HOLDING CONCENTRATED PUBLIC STOCK
What does Circuit City, General Motors, Sprint and Citigroup have in common? They lost nearly all of their value over the last decade. So did Clear Channel, Radio Shack and Peabody Energy. Why? The hidden dangers of concentrated equity positions.
This blog post discusses a new strategy in executive benefits which, we believe, has the potential to defuse a lurking time bomb on your personal balance sheet: substantial holdings of restricted stock or restricted stock units that could suffer significant losses.
According to J.P. Morgan Asset Management, 320 stocks have been removed from the S&P 500 since 1980 due to “business distress” and 40 percent of Russell 3000 stocks have suffered a permanent decline of 70 percent or more from peak value. So this type of downside risk is not unusual.
Many executives, due to their compensation packages, hold large concentrated equity positions. The reasons vary: corporate optics, stock ownership guidelines, restrictions, tax considerations.
Protect Your Downside Risk
- Many strategies do protect your downside risk such as:
- Outright sale of the stock
- Exchange funds
- Put options
- Equity collars
- Prepaid variable forwards
- Stop-loss orders
- Securities-backed loans
As outlined in the table below, each of these strategies present significant limitations few executives will find attractive. These limitations include short terms, high fees, high taxes, appearance of disloyalty, complexity and, at times, special attention from the IRS.
|Name||How It Works||Considerations|
|Sell & Diversify||Sell shares, pay capital gains tax, reinvest remainder||Cap gains taxes (30%)1. Forego subsequent appreciation. SEC filing; reputation/optics risk for insiders. Employment contracts may disallow. Not available for restricted/unvested shares.|
|Exchange Fund||Exchanges your position for diversified portfolio of positions contributed by others. Min. 7-year holding period; tax deferral.||SEC filing; reputation/optics risk for insiders. Lock-up/illiquidity. Most funds continually adding other stocks people want to hedge. Expensive.|
|Put options (AKA “Prospective Put”)||Purchase “put option” with strike price below current market, sets a floor for the stock.||Option premiums can be very expensive. Employment contracts may disallow. No role for restricted/ unvested shares. Tax on gains and dividends; losses not deductible. Counterparty risk. SEC filing; reputation/optics risk for insiders.|
|Equity Collar||Purchase a put and sell a call on the stock at negotiated strike prices||Forfeit significant upside potential. Employer contracts may disallow. Does not work for restricted/ unvested shares. Tax on gains and dividends; losses not deductible. Counterparty risk. SEC filing; reputation/optics risk for insiders.|
|Prepaid Variable Forward||Contract to sell shares in the future in exchange for cash today (~70-90% of current value). Protection floor; cap gains deferral||Expensive. Must forfeit significant upside. Employment contracts may disallow. Not available for restricted/unvested shares. SEC filing; reputation/optics risk for insiders|
|Stop-loss order||Place stop-loss order at below current market, protecting further downside by triggering sale.||Ineffective for very large blocks. Simple volatility can trigger sale. Employer contracts may disallow. Stop-loss order may fail in times of market stress.|
|Securities-backed loan||Securities-backed loan with stock pledged as collateral; proceeds used to buy portfolio of stocks.||Potential margin calls. No floor on downside of pledged stock or securities purchased. Lock-up on pledged shares. Employment contracts may disallow.|
Source: Fieldpoint Private Spring 2016 http://www.fieldpointprivate.com/ Disclosure: Executive Benefit Solutions (EBS) or its broker dealer Lion Street Financial does not sell or provide any advice as it relates to these strategies. Readers should seek their own advisors.
- 1. Long-term capital gains taxes: 20% federal rate + 3.8% Obamacare surtax + 6.1% average state LTCG tax. (California is nation’s highest combined, at 37%).
A New Strategy for Protecting Shares of Company Stock
A new strategy, known as the Stock Protection Fund (SPF), was created recently by StockShield, LLC. An SPF mutualizes the downside risk of your concentrated holding across a group of diversified investors, building a pool of liquidity to compensate for losses.
The process does not touch a single share of the concentrated position; no stock sales required; no encumbrances or lock-ups; no SEC filings or employer restrictions.
While the downside is hedged, you can continue to participate 100 percent in the stock’s upside and any dividends. Or, if you wish, you can sell outright. The secret to the strategy is no more complex than U.S. government bonds and the principal of mutualization.
How it Works – Overview
The SPF consists of 20 investors (see figure below) who participate in a limited offering with a pre-set closing. Each investor protects a different stock in a different industry for diversification purposes. They contribute cash (not shares) into the fund, equal to 10 percent of the value of the shares they wish to protect. The fund is then invested in U.S. Treasuries for a term of five years.
When the bonds mature, the fund is terminated and the cash distributes back to the participants. If the fund exceeds the total of the declines (as illustrated below), those with declines are made whole, and any remainder returns equally to the others.
On the other hand, if declines exceed the value of the fund, the decliners may not be made 100 percent whole but their losses can be substantially reduced. During the term of the SPF, you are free to sell, gift, leverage or do whatever you wish with your shares. When the term concludes, you can renew your protection with a new fund.
Example: SPF Deployed Throughout the Financial Crisis
On June 1, 2006 a protection fund was formed with a 10-percent cash contribution and a five-year term protecting 20 investors who owned and wished to protect stock positions in 20 different industries. Five years later, at the conclusion of the fund, the maximum stock loss was 0 percent, meaning the cash pool eliminated (i.e. reimbursed) all stock losses. Of the cash contribution (or premium), 31 percent ultimately was returned to the investors.
For executives with significant concentrated wealth in company stock, the SPF strategy has the potential to reduce risk without disturbing ownership of shares or requiring disclosure filings, and therefore may be a tool worth investigating.