing the asset.

Investment Constraints Related to Concentrated Positions

Investment constraints are crucial factors that significantly influence the investment decisions and strategies of owners of concentrated positions, including those who own small and medium-sized privately held businesses. These constraints can be numerous and varied, and can significantly impact the investment decisions and strategies of these owners.

• Lack of Liquidity:One of the primary constraints faced by owners of concentrated positions is a lack of liquidity. For instance, owners of start-ups with high growth potential may find it difficult to sell their shares as they anticipate future growth.

• Time Horizon:The time horizon is another significant constraint. This is influenced by both the company’s life cycle stage and personal factors, such as the age of the entrepreneur and other family members, as well as legacy goals. For example, an older entrepreneur may have a shorter investment time frame, which can affect tax management strategies.

• Control: Control is a crucial factor for many owners of concentrated positions. Some owners may wish to keep voting control personally or within the family, while others may want to transfer control to key employees in recognition of their service. This factor becomes especially relevant if the concentrated position is in real estate that is crucial to a business or for family enjoyment.

• Regulatory Constraints: Regulatory constraints can also impact investment decisions. For example, executives who are paid in shares may be contractually obligated to hold these shares for a defined period, aligning their incentives with the company’s.

• Psychological: Psychological factors can also serve as constraints. An emotional attachment to the original wealth source may deter risk reduction as an investment goal. Similarly, emotional ties to a privately owned business can temper the desire to reduce risk.

These constraints can be so significant that they become primary or secondary objectives themselves, such as elevating tax management to an investment objective. More commonly, however, they are conditions that must be met while pursuing previously defined objectives.

Managing Private Company Concentrated Positions

Managing private company concentrated positions involves understanding the unique characteristics and challenges of privately owned businesses, particularly those in the middle-market category. These businesses, typically valued between USD10 million and USD500 million, often represent a significant portion of the owner’s net worth. This can lead to a situation where the owner is “asset rich, but cash poor.”

• Business and Personal Identity: The business often intertwines with the owner’s personal identity and pride, serving as the main income source and a vehicle for achieving legacy and philanthropic goals. For instance, a family-owned bakery that has been passed down through generations.
• Valuation: Owners often underestimate their business’s risks and overvalue their enterprises. For example, a tech startup might overestimate its market potential and undervalue its competition.
• Exit Strategy: Many owners lack an exit strategy or knowledge about selling or transferring the business. Triggers pushing an owner to action can vary and include unsolicited offers, personal or family illness, or a family member’s disinterest in joining the business.

Risk Avoidance by Selling the Business

Business owners often face the challenge of having a significant portion of their wealth tied up in their business. This can lead to a lack of liquidity and a high concentration of risk. One way to mitigate this risk is by selling the business. This note explores the financial situation of business owners, the challenges they face in achieving liquidity, the benefits and considerations of selling the business, and the tools available for achieving liquidity.

• Business Owners’ Financial Situation: Consider the case of a restaurant owner whose majority of net worth is tied up in the business, leading to a lack of cash for personal needs or investment diversification.

• Challenges in Achieving Liquidity: For instance, a tech startup may have restrictions against selling shares to outside parties, limiting the liquidity options for the owners.

• Benefits of Selling the Business: By selling the business, the owner can use the proceeds to meet personal financial needs or diversify their investment portfolio, reducing the risk concentration.

• Considerations in Selling the Business: However, selling a business is not just about financial considerations. It also involves emotional and family factors, such as the willingness of heirs to take over the business.

• Tools for Achieving Liquidity: There are various tools available for achieving liquidity in a private business, such as selling shares to private investors or going public through an IPO.

Capital Gains Tax in Concentrated Asset Positions

When an individual or a family decides to sell a highly appreciated concentrated asset position, such as a family business, they often face a substantial capital gains tax. This is primarily because these assets usually have a low tax cost basis compared to their current market value. For instance, consider a family business that was started with a small investment but has grown significantly over the years. Despite the tax burden, business owners are likely to accrue more after-tax wealth from an outright sale due to reduced volatility drag on wealth accumulation.

The prospect of capital gains tax can be a psychological barrier for families who have built their wealth through years of calculated business risks. The tax impact can also be an economic barrier, preventing the owner from selling the business until some of the tax implications are addressed. Therefore, deferring or even eliminating this tax is often a primary goal, and various strategies exist to achieve this objective.

In certain jurisdictions like the United States, holding the asset until death allows heirs to benefit from a step-up in basis. This effectively resets the tax cost basis to the asset’s market value at the time of death, potentially avoiding capital gains tax. This can impact the intergenerational transfer of businesses with a low basis.

Managing Timing Risk in Asset Sales

Timing risk can also be an issue when selling a business. Selling an asset in multiple tranches can mitigate this risk, as can tax-loss harvesting strategies, which allow for the offset of capital gains with capital losses. In jurisdictions with progressive tax rates on capital gains, spreading out the recognition of capital gains can further reduce tax liabilities.

Effectively, divesting a concentrated ownership structure incrementally over a period can mitigate tax impact and distribute the tax obligation more evenly over time. This strategy, known as staged diversification, retains some level of concentrated risk until the asset is sufficiently liquidated. The seller retains a degree of control over the business, and the remaining level of exposure varies with the rate at which the asset is sold. Wealth managers commonly use this approach to address the psychological resistance clients often have to selling all at once. However, the tax implications can be sizeable.

Equity Monetization and Sale Strategies

Equity monetization is a crucial decision for business owners and advisers, often perceived as a binary choice of “sell or hold”. However, this is a misconception as there are multiple strategies that can be designed to create staged or phased exit plans, leading to multiple liquidity events. The effectiveness of these strategies is influenced by market conditions, which can fluctuate over time. Sale strategies are typically designed to satisfy two common objectives—mitigate risk and generate liquidity.

Types of Sale Strategies

There are various types of sale strategies. For instance, strategic buyers, usually industry competitors, often offer the highest purchase price due to their long-term investment perspectives and anticipated synergies. A real-world example could be Google’s acquisition of YouTube. Another strategy involves financial buyers, such as private equity firms, who target stable, middle-market companies that have strong potential for value creation. By consolidating multiple such companies within the same industry or sector, they can form a lucrative conglomerate, which can command a premium when sold or taken public. Private equity firms often have shorter investment horizons than strategic buyers and have considerable incentive to increase sales and reduce costs.

Management Buyouts (MBOs)

Management buyouts (MBOs) are another sale strategy that involves selling the business to senior managers or key employees who are familiar with the business. However, these employees may lack the entrepreneurial acumen needed to successfully run the business, which makes it difficult for them to secure financial backing from private equity firms or banks. As a result, the owner often has to finance a significant part of the sale through a promissory note, deferring a large portion of the purchase price to a later date and sometimes making the transaction contingent on the company’s future performance.

Risk of MBO Transactions

Management Buyout (MBO) transactions carry significant risk due to their complexity and the high level of debt often involved. For instance, when Michael Dell, the founder of Dell Inc., led a MBO in 2013, the company had to take on substantial debt to finance the buyout.

Leveraged Recapitalization

Leveraged recapitalization is a strategy often used by business owners to diversify their assets and reduce wealth concentration. A real-world example is when Dunkin’ Brands Group underwent a leveraged recapitalization in 2006, allowing the company’s owners to cash out a portion of their stock while retaining a minority ownership.

Employee Ownership

In some jurisdictions, laws incentivize business owners to sell shares to employees, effectively enabling employee ownership. For example, Publix Super Markets in the United States is largely owned by its employees through an Employee Stock Ownership Plan (ESOP).

Business Financing and Capital Distribution Strategies

Businesses, particularly those with strong cash flows and unlevered assets, can adopt a strategy of redirecting these cash flows to increase dividends or related capital distributions. This strategy involves financing the business through external private debt, primarily bank loans, provided the business has borrowing capacity. However, this approach may lead to tax implications.

Dividends and similar payouts often undergo double taxation in many areas, but there are methods available to reduce this impact. While these transactions effectively monetize assets, they may not initially reduce risk. After the initial liquidity event, the business owner holds a reduced equity stake and lowers asset concentration to some extent.

Leverage and Risk

If the owner finances the sale with debt or holds more highly levered equity, the added leverage from the recapitalization increases the risk linked to this smaller equity position.

Initial Public Offering (IPO)

An Initial Public Offering (IPO) is a possible option for companies in investor-favored industries with strong growth trajectories. Going public incurs substantial costs, but the potential pricing valuation often outweighs them. However, the IPO process eliminates the privacy and the autonomy many successful entrepreneurs and business owners value. As the CEO of a public company, the owner faces intense scrutiny and must adhere to investors’ short-term financial expectations.

An IPO is generally not suitable for owners looking for a quick exit; instead, it serves as a growth financing mechanism for those planning to stay actively involved in the business for an extended period. Additionally, the size of the company needs to meet certain minimum requirements to make it attractive to investors and to make the IPO cost effective.

Sale or Gift to Family Member or Next Generation

Ownership transfer in privately held businesses, such as a family-owned bakery or a small tech startup, can be achieved through tax-advantaged gifting strategies. This is often the case when family members, similar to senior managers in a Management Buyout (MBO) scenario, lack the financial resources for a full cash offer and struggle to secure external financing. In such instances, the owner may finance a large portion or even all of the purchase via a promissory note, effectively increasing leverage on their remaining equity.

Gifting as a Transition Method

Gifting is a prevalent method for generational ownership transition. However, it is usually not viable unless the owner, for instance, a successful entrepreneur, has accumulated other significant assets outside of the business to maintain their lifestyle independent of the business.

Structuring Ownership Transfers

The structuring of ownership transfers among family members varies by jurisdiction and considers several factors. These factors include the business’s legal and tax location; the family members’ legal and tax residency; the business’s size, valuation, and growth trajectory; and the existing ownership structure. These factors collectively influence the legal and tax implications of the transfer.

Legal and Tax Advice

Apart from financial advice, legal and tax advice is essential to ensure that the ownership transfer meets all legal requirements and taxation rules. For example, a tax attorney or a certified public accountant (CPA) can provide valuable insights into the process.

Evaluating Different Sales Strategies for Private Companies

The evaluation of various sales strategies for privately held companies. It delves into the factors that influence the value of such companies, the objectives of strategy evaluation, considerations for the sale price, and methods of mitigating and transferring risk.

Value Variation

• The value of a privately held company, such as a family-owned restaurant, can fluctuate based on the chosen exit or monetization strategy.
• Unlike public companies like Apple with established markets, private firms require a market to be created and potential buyers identified, driven by the potential buyers’ valuation perspectives.

Objective of Strategy Evaluation

• The goal in evaluating different strategies should be to maximize the after-tax proceeds that are available to the business owner to reinvest, not just maximizing the sales price.
• Transactional tax planning and structuring, like utilizing tax credits or deductions, is extremely important and can result in significant tax savings for the owner.

Sale Price Considerations

• Typically, a majority of the sale price is paid upfront, but it is not uncommon for a portion to be deferred or conditional on future milestones, like an “earn-out” based on revenue or earnings targets.
• The final “sale price” should account for upfront, deferred, and contingent payments and their likelihood of being received.
• Consideration of after-tax proceeds is crucial in the decision-making process.

Mitigating and Transferring Risk

• A primary objective in managing concentrated asset risk is reducing total risk, systematic risk, and/or unsystematic risk.
• Although sales strategies both avoid risk and generate liquidity, other strategies only focus on risk mitigation, and many do not generate liquidity.
• If the business owner has few cash flow needs, strategies that focus on risk mitigation only may be appropriate.

Completion Portfolio

A completion portfolio is a strategic approach used by wealth managers to diversify a concentrated asset position. This strategy involves creating an index-based portfolio through a quantitative optimization process. For instance, if an investor has a significant portion of their wealth tied up in a family-owned manufacturing business, a completion portfolio could be created to balance this concentration with investments in other sectors like technology or healthcare.

Optimization Process

The optimization process of a completion portfolio should account for both explicit and implicit assets on the family’s extended balance sheet. It should treat the family business as a distinct asset, taking into consideration its volatility and correlations with other assets. The portfolio weight of the illiquid family business should be limited to the equity retained. The remaining liquid assets should be adjusted to form a portfolio that resides on an efficient frontier.

Desired Outcome

The desired outcome of a completion portfolio is to offset high equity exposure from the illiquid family business by adopting a more conservative stance for the liquid portfolio. The allocation will favor risky assets that are either uncorrelated or negatively correlated with the family business over those highly correlated. Although asset allocation weights in the completion portfolio are usually constrained to be greater than zero, certain financial products enable long positions with short exposure.

For instance, the owner of a privately held IT company can achieve short exposure to the IT sector by taking a long position in an inverse exchange-traded fund (ETF) that tracks this sector. This strategy enables the owner to indirectly obtain short risk exposure through long positions. The completion portfolio can also be tax optimized on an ongoing basis.

Systematic Risk

Pairing a completion portfolio with a staged diversification strategy can gradually mitigate concentrated risk. While this approach does reduce firm-specific and total risk, it’s less effective against systematic risk due to the portfolio’s maintained beta exposure.

Strategies for Managing Concentrated Real Estate Positions

When a family’s wealth is primarily derived from real estate, such as property development or ownership of undeveloped lands, several unique risks emerge. These risks include concentration risk in the real estate sector, specific property risks, and the overarching issue of illiquidity. This is because real estate transactions can be involved, lengthy, and complex negotiations among private parties.

For instance, consider the Walton family, owners of Walmart, who also have significant real estate holdings. Their assets may either constitute the family’s business itself, such as apartment buildings, hotels, or shopping malls, or serve as critical assets within the enterprise. These assets may be directly owned by the family, held in a separate corporate structure in which the family controls both the real estate and the operating business, or even encompass additional non-core assets like machinery, airplanes, boats, and secondary residences.

Real Estate Liquidity Strategies

For short-term liquidity needs, owners might consider divesting these non-core assets as an alternative to selling equity in a privately owned business. Like holdings in public or private equity, concentrated real estate positions often come with a low tax basis, making a sale potentially costly due to capital gains tax. Additionally, owners may not fully appreciate the unique risks tied to their properties, making an outright sale less appealing.

To monetize these assets without selling, owners frequently opt for various debt and equity financing strategies. Common methods include mortgage financing: recourse or non-recourse, fixed or floating rate. Different tax jurisdictions also offer unique real estate monetization techniques. For instance, many US public real estate investment trusts originated from developers who consolidated multiple properties into a portfolio and then went public by selling shares in that portfolio.

Real Estate Financing and Monetization

Real estate financing and monetization is a strategy used by investors to diversify their asset portfolios and generate liquidity without incurring a tax liability. This is achieved by leveraging the cash flow from loans such as mortgages to monetize the equity value in the property, which is essentially the price appreciation.

Consider a corporate owner in the United States with a high-quality, income-generating property valued at $100 million. If they sold the property outright, they would incur a 21% corporate tax, leaving them with $79 million in after-tax proceeds but no share in future price appreciation.

Alternative Strategy

An alternative strategy is to secure a fixed-rate real estate loan against the property, setting the loan-to-value (LTV) ratio at a conservative 60%. This allows the investor to monetize $60 million tax-free. The loan repayments are offset by the net rental income. The investor retains potential asset appreciation, and the leverage increases to 1.60:1 ($160,000,000/$100,000,000). This added leverage increases systematic risk, essentially trading off one type of risk for another.

Interest-Only Loan with Balloon Payments

Another financing option is an interest-only loan with balloon payments, with the loan and rental income funding other investments. If structured as non-recourse borrowing against appreciated, income-generating real estate, it is a viable strategy for monetizing unrealized gains, retaining the upside potential, and potentially avoiding an immediate capital gain tax liability.

Effectiveness of Strategies

The effectiveness of these strategies depends on the level, volatility, and trend of interest rates as well as whether the debt is fixed or floating rate. They are most effective in stable financial environments, characterized by consistent interest rates and markets that show a long-term upward trend. However, in volatile periods, investors may need to amplify the assets they pledge as collateral against loans or liquidate assets at a potential loss to maintain their liquidity. There is an element of added risk in volatile environments and with floating rate borrowings when evaluating these strategies.

Psychological Factors in Concentrated Positions

Concentrated positions often present psychological challenges for clients, acting as barriers to effective risk management. These psychological factors can differ based on whether the client is a business owner or an employee.

Business Owners’ Psychological Factors

Business owners may resist reducing concentrated risk due to various psychological factors, such as:

• Confidence in the business’s wealth-generating capacity, causing hesitation in diversification or sale.
• Perception of the business as an integral part of their family identity.
• Reliance of family members on the business for financial stability.

Employees’ Psychological Factors

Employees may also resist reducing concentrated risk due to their own psychological factors, such as:

• Perceived disloyalty towards the company if they sell their stock, especially after long-term employment.
• Fear of peer judgement upon selling their stock.
• Emotional attachment to the stock, particularly if chosen by a deceased loved one.
• A sense of obligation to pass on business ownership to future generations.

The Role of Financial Advisers

Financial advisers play a pivotal role in assisting clients to navigate these psychological barriers. They must identify and address cognitive and emotional biases, and communicate effectively to facilitate rational decision-making.

Emotional Biases in Investment Decision-Making

Emotional biases are psychological factors that can negatively impact the decision-making process of investors, particularly those holding concentrated positions. These biases can take various forms, including overconfidence and familiarity, status quo bias, naïve extrapolation of past returns, endowment effect, and loyalty effects.

• Overconfidence and familiarity: Also known as the illusion of knowledge, this is a bias where investors believe they have a better understanding of their investments than they actually do. For instance, an investor might overestimate their knowledge about the tech industry because they work in it, leading to risky investment decisions.
• Status quo bias: A preference for no change, where investors are reluctant to alter their investment strategies, even when change may be beneficial. For example, an investor might stick to investing in bonds despite low returns because they are afraid of the volatility of the stock market.
• Naïve extrapolation of past returns: Also known as recency bias, this occurs when investors expect current trends to continue into the future, disregarding the possibility of change.
• Endowment effect: A bias where investors value their own assets more than others, often asking for more money to sell an asset than they would be willing to pay to buy it.
• Loyalty effects: Refers to the emotional attachment investors may have to certain investments, which can cloud their judgement.

Overcoming Emotional Investment Biases

Addressing these emotional biases can be challenging, as drawing attention to them may lead to defensive reactions rather than openness to considering alternatives. One strategy to overcome these biases is to ask the investor how they would invest an equivalent sum if they received it in cash today. This can help the investor to consider other investment options and potentially realize the risks associated with their concentrated position. If the asset was inherited, understanding the intent of the deceased donor in owning and bequeathing the concentrated position can also be helpful. If the primary intent was to leave financial resources for the benefit of the heirs, rather than the specific concentrated position, the heirs may be more open to strategies to reduce concentration risk. Reviewing the historical performance and risk of the concentrated position can also be a useful strategy.

Cognitive Biases and Family Governance

Cognitive biases are psychological tendencies that significantly influence decision-making, especially for individuals or entities with concentrated positions. These biases can take various forms, including conservatism, confirmation, illusion of control, anchoring and adjustment, and the availability heuristic.

Types of Cognitive Biases

• Conservatism: The reluctance to revise one’s beliefs, even when new information is presented. For instance, a stock trader might refuse to sell a declining stock due to their initial belief in its potential.
• Confirmation bias: The tendency to seek out and give more weight to information that confirms one’s existing beliefs, while ignoring or downplaying contradictory evidence. An example could be a climate change denier who only reads articles that support their viewpoint.
• The illusion of control: A cognitive bias where individuals overestimate their ability to control events. For example, a gambler who believes they can influence a dice roll.
• Anchoring and adjustment: A decision-making process where individuals make adjustments from an initial position, or “anchor”, rather than considering all available information. For instance, a car buyer who negotiates from the initial price offered by the dealer.
• The availability heuristic: A mental shortcut where the probability of events is influenced by how easily examples of the event can be recalled. For example, people might overestimate the likelihood of plane crashes because they are widely reported in the media.

It is crucial to note that if these cognitive errors are brought to the attention of the investor, they are likely to be more receptive to correcting the errors.

Family Governance

Family governance is a system established by families, particularly large and wealthy ones, to manage behavioral and emotional challenges that may impact decision-making regarding the family business and wealth transfer. These challenges can include generational conflict, disability, sibling rivalry, and the inability of children to take over the business. Family governance aims to ensure the effective generation, transition, preservation, and growth of wealth over time.

According to Stalk and Foley (2012), family-owned enterprises tend to decline by the third generation, a phenomenon so common that it has given rise to sayings in many cultures. The founder creates wealth, the second generation maintains it, and the third generation often depletes it. This pattern is reflected in sayings such as “Shirtsleeves-to-shirtsleeves in three generations” in English, “Rice paddies to rice paddies in three generations” in Japanese, “The father buys, the son builds, the grandchild sells, and his son begs” in Scottish, “Wealth never survives three generations” in Chinese, and “From stables to stars to stables” in Italian.

Challenges in Transitioning Family Businesses Across Generations

Family businesses, which form the backbone of many economies, often grapple with the challenge of transitioning management and ownership across generations. A staggering 70% of these businesses either fail or are sold before the second generation gets a chance to take over, and only 10% make it to the third generation. This decline in wealth across generations can be attributed to several factors.

Factors Contributing to the Decline

• Dilution of Wealth: As the family expands, the wealth is divided among more descendants, reducing the individual share. For instance, a business started by a single individual would have to be divided among multiple children and grandchildren in subsequent generations.
• Lack of Interest: Younger generations may not be interested in the family business due to various reasons such as a desire to pursue different career paths or a lack of understanding or appreciation for the family business. For example, a third-generation family member might be more interested in technology and choose to start a tech startup instead of taking over the family’s manufacturing business.
• Lack of Education and Planning: Without proper knowledge and preparation, family members may not be equipped to manage the business effectively. For instance, if a family member inherits a real estate business but has no knowledge or interest in real estate, they may not be able to manage the business effectively.
• Differences in Values and Perspectives: Differences in values, work ethic, and perspectives of subsequent generations can lead to conflicts and misunderstandings, hindering the smooth operation of the business. For example, a younger generation might prioritize work-life balance more than the older generation, leading to conflicts.

Family Governance Framework

A robust family governance framework can mitigate some of these issues and behavioral biases that impede effective decision-making. If established early and with all family members recognizing the importance of regular communication and collective decision-making, it can be an effective value-added tool.

Business Succession Planning

Having a family business as the core of the family’s wealth adds an additional layer of complexity. At some point, the founder must face the question of business succession planning: Will the management and ownership of the business be transitioned to a new generation within the family, or will the business be sold?

Allocation of Shares

Founders may allocate shares in the business to the new generation during their lifetime or after their death. The shares may be transferred directly or via trust. Control is an important issue for founders to address. Who will control the business after transition?

A founder may choose to keep voting shares to retain power and operating control—transferring only non-voting shares to children in trust by gift or other methods. Alternatively, a founder may decide to pass voting shares to family members who are actively involved in the business and non-voting shares to family members who are not actively involved in the business.

Emotional Value and Endowment Bias in Family Businesses

Family businesses are often more than just a source of income for the founders and family members. They hold a significant emotional value, which can sometimes lead to an endowment bias. This bias is a psychological phenomenon where the founders overestimate the value of their business due to their emotional attachment, often overlooking its weaknesses. For instance, a founder might value a family-run bakery higher than its market value due to its sentimental value. This bias can complicate the sale negotiations, and this is where private wealth advisers come into play. They manage the founders’ expectations to ensure a smooth business sale process.

Implications of Exiting a Family Business

Exiting a family business is a complex process that involves more than just determining the business’s fair value. It also impacts other aspects such as business, personal, family, and charitable goals. For example, the sale of a family-owned restaurant might affect the family’s income, estate planning, and charitable gifting strategies. Capital gains and income taxes will be due upon sale, and the timing of the sale is another important consideration.

Ownership Transfer and Tax Liability

Many business owners strategically transfer the business’s actual ownership to a trust or other vehicle well before a potential business sale. This strategy removes any future appreciation from the business owner’s estate. A discount may be applied to the transfer value due to lack of control or lack of marketability, which can reduce the gift and estate tax liability.

Liquidity and Asset Dispersal

The sale of a family business creates liquidity that can be used to establish a new business or a philanthropic entity. However, without advance planning, the assets may be dispersed among numerous family members, causing the business activity that brought the family together to disappear.

Family Unity and Philanthropic Goals

With suitable structures put in place in advance, such as a family foundation, the family can remain united after the business exit by pursuing philanthropic goals. This approach can increase the family’s social capital, train younger generations, and promote the family’s values. Founders who prefer to maintain control over the funds’ distribution can specify the charitable causes to be funded by the foundation or provide a list of specific charities and funding amounts.

Practice Questions

Question 1: Altrata’s research provides a breakdown of the sources of wealth among the ultra-high-net-worth population. It also compares the wealth levels of entirely self-made entrepreneurs and inheritors of wealth. According to the research, what percentage of the ultra-high-net-worth population has wealth that is partially self-made and partially inherited, and how does the mean inherited wealth compare to the median wealth of entrepreneurs?

1. 21% of the ultra-high-net-worth population has wealth that is partially self-made and partially inherited, and the mean inherited wealth is USD52 million, compared to the median wealth of entrepreneurs of approximately USD78 million.
2. 73% of the ultra-high-net-worth population has wealth that is partially self-made and partially inherited, and the mean inherited wealth is USD52 million, compared to the median wealth of entrepreneurs of approximately USD78 million.
3. 7% of the ultra-high-net-worth population has wealth that is partially self-made and partially inherited, and the mean inherited wealth is USD52 million, compared to the median wealth of entrepreneurs of approximately USD78 million.

Answer: Choice A is correct.

According to Altrata’s research, 21% of the ultra-high-net-worth population has wealth that is partially self-made and partially inherited. This means that these individuals have both created their own wealth and inherited some wealth. The mean inherited wealth is USD52 million, which is the average amount of wealth that is inherited by this group. This is compared to the median wealth of entrepreneurs of approximately USD78 million. The median is the middle value in a list of numbers, so this means that half of the entrepreneurs have wealth less than USD78 million and half have more. This comparison provides insight into the distribution of wealth among the ultra-high-net-worth population and the different sources of this wealth. It shows that while a significant portion of this population has wealth that is partially self-made and partially inherited, the wealth of entrepreneurs tends to be higher.

Choice B is incorrect. According to Altrata’s research, 73% of the ultra-high-net-worth population does not have wealth that is partially self-made and partially inherited. This percentage is significantly higher than the correct answer and does not accurately represent the distribution of wealth among this population.

Choice C is incorrect. According to Altrata’s research, 7% of the ultra-high-net-worth population does not have wealth that is partially self-made and partially inherited. This percentage is significantly lower than the correct answer and does not accurately represent the distribution of wealth among this population.

Question 2: An entrepreneur from Sweden has a net worth of SEK60 million, with SEK50 million tied up in her business. This scenario is an example of a concentrated position. As a wealth manager advising this client, you would need to consider several key aspects of this concentrated position. Which of the following is NOT one of the key aspects you would need to consider in this scenario?

1. Wealth Concentration
2. Low Cost Basis and High Unrealized Capital Gains
3. Market Liquidity

Answer: Choice B is correct.

Low Cost Basis and High Unrealized Capital Gains is not one of the key aspects to consider in this scenario. This term refers to a situation where an investor has a significant portion of their wealth tied up in a single investment that has appreciated in value, but the investment has not been sold, and therefore, the capital gains are unrealized. In this scenario, the entrepreneur’s net worth is tied up in her business, not in an investment that has appreciated in value. Therefore, the concept of a low cost basis and high unrealized capital gains does not apply.

Choice A is incorrect. Wealth Concentration is indeed a key aspect to consider in this scenario. The entrepreneur has a significant portion of her wealth tied up in her business, which is a concentrated position. This concentration of wealth can pose significant risks, as the entrepreneur’s financial well-being is heavily dependent on the success of her business. As a wealth manager, it would be important to consider strategies to diversify this risk.

Choice C is incorrect. Market Liquidity is also a key aspect to consider in this scenario. If the entrepreneur needed to quickly convert her business assets into cash, she may face challenges due to market liquidity issues. This could be particularly problematic in a situation where she needed to raise funds quickly, for example, to cover unexpected business expenses. Therefore, as a wealth manager, it would be important to consider the liquidity of the entrepreneur’s assets when advising her on her financial strategy.

Glossary

• Entrepreneurship: The activity of setting up a business or businesses, taking on financial risks in the hope of profit.
• Ultra-high-net-worth individuals: Individuals with investable assets of at least $30 million, excluding personal assets and property such as a primary residence, collectibles, and consumer durables.
• Human Capital: The skills, knowledge, and experience possessed by an individual or population, viewed in terms of their value or cost to an organization or country.
• Entrepreneur’s Wealth: The total value of all physical and intangible assets owned by an entrepreneur, minus any liabilities.
• Concentrated Position: A significant portion of an investor’s portfolio being invested in a single asset.
• Systematic Risk: The risk that affects all companies in the market.
• Non-Systematic Risk: The risk specific to a company or property.
• Liquidity: The ability to quickly convert an asset into cash without affecting its price.
• Tax Minimization Strategy: A financial strategy aimed at reducing the amount of taxes paid by an individual or organization.
• Endowment Bias: A psychological phenomenon where individuals overvalue something they own, often due to their emotional attachment.

Private Wealth Pathway Volume 2: Learning Module 6: Advising the Wealthy;

LOS 6(c): Discuss and recommend appropriate private wealth management approaches that maximize the human capital, financial capital, and economic net worth of entrepreneurs and business owners