By Greg Hutto, CFP®, CFA®
In one of my recent articles, I covered a little-known but powerful structure called a swap fund. In a nutshell, a swap fund can help an executive increase diversification and defer capital gains taxes on their concentrated stock holdings.
A swap fund works like this: high-net-worth investors contribute some or all of their shares of common stock (in a public swap fund) or private equity (in a private swap fund) for units or shares in the entire holdings of the swap fund. A public swap fund that has been in existence for several years will typically have hundreds of stocks in the portfolio, thus providing diversification similar to an index fund. If the exchange is performed correctly, no taxes are realized until shares of the swap fund are sold at a later date.
But swapping your shares for a diversified basket of other stocks means you’ll be parting with your dearly beloved stock right now, and you might be bullish on the upside potential of your company stock. Wouldn’t it be nice if there was a strategy that could put a floor under the price of your stock, yet allow you to sell at a higher price in the future? After all, as the saying goes, we all like having our cake and eating it too, right?
It’s A Mouthful: Prepaid Variable Forward Sales
Our next strategy in “The Perceptive Executive Series” is utilized more than swap funds because it allows you to keep their current stock for now (that’s having your cake), but also allows for growth in the shares over a predetermined number of years, if in fact the shares do appreciate in value over time (that’s eating it too).
The technical term for this arrangement is a prepaid variable forward sale (PVFS). This is a mouthful, so let’s break down the terms. A PVFS can be an agreement between two individuals or two entities, but in our example, it involves an investor with a sizable position in one stock (usually more than $1,000,000 worth) and a major brokerage firm. The word “forward” in this context means that the shares will be delivered (forwarded, if you will) by the investor at a future date to the brokerage firm.
This transaction is a type of derivative instrument. The party agreeing to buy the underlying asset in the future (the brokerage firm) assumes a long position, and the party agreeing to sell the asset in the future (the investor) assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.
This structure is referred to as “prepaid” because the investor typically receives a large percentage of the value of his or her stock as an up-front cash payment (usually in the 80-90% range), without relinquishing the share ownership. The prepayment does not trigger a capital gains tax under current U.S. tax law* because the transaction is not completed yet. The payment is treated as a loan with the underlying security providing the collateral.
Finally, this contract is “variable” since the number of shares to be delivered by the investor is dependent upon the stock price at contract maturity. At the execution of the contract, a lower strike price (a floor) and an upper strike price are usually set. These strike prices determine the number of shares due at expiration.
Hypothetical Prepaid Variable Forward Sale
If your head is swimming (I don’t blame you), I’ll be a generous writer and help you out with an example to help you understand the details. To set the scene, a large local defense/aerospace company has common stock trading in the $356 range.
|Investors can hedge and monetize their position and receive significant liquidity by entering into a prepaid variable forward transaction. With a prepaid variable forward, there are no restrictions on the use of proceeds. A variable forward transaction allows an investor to achieve downside protection and receive an up-front payment in exchange for potential future price appreciation up to a certain level. The information below is an example of a typical transaction.|
Stock price: $356 Option style: European
Current dividend yield: 2.70% Settlement consideration: cash or physical settlement
Notional size: $1,000,004 Buyer: custodian’s confidential client
Number of shares: 2,809
|Duration||Floor $ / %||Cap $ / %||Up-front Payment|
|2 years||$356 / 100%||$445 / 125%||$885,544|
|3 years||$356 / 100%||$445 / 125%||$869,934|
Indicated prices, share amounts, and payments are used for illustrative purposes only.
Assumptions: Street borrow. The buyer retains any and all dividends over $2.40 per share paid quarterly during the duration of the contract.
Collateral terms: The shares are pledged on trade date as collateral, and must remain with the custodian until maturity of contracts.
Seller conditions: It is assumed that the seller has consulted appropriate outside advisors regarding any relevant tax, legal, or regulatory issues relating to this transaction, and is not relying on the buyer or custodian for such advice.
In Plain English
Basically, the seller is agreeing to deliver either $1,000,004 in cash or $1,000,004 worth of stock upon the maturity of the contract (2 or 3 years, in this example). The seller is receiving an up-front cash payment of $885,544 for a 2-year arrangement or $869,934 for a 3-year arrangement, and he or she is entitled to the current quarterly dividends of $2.40 per share as well.
Today’s super-low interest rates make this a great time to borrow money. When the receipt of dividends is factored into a time-value of money calculation, one only needs to earn a return of approximately 1.8% on the cash advance and future dividends to have the $1,000,000 needed on a 3-year contract, and around 3.3% on a 2-year contract.
So what is the “sweet spot” in this arrangement? Any future price between $356 and $445 is good for the seller, and the ideal price upon maturity is exactly $445 (see the yellow highlighted row in the table below). This is the price that allows the seller to retain the maximum number of shares at expiration (562) while still delivering the agreed-upon cash or value of shares to the buyer.
Note that the net value retained by the client doesn’t exceed $250,000 regardless of how much the stock appreciates. That’s because the cash requirement upon settlement is adjusted proportionally if the stock appreciates more than the cap percentage of 125%.
If the seller is still very bullish on the stock at expiration and has a sufficient amount of cash on hand to deliver to the buyer, then he or she could choose to cough up a lot more than $1,000,000 to satisfy the terms of the agreement. In the case of an assumed 50% appreciation (orange highlighted row) then the buyer could choose to deliver $1,250,005 in cash or deliver 2,341 shares of stock, thus retaining 468 shares.
Is This Right For You?
A primary reason many investors with concentrated stock choose to enter into a PVFS transaction is for diversification. Delivering the $1,250,005 in cash rather than 2,341 shares in our example could defeat the purpose of reducing one’s holdings in a stock that may be a large percentage of his or her net worth.
Participants in a PVFS are bound by the same insider trading restrictions that normally apply to an executive, so contact your tax and legal advisors before implementing this transaction. Not all custodians participate in PVFS transactions. Call Greg Hutto, CFA®, CFP®, at 817-503-0100, or email him at firstname.lastname@example.org for a list of major custodians that have this capability. And, as always, if you have questions about your employee stock and the role it plays in your financial plan, don’t hesitate to schedule a free introductory meeting.
*Neither Heritage Retirement Advisors nor their advisors provide tax or legal advice. Please consult your tax and/or legal advisors before entering into a PVFS transaction.
Greg Hutto, president and CEO of Heritage Retirement Advisors, comes from a family of educators, so it’s no wonder he holds a bachelor’s degree in business from Texas A&M University, and a master’s degree in education from Tarleton State University. He spent years as a teacher and coach before entering financial services in 1996. After 14 years in the industry working for such powerhouses as UBS Paine Webber and Raymond James, Greg founded Hutto Retirement Advisors LLC in 2010, now Heritage Retirement Advisors. He holds both the Certified Financial Planner® (CFP®) and Chartered Financial Analyst (CFA®) designations. Additionally, he is the founder of Heritage Tax Advisors LLC. Greg and his wife, Angie, have three children. He likes to cycle, play golf, travel with his family, and he’s still trying to convince Angie of his dream of being husband-and-wife truck drivers, or at least working and living on the road in an RV! To learn more about Greg, connect with him on LinkedIn.