Frequently, the wealth of individuals and families is concentrated in an asset or group of assets that has played a role in their accumulation of wealth. Wealth managers must be able to assist private clients with decisions concerning such positions. Three major types of “concentrated position in a single asset” are
- publicly traded stock
- a privately owned business
- commercial or investment real estate
Concentrated positions can have consequences for return and risk. The assets may not be efficiently priced and, therefore, not generate a fair risk-adjusted return. Illiquid assets can be difficult and costly to exit or non-income producing. The risk in such assets is both systematic and company- or property-specific.
- Systematic risk is the risk that cannot be diversified away through holding a portfolio of risky assets. In the single factor CAPM, this would be beta. In multifactor models there will be more than one systematic risk. Multifactor models might include unexpected changes in the business cycle or inflation as systematic risks.
- Company-specific risk is the nonsystematic risk of an investment that can be diversified away. It would derive from events that affect a specific investment but not the overall market. A corporate bankruptcy as a result of financial fraud would be an extreme example of company-specific risk. Nonsystematic risk increases the standard deviation of returns without additional expected return.
- Property-specific risk for real estate is the direct counterpart to company-specific risk for a company. It is the additional, diversifiable risk associated with owning a specific property.
There are three common objectives when managing a concentrated position:
- Reduce the risk caused by the wealth concentration.
- Generate liquidity to meet diversification or spending needs.
- Optimize tax efficiency to maximize after-tax ending value.
Reducing the concentrated position is not appropriate for all clients. There are other client specific objectives and constraints to consider:
- Restrictions on sale. Stock ownership in a public company may be received by a company executive as part of a compensation package, with company expectations or regulatory requirements that the executive will hold the stock for a certain length of time.
- A desire for control. Majority ownership brings control over the business.
- To create wealth. An entrepreneur may assume high specific risk in expectation of building the value of the business and his wealth. He may want to begin passing portions of the ownership to key employees as part of an incentive compensation plan or begin to transfer ownership to succeeding generations of the family.
- The asset may have other uses. Real estate owned personally could also be a key asset used in another business of the owner.
Sale of a concentrated position may trigger a large capital gains tax liability. A large concentrated position is often accumulated and held for many years, resulting in a zero or low tax basis. A plan to defer, reduce, or eliminate the tax may be desirable.
Illiquidity and/or high transaction costs can be a factor even if there is no tax due. A public company trading with insufficient volume may require a price discount to sell. The expense of finding a buyer for a private business or real estate can be substantial. The intended use by the prospective buyer may affect the price.
Institutional and capital market constraints such as tax law (covered previously) can significantly affect the costs of selling or monetizing a concentrated position. Legal issues can depend on the form of asset ownership: sole proprietorship, limited partnership, limited company, or public stock. Other specific issues that may exist include:
- Margin lending rules limit the percentage of the asset’s value that can be borrowed. Derivative positions can be used to reduce the risk of the asset position and increase the percentage of value that can be borrowed. Rule-based systems tend to be rigid and define the exact percentage that can be borrowed, while risk-based systems consider the underlying economics of the transaction.
- Securities law and regulations may define the owner as an “insider” (who is presumed to have material, nonpublic information) and impose restrictions, regulations, and reporting requirements on the position.
- Contractual restrictions and employer mandates may impose restrictions beyond those of securities law and regulation.
- Capital market limitations in the form of market structure and regulation can have indirect consequences. Monetization strategies commonly require over-the-counter derivative trades with a dealer to hedge the security’s risk and increase the LTV ratio. To offer such trades, dealers must be able to hedge the risks they assume. This may be impossible. Without sufficient price history and liquidity in the underlying instruments, monetization techniques may be unavailable.
A number of emotional biases can combine to negatively affect the decision making of holders of concentrated positions, including the following:
- Overconfidence and familiarity (illusion of knowledge)
- Status quo bias (preference for no change)
- Naïve extrapolation of past returns
- Endowment effect (a tendency to ask for much more money to sell something than one would be willing to pay to buy it)
- Loyalty effects
To overcome emotional biases, it might be helpful to pose the question, if an equivalent sum to the value of the concentrated position were received in cash, how would you invest the cash? Often, the answer is to invest in a portfolio very different from the concentrated position.
It may also prove useful to explore a deceased person’s intent in owning the concentrated position and bequeathing it: Was the primary intent to leave the specific concentrated position because it was perceived as a suitable investment based on fundamental analysis, or was it to leave financial resources to benefit the heirs? Heirs who affirm the latter conclusion are more responsive to considering strategies to reduce the concentration risk.
It should also prove useful to review the historical performance and risk of the concentrated position.
A number of cognitive biases can combine to negatively affect the decision making of holders of concentrated positions, including the following:
- Conservatism (in the sense of reluctance to update beliefs)
- Confirmation (looking for what confirms one’s beliefs)
- Illusion of control (the tendency to overestimate one’s control over events)
- Anchoring and adjustment (the tendency to reach a decision by making adjustments from an initial position, or “anchor”)
- Availability heuristic (the probability of events is influenced by the ease with which examples of the event can be recalled)
A goal-based decision process modifies traditional mean-variance analysis to accommodate the insights of behavioral finance theory. The portfolio is divided into tiers of a pyramid, or risk buckets, with each tier or bucket designed to meet progressive levels of client goals. The risk buckets and sequence of priority are:
- Allocate funds to a personal risk bucket to protect the client from poverty or a drastic decline in lifestyle. Low-risk assets such as money market and bank CDs, as well as the personal residence, are held in this bucket. Safety is emphasized, but a below-market return is likely.
- Next, allocate funds to a market risk bucket to maintain the client’s existing standard of living. Portfolio assets in this bucket would be allocated to stocks and bonds earning an expected market return.
- Remaining portfolio funds are allocated to an aspirational risk bucket holding positions such as a private business, concentrated stock holdings, real estate investments, and other riskier positions. Allocating these holdings to the aspirational risk bucket highlights their risky nature for the client. If successful, these high-risk investments could substantially improve the client’s standard of living.
To implement a goal-based plan, the manager and client must determine the primary capital necessary to meet the goals of the first two risk buckets and the amount of any remaining surplus capital to meet aspirational goals. If a concentrated holding in the aspirational bucket leaves insufficient funds for the first two primary capital buckets, sale or monetization of the concentrated position must be discussed with the client. Some questions to address are:
- What are the client’s lifetime spending needs and desires?
- What is the present value of those needs and desires?
- What is the value of the concentrated position and do different approaches to sale or monetization produce different values?
- What other assets does the client have and how liquid are they?
- Would sale or monetization of the concentrated position be sufficient to fund any shortfall in the primary capital?
Asset location determines the method of taxation that will apply. Location in a tax-deferred account would defer all taxes to a future date. In a taxable account, interest, dividends, and capital gains may be subject to different tax rates (or deferral possibilities in the case of when to realize capital gains). If the concentrated position owner has control over the asset, other tax strategies to maximize after-tax ending wealth will be discussed.
Wealth transfer involves estate planning and gifting to dispose of excess wealth. The specific strategies used depend on the tax laws of the country and the owner’s situation. Key considerations include:
- Advisors can have the greatest impact by working with clients before significant unrealized gains occur. If there are no unrealized gains, there are generally no financial limitations on disposing of the concentrated position.
- Donating assets with unrealized gains to charity is generally tax-free even if there are gains.
- An estate tax freeze is a strategy to transfer future appreciation and tax liability to a future generation. This strategy usually involves a partnership or corporate structure. A gift tax would be due on the value of the asset when the transfer is made; however, the asset (including any future appreciation in value) will be exempt from future estate and gift taxes in the giver’s estate. Any tax owed is “frozen,” meaning paid or fixed near an initial value.