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2013, Study Session # 4, Reading # 13

LOW-BASIS STOCK
EF = Exchange Funds
1. DEFINING THE PROBLEM

 Basis price that serves as the basis for the computation of capital gains
(might be different from the initial cost).
 Low basis holdings in an individual portfolio may arise through:
 Entrepreneurial success:
 Significant shares in a founded company.
 Cost equals to original investment in the venture.
 Executive success:
 Usually through equity compensation.
 Value of these holdings may have risen substantially above the cost.
 Investment success:
 Portfolio comprising of several substantially appreciated securities.
 Challenges while dealing with low-basis holdings:
 Psychological attachments.
 Investment issues (e.g. risk return tradeoff & taxes).

2. UNDERSTANDING STOCK RISK

Market Risk

 Affect all securities.


 Cant diversify away.

Specific Risk

 Security specific.
 Can be diversified away.

Residual Risk

Counterparty Risk
Risk due to
dependence on a
counterparty to
complete a
transaction

Regulatory Risk
Risk that tax
authorities may
reject a tax
treatment chosen.

Stages of Equity Holding Life

Entrepreneurial Stage

 Very high specific risk.


 Single security dealing.
 Immature company.

Executive Stage

Investor Stage

 The investor enters the


executive stage once the
business is public.
 Specific risk is somewhat lower
but still high.
 Less diversified equity holdings.

 Multi security portfolio.


 Two stages:
 Diversified investor stage.
 Indexing stage.

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2013, Study Session # 4, Reading # 13

3. APPLYING THE MODEL TO INDIVIDUAL CIRCUMSTANCES

The Entrepreneurial Stage

The Executive Stage

 No diversification desire.
 Look for ways to minimize
transfer costs.

 Diversification desire is linked to


the degree of control.
 The individuals position in the
organization,  specific risk
tolerance.

The Investor Stage

 Investor strongly requires


diversification.
 Advisor should focus on
investors psychology.

4. REDUCING A CONCENTRATED EXPOSURE

 Two fundamental strategies.


 Financial strategies.
 Charitable strategies.

Financial Strategies

Outright Sale






Exchange Funds

Simple & often most expensive.


Capital gains tax.
Maximum flexibility.
Eliminates all residual risks.

Public EF

Private EF

 Partnership for a minimum of seven years.


 20% illiquid assets.
 Each partner receives proportional
distribution.
 Shortcomings:
 High management cost.
 Lack of control.
 Inflexibility.

Completion Portfolios

 Usually involve a single security.


 Investor or investors with concentrated
low basis stock positions join partnership
with an unrelated party who buys the
same holdings.
 Benefits:
 Create opportunity to borrow.
 No exposure to illiquid assets.
 Flexibility.

Hedging Strategies

 Utilized by investors with other, liquid assets in addition to the


large low-basis position.
 Investors goal is to reach a desired target portfolio (e.g. index).
 Tax loss harvesting to shelter the capital gain realized each time
any low-basis stocks is sold.
 May be time taking strategy.

 Law often prohibits constructive sale (offsetting position).


 Illiquid portfolios can be effectively monetized.

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2013, Study Session # 4, Reading # 13

Two Alternatives

Pure Hedging Strategy

Pure Monetization Strategy

 Protect gains & let profits run.


 Reduce or eliminate downside
risk

 Get the money out of a position


(without taxable event).
 Reinvesting proceeds in a
desired way.

Equity Collars






Variable Prepaid Forwards

Buying put selling call option.


Principal requirement no constructive sale.
Collar may have +ve, zero or negative cost.
Collar sets the minimum value (serve as collateral), so
monetization is easy.

 Forward sale of a contingent no. of low cost basis


shares in exchange for advance cash today.
 No constructive sale requirement.

5. SUMMARY AND IMPLICATIONS

Useful for investors & advisors to


think in terms of diversification

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