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Challenges of cw


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Challenges of cw

  1. 1. Concentrated Wealth StrategiesA quick look at strategic alternatives formanaging concentrated wealth positions.
  2. 2. Concentrated Wealth StrategiesAn investor can find him or herself holding the impact on that investor’s wealth, and the financial fortunes of the investor’sa concentrated equity position for any family, can be devastating. The recent collapse of former market stalwarts likenumber of reasons—inheritance, a sale of a Lehman Brothers illustrate the danger of holding concentrated for stock, executive compensationor simply shrewd investing. Regardless of Clearly, the advantages of moving away from an over-concentration are numerous.the source, concentrated equity positions However, individuals holding such positions face a two-fold challenge. They mustcan increase risk in an investor’s portfolio diversify their portfolio while effectively managing the substantial underlying taxby putting too many eggs in one basket. costs. Balancing these two challenges in the context of each individual’s uniqueIf the equity in which the investor has a circumstances and goals is the key to identifying the right strategy for eachconcentrated position declines significantly, concentrated wealth situation. The Potential Peril of Concentrated Positions BANK OF AMERICA CORP. GENERAL MOTORS CO. NETFLIX, INC. In 2008, as investors became uneasy It’s not just small companies or growth In September 2011, Netflix about the health of financial companies, companies with crazy valuations that announced its intentions to rebrand the financial sector weakened. Coming can suffer substantial falls. Consider and structure its DVD home media out of the financial crisis, Bank of the case of venerable GM, a stock very rental service as an independent America faced growing litigation risk, often held in concentrated positions subsidiary company called rising credit losses and concerns over because of its blue-chip status. From Qwikster, separating DVD rentals credit availability. Earnings power 10/12/07 to 11/19/08, the stock moved and streaming. Less than a month was reduced by asset sales and the from $41.39 to $2.79, a drop of 93%. later, following strong negative impact of more onerous regulation. In the midst of a deepening global reactions from subscribers and Shareholders also endured tremendous financial crisis, the big three carmakers, investors, the company abandoned dilution from the company’s need to including GM, were in a precarious its plans. The stock price continued raise substantial equity capital. financial position. to slide, however, declining by more than 50%. Bank of America shareholders On June 1, 2009, General Motors filed suffered greatly with the stock for bankruptcy protection. Existing Netflix’s 52-week range ending dropping 92% from $41.26 equity investors lost any remaining 12/31/11 was as high as $304.79 (12/31/07) to $3.14 (3/6/09). Even value as the company restructured and and as low as $62.37. today, the stock trades at prices lower exited from bankruptcy protection a than 20 years ago. mere 40 days later.1
  3. 3. Concentrated Wealth StrategiesUnderstanding Goals Identifying StrategiesAligning Strategic Alternatives with Strategies for Managing Concentrated PositionsIndividual ConcernsA number of techniques can mitigate the Usually, an investor has several of the concerns and issues previously identifiedrisk of a concentrated position and help to and, as such, the ultimate solution often involves several different tactics. Oncemove toward a more diversified portfolio. specific objectives and concerns have been identified, a plan can be crafted, usingEach of these techniques addresses certain the strategies described below to satisfy the investor and work toward a wellconcerns that an investor might have diversified portfolio.regarding a concentrated position andis not universally applicable. Therefore, Three primary approaches can be used to address a concentrated position:before action can be taken to address a 1. Sell and Diversifyconcentrated position, it is important to This strategy seeks to liquidate the concentrated position and redeploy the assetsidentify the investor’s concerns, which in a broadly diversified portfolio. It addresses the issues of liquidity and portfoliomight include: risk, while taking advantage of current favorable federal long-term capital gains• Need for liquidity or income to rates. There are several means with which to execute this strategy, including: meet certain financial targets or obligations • Direct Sales Programs and Strategic Sales Structures• Desire to decrease portfolio risk Investor establishes a strategy for selling out of a stock at given price through diversification parameters, timing intervals or dollar targets. Limit orders and writing• Tax impacts surrounding the sale of covered calls are often part of this strategy. Outright sales will take appreciated equities advantage of the low long-term capital gains rate of 15%*.• The charitable intent of the investor • Variable Forward Sales and his or her family Investor agrees to deliver shares of the subject stock at a future date and in• Emotional ties to the security return receives discounted proceeds currently. This structure allows capital• Company-imposed retention gains deferral and possible participation in appreciation of the underlying stock. requirements*Set to expire in 2013.2
  4. 4. Concentrated Wealth Strategies • 10b5-1 Trading Plans Insiders in a publicly traded company have unique issues when it comes to concentrated wealth. Generally, an insider is a senior person at the company who may have accumulated much of his or her wealth through direct purchases and equity awards, such as stock options and restricted stock. Insiders are prohibited from buying or selling shares of common stock of their company while they are in possession of material non-public information and often only are able to sell shares in their company during limited trading windows after the company’s earnings announcements. This limited ability to sell company shares makes it very difficult for an insider to implement a wealth plan that calls for a diversified investment portfolio. Rule 10b5-1 of the Securities Exchange Act of 1934, however, affords insiders a way to diversify their portfolio through regular sales, without running afoul of the insider trading rules. The insider would develop a trading plan to control a certain number of company shares in accordance with his or her directions, i.e., sales at certain target prices or at certain dates. The insider would then sign the plan and place it with an institution for execution during one of the permissible trading windows. If certain targets are hit as specified in the plan, shares can be sold even if the sale does not take place during a trading window. Once the plan is in place, however, the insider can have no further input as to the plan, other than the possible ability to terminate it. The primary benefit of a trading plan is the ability of an insider to diversify their portfolio in an orderly manner without taking the market risk of being confined to certain trading windows. Additionally, a trading plan can serve a public relations role. Making a trading plan public at the time of inception can inform Wall Street that future sales are part of a plan for diversification and not an indication of lack of confidence in the company.3
  5. 5. Concentrated Wealth Strategies2. Charitable Giving 3. Holding a Position and Diversifying through Borrowing or DerivativesCharitable strategies can afford significant This strategy recognizes that factors, including emotional ties or a pending step-benefits in terms of deferral and avoidance up in tax cost of the concentrated security, can make selling a stock undesirable.of federal capital gains taxes while also Borrowing or use of derivatives can allow the investor to retain some or all of theallowing a family the opportunity to concentrated security while at the same time generating liquidity to diversifybuild a legacy of philanthropy. Charitable the investor’s portfolio or to meet other financial needs. The primary tactics forstructures include: executing this strategy include:• Charitable Remainder Trusts • Borrow and Reinvest Investor funds an irrevocable trust Investor borrows funds that are secured by the concentrated position and that allows the investor, as the reinvests those funds in a diversified portfolio. donor, and/or other designated • Protective Put Options individuals to receive annual Investor pays premium for right to sell security at a certain price, providing payments for a specified time downside protection by setting a minimum security price. period with the remainder interest • Covered Call Options passing to charity. Investor receives premium for the sale of the obligation to sell security at• Private Foundations a fixed price, effectively increasing income from security but limiting their Investor creates a non-profit, own ability to participate in stock appreciation. grantmaking entity organized • Equity Collars in furtherance of the investor’s Investor sells a call and uses the premium received to buy a put in order to charitable philosophy and get downside protection. objectives. Many of our nation’s largest foundations were founded Exhibit 1 on the next page summarizes how certain tactics address distinct needs with a single stock. or objectives that an investor might have.• Donor Advised Funds Investor works with an existing charitable entity to establish a fund similar in purpose and operation to a private foundation, but with less administrative oversight required.4
  6. 6. Concentrated Wealth StrategiesExhibit 1Strategic Alternatives for Managing Concentrated Wealth PERSONAL STRATEGIES OBJECTIVE Sell and Diversify Charitable Giving Hold and Diversify Liquidity Provides liquidity Charitable remainder trusts Borrow and reinvest provide liquidity strategies provide liquidity subject to regulatory and Private foundations/donor credit limitations advised funds do not provide liquidity Hedging-related strategies provide liquidity if coupled with margin loan Portfolio Generally reduces portfolio Reduces portfolio risk Borrow and reinvest Risk risk strategies diversify specific risk, but increase broad market and interest rate risk Hedging-related strategies reduces portfolio risk Income May increase investment Charitable remainder trusts Borrow and reinvest Needs income may increase investment strategies can increase income income, net of debt cost Private foundations/donor Hedging-related strategies advised funds do not can increase income increase investment income depending on structure Tax Direct sales do not minimize Minimizes estate and gift Generally defers tax cost of Protection or defer taxes taxes sale Variable forward sales defer tax cost of sale5
  7. 7. Concentrated Wealth Strategies Other Alternatives In addition to the strategies and tactics previously described, commonly used wealth transfer techniques also can be employed to address a concentrated position by moving the securities to other family members or family entities. These wealth transfer strategies do not, in and of themselves, provide the necessary diversification from concentrated positions. However, they do create new investment vehicles with new time horizons, risk characteristics and tax impacts. For this reason, they can be worthy of consideration in some circumstances. Some common wealth transfer techniques include: • Grantor Retained Annuity Trusts • Family Limited Partnerships/Family Limited Liability Companies • Generation Skipping (Dynasty) Trusts • Irrevocable Intentionally Defective Grantor Trusts Concentrated positions in one security can build great wealth, however, they also carry great risk and can destroy a family’s wealth without warning. A concentrated position deserves close attention and a well-thought-out strategy. It is important to emphasize that a single solution approach to managing—or managing out of—a concentrated position is rare. The various vehicles or approaches available are simply building blocks of an overall strategy. What is most critical is to combine the practical knowledge and experience necessary regarding the financial implications of various diversification strategies with a very thorough understanding—and analysis—of the investor’s complete situation. Any plan must be tailored in light of the preferences, tolerances and goals of each investor and his or her family.The information provided is for illustrative/educational purposes only. All investment strategies referenced in this material come with investment risks, includingloss of value and/or loss of anticipated income. Past performance does not guarantee future results. This material is not intended to constitute legal, tax, investmentor financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intendedto be a full and exhaustive explanation of the law in any area or of all of the tax, investment or financial options available. The information discussed herein may notbe applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation.Pursuant to IRS Circular 230, we inform you that any tax information contained in this communication is not intended as tax advice and is not intended or writtento be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to anotherparty any transaction or matter addressed herein.©2012 The Bank of New York Mellon Corporation. All rights reserved.6 Rev. 2/2012