Protecting against large stock positions Featured

12:51pm EDT June 29, 2006
People with large investments in stocks — especially when those stocks are limited to one or two companies — are constantly on the lookout for protection against significant declines in their market value. There exist a bewildering number of products to help them with portfolio evaluation and asset allocation strategies. The myriad of products presents another problem: how do investors pick the right ones that will help them offset, or “hedge,” their investment risks — or even understand the terminology associated with them?

Since there is no one product that guarantees risk-free investments, the best approach for individual investors is generally to work with qualified professionals to determine which plans and products are best suited to their unique needs and circumstances.

Smart Business spoke with Beau Collins to learn how investors can effectively implement wealth management plans and leverage available products to reduce their risks and protect their assets.

Are there innovative ‘hedge’ products available for higher net worth investors who have large positions in stock?
Two come to mind: equity collars and prepaid forward contracts. Both are designed to protect higher net worth investors such as executives and business owners with large positions in stock from declines in stock prices.

How are ‘high net worth’ and ‘large position in stock’ defined in the context of equity loans and prepaid forward products?
Transaction sizes are typically in the $1 million in market value range, but there are programs for investors whose net worth is less than that. People who want to take advantage of such products should work with specialists like Chartered Wealth Advisors and tax advisers to find out how to take advantage of the products available.

What are the purposes of these products?
One offers a way for investors to diversify large stock positions; the other insures them against downward moves in the market. That applies especially to investors who have large holdings of one stock in one company, such as people who were awarded stock options by their employers, and who have held them for long periods of time. Products like equity collars and prepaid forward contracts help protect investors in a dramatic loss in the market values of those stocks.

How do the products work?
Let’s start with the equity collar. There are two types: with or without a loan. Neither requires a large up-front payment and both retain some upside potential in the security. The equity collar with loan offers the advantages of the basic equity collar, but it also has the monetizing benefits of a loan.

Both products offer similar benefits. In addition to the little or no up-front payment, there is no taxable sale of shares and some benefit from upward stock price movements up to the call option strike price. Significantly, the investors’ upside is limited, and tax straddle rules may impact holding period and loss recognition, which is one reason to consult tax advisers.

The products are based on certain time frames, as well. The contract range is generally one to five years.

How does the prepaid forward contract compare to the equity collar?
The prepaid forward contract is a sale agreement in which the investor receives an upfront payment in exchange for a commitment to deliver securities in the future. The number of shares to be delivered varies with the share price at maturity. And, like the equity collar, the transaction is based on a contract period. Typically, the investor receives between 75 percent and 80 percent of the stock’s current value, and owes no taxes until the transaction matures.

How does that differ from the equity collar?
The prepaid forward contract is an alternative to the equity collar with loan, because 100 percent of the upfront payment may be invested in the market, and there are no periodic interest payments. Moreover, there is more flexibility due to the way the contract is structured.

For example, an investor may elect to accept more downside risk in exchange for more upside potential. Or, the investor may opt to limit all the upside above a defined level in return for a greater advance rate.

Are these one-size-fits-all products?
Since every investor’s case is different, they are structured to meet individual investors’ objectives. And they are not something that investors are advised to create by themselves. Investors should consult with professional advisers when considering these products.

What should investors be aware of when considering equity collars or prepaid forward contracts?
Any legal, contractual or employer restrictions have to be taken into account. Hilliard Lyons does not offer tax or legal advice. Investors should always consult their tax advisers or attorneys before making any decision that may affect their tax or legal situation.

BEAU COLLINS is a financial consultant and Chartered Wealth Advisor in the Dublin, Ohio, office of J.J.B.Hilliard, W.L. Lyons. Reach him at (614) 210-6281 or bwcollins@hilliard.com.