ESG Considerations for Private Wealth Management – Concentrated Asset Positions

One of the most significant events in sustainable finance came in 2020 when Larry Fink, the CEO of BlackRock, the largest asset manager in the world, called for a fundamental reshaping of finance. The reshaping that Larry had in mind was to put climate change and sustainability issues at the center of risk assessment and capital allocation. The letter is a clear warning to company CEOs: climate and sustainability risk is investment risk. As other investors come to this same realization, the implications for asset values and the reallocation of capital could be profound. Changes to capital markets could come much more quickly than the physical impacts for climate change itself given the propensity of capital markets to discount future risk today.

Considering climate and sustainability risk in your company’s capital allocation process is no longer optional. In fact, BlackRock has even gone as far as to state that they will vote against management and board directors of companies that are not sufficiently incorporating sustainability practices into business plans. BlackRock has stated that they expect that sustainability integration will ultimately result in lower investment risk and better market returns. In short, sustainability is the new standard for investing.

Given that companies will face increasing shareholder pressure to incorporate sustainability into capital allocation, enterprise risk management, and standard operating procedures, it is essential to understand the underlying investment drivers for asset managers and how they might consider environmental, social, and governance (ESG) or sustainability risk factors. Clearly, climate-related risk is the most material ESG risk for many industries and sectors, but health and safety, labor management, anti-corruption, and toxic environmental releases are also key issues that must not be overlooked ^[1].

In this thought-leadership series, we look to put you in the shoes of the asset manager. How are investment decisions made? What are the unique implications for various asset-classes? How do asset managers consider investment risk? How is traditional asset management balanced with ESG considerations? These are some of the questions that we hope to tackle. Our goal is to help companies better understand the asset manager process and prepare for the shifting expectations around sustainability integration and disclosure. Those companies that can navigate this fundamental reshaping in finance will be best positioned for growth as the economy transitions to a more sustainable, lower-carbon future.

Introduction

In this thought-leadership piece, we provide the reader with an overview of some of the foundational concepts associated with managing a concentrated single asset position. We then shift our discussion from foundational concepts to implications for ESG-investing. A concentrated position in a single asset may take the form of a large publicly traded stock holding, a private business, or a real estate investment. In any case, a concentrated position in a single asset creates investment risk as the holding may be inefficiently priced or not generating a fair return given the inherent risk of the asset. A concentrated position may also have the potential drawback of being illiquid and non-income generating. A concentrated asset will be subject to both systematic and unsystematic risk (i.e. company-specific and property-specific risk).

The objective of the private wealth manager in dealing with concentrated positions is to reduce risk, generate liquidity, and optimize tax efficiency. A client may have certain objectives and constraints that the private wealth manager must consider. These include, restrictions on the sale of the asset, a desire for asset control, a preference to hold the asset in order to generate wealth, or the need to hold the asset because it has multiple uses (e.g. real estate). The private wealth manager must also consider tax implications for an outright sale, the potential illiquid nature of a concentrated position, and psychological considerations.

Consideration for Taxes, Liquidity, and Constraints

Tax consequences are a vital concern for concentrated single asset positions. If the asset is a business that has been built from the ground up, its sale would trigger a capital gain with a cost base of zero. Illiquidity must also be considered for concentrated positions as this could make the asset hard to sell, result in a time lag on a sale, or result in high transaction costs. A price discount may have to be accepted for the asset holder to quickly sell private equity or real estate.

Institutional and capital market constraints may be a consideration for some concentrated positions. We will discuss monetization techniques later in this newsletter, but at this point we should note that margin lending rules may place limits on borrowing against assets. Securities laws and regulations that place restrictions on when corporate insiders can sell publicly traded securities is another constraint the private wealth manager should consider. The asset holder may also be bound by contractual restrictions and employer mandates that specify blackout trading periods. Limitations on monetization may also arise in the form of capital market limitations. This could be the case if a dealer is required to hedge risk by borrowing and shorting a stock but is constrained due to the sock being illiquid or in the process of undergoing and initial public offering.

Psychological Considerations, Goals-based Planning, and Asset Location

Concentrated positions may be held by a company founder or corporate executive that have a strong emotional attachment to the firm. Emotional biases, like overconfidence, can arise when the asset holder overestimates the expected returns and future growth prospects of the company. This is closely related to familiarity bias where the individual will believe that their knowledge of the firm gives them an investment edge. Other common emotional biases that may arise include illusion of knowledge, status quo bias, naive extrapolation, endowment bias, and loyalty effects. Concentrated asset holders can also exhibit cognitive biases in addition to emotional biases. For example, conservativism bias may lead the asset holder to hold an outdated view and be slow to update that view when presented with new information. Confirmation bias results in an individual seeking out information that reinforces a view that is already held and ignoring information that may contradict that view. Other common cognitive biases related to the management of concentrated single asset positions include illusion of control, anchoring, and availability bias.

One way that private client managers can help asset holders manage emotional bias is by using goals-based planning. Goals-based planning looks at capital in different buckets, each with separate risk and return objectives. The personal risk bucket has the goal of protecting the individual from poverty or a dramatic decrease in lifestyle. The market risk bucket has the objective of maintaining the individual’s current standard of living. The personal risk bucket and the market risk bucket are referred to as primary capital. Surplus capital is managed through an aspirational risk bucket. The goal of this bucket is to give the asset holder the opportunity to increase wealth substantially. The location of the concentrated position should also be considered and if possible, assets that are expected to result in a large future tax liability should be held in a tax deferred or tax-exempt account. Early planning with respect to asset location is important for avoiding wealth transfer costs and complexity.

Strategies for Managing Concentrated Publicly Traded Share Positions

There are three broad techniques for individuals looking to reduce their position in a concentrated asset:

1. sell the asset;
2. monetize the asset; or
3. hedge the asset value to limit downside.

Monetizing the asset is a term that refers to accessing the assets cash value without transferring ownership. This allows the individual to gain liquidity without triggering taxes. There are two steps associated with asset monetization. The first step is to hedge a large part of the risk of the position through either a short sale against the box, an equity forward sale contract, a forward conversion with options, or a total return swap. The second step in asset monetization is to borrow, using the hedged position as collateral, and then use the loan proceeds to invest in a diversified portfolio. A critical question is whether an equity monetization strategy will be treated as a taxable event. A taxable event in one country may not be treated as a taxable event in another country. Most tax regimes respect the legal form of a transaction over economic substance, and therefore, equity monetization techniques, if structured properly, do not typically trigger an immediate taxable event.

We now explore modified hedging as a technique used by individuals looking to reduce their position in a concentrated asset. Hedging is used to minimize downside risk while retaining some return upside. The two major hedging approaches that investors can consider are the purchase of puts or cashless (i.e. zero-premium) collars. In some cases, the private wealth manager may lower the costs of the hedging by entering into one of the following derivative strategies: go long out of the money puts, buy puts with a shorter time to expiration, buy puts with a high strike and sell puts with a low strike, use knock-out features (where the option expires early if price increases to a certain level), use a no cost collar, use a Prepaid Variable Forward (PVF) (which is similar to a collar and a loan), and finally, enhance yield with covered calls.

Tax Considerations

Private wealth managers must be cognizant of the potential for a hedging strategy to result in a mismatch in character. A mismatch in character can result when the gain or loss in the concentrated position, and the offsetting loss or gain from the hedge, are subject to different tax treatments. For example, the economics of a collar can be achieved through a variety of derivative tools, including exchange-traded options, over-the-counter options, forwards, and swaps; however, this can result in short-term capital gain/loss tax rates that differ from long-term capital gain/loss tax rates. Given that a perfect hedge may trigger taxes, a cross hedge may be used. Cross hedges can also be used when the concentrated position cannot be sold short. This can be done by shorting shares of stock that have a high correlation with the concentrated position, shorting an index with a high correlation to the concentrated position, or by buying puts on the concentrated asset. Asset owners can also pledge there shares to an exchange fund whereby owners of other concentrated positions also pool their shares so that diversification can be achieved in aggregate.

Alternative tax optimization equity strategies include index tracking with active tax management or creating a completeness portfolio of other assets in order to increase diversification benefits. For example, if the executive of a coal mining company retires with a large position in company stock, rather than place a collar on this position, he may simply look to balance his portfolio by purchasing securities that have a low correlation with coal stocks to develop a completeness portfolio. This might include stocks in the health care, financials, and the technology sector. This diversification through a completeness portfolio could also take an ESG-risk factor lens. In this case, the individual would purchase securities from companies and sectors with high ESG ratings (e.g. renewable energy) to round out the concentrated position in the coal-mining company which is likely to have a low-ESG rating.

Private Business and Real Estate

Concentrated positions in privately held businesses are a common situation for the wealth manager to encounter. An entrepreneur may have spent his lifetime building a business, growing sales and the balance sheet. Then, when the entrepreneur is ready to retire, he may be unable to access the value of his business. The private wealth manager can help the asset owner with exit strategy considerations. This includes answering the following questions: What is the value of the business? What will be the tax rate on a sale? What is the availability and terms of credit? What is the buying power of a potential purchaser? What currency values are relevant to a potential transaction?

A sales strategy could consist of a sale to a third-party such as a strategic buyer (which may pay a premium due to potential synergies) or a financial buyer (which is unlikely to pay a premium and will seek to purchase the business with debt and quickly flip the business at a profit). Selling to a corporate insider is also common. This could include a management buyout, a sale to employees through an employee stock ownership plan, or a sale (or gift) to family. Other sale strategies include a recapitalization (sell 60-80% to a private equity firm), the sale of non-core assets only (while retaining control of the business), a personal line of credit (typically secured against shares in the company), or an initial public offering. If the concentrated position is in real estate, the asset owner may consider reducing their concentrated position through mortgage financing with a non-recourse loan, setting up a donor-advised fund or charitable trust, or selling the property and then leasing it back.

Implications for ESG Investing

Having covered some of the foundational concepts of concentrated asset positions, we now turn our attention to ESG and sustainable investment considerations. Management of concentrated asset positions requires an understanding of basic terminology, tax implications, and consideration of psychological and nonfinancial issues. The private wealth manager needs to also emphasize to the asset holder that the sales process is not a binary on-time event. The sale can be staged to increase liquidity over a period of time. For example, an exchange fund can be used to reduce a concentrated position in a public company with an initial contribution of shares, achieve diversification, and avoid a tax trigger until the fund is exited. The private wealth manager must also understand ESG and sustainability issues as this is relevant to managing a concentrated asset position.

ESG ratings can help to accurately quantify the environmental risk to businesses. Climate value-at-risk is a form of scenario analysis incorporated into ESG ratings. The process looks at physical risk and can be used as an alternative to backward looking carbon footprint data ^[2]. Both value-at-risk and carbon footprint data provide a holistic view of a firm’s climate risk. These risks can be used in ESG ratings and allow the investment analyst to reduce ESG-related risk exposure in portfolios. This analysis can be extended to private businesses, which often have concentrated ownership. For example, a business or asset located in a geographic area that is subject to adverse long-term climate trends, including sea level rise, could create extra risk for the concentrated asset holder. Applying this type of ESG-focused risk analysis could give asset owners insight into long-term value creation and liquidation urgency.

It is important to note that impact investing has traditionally been concentrated in illiquid asset classes such as private equity and private debt ^[3]. Illiquidity is a characteristic of concentrated single asset positions; however large institutional investors would likely be less concerned with illiquidity as they have the option to diversify across a large asset base. For individuals however, a concentrated single asset position poses a real liquidity risk. But where there is risk, there is also opportunity. A concentrated asset holder has a greater ability to engage with management and can transform the business by exercising their voting rights. Concentrated positions may give the asset owner more control of the business, and with control, comes the ability to drive meaningful change in sustainability practices.

Conclusion

As we look to put you in the shoes of the asset manager, our hope is you will gain a deeper understanding of ESG integration and the investment management process. The companies that understand the asset manager’s decision-making rationale for incorporating sustainability and climate-related risk are likely to be the most responsive to changing investor requirements and trends. As global efforts are made to transition the economy to a more sustainable, lower-carbon future, we expect that investor demands for sustainability performance and disclosure are set for significant growth. Companies should begin to prepare today in order to meet investor expectations in the future. This will require having the right infrastructure for collecting sustainability-related data, understanding performance, reporting on key indicators, and setting targets to improve. Ultimately, companies that can master this core competency will gain more shareholder interest and will be poised for superior performance. Now is the time to seize the opportunity in the shift to sustainable investment.

References

1. https://www.msci.com/www/blog-posts/which-esg-issues-mattered-most/01934601065
2. https://reporting.unpri.org/surveys/PRI-reporting-framework-2020/06A299E4-2079-4E04-9367-4905AD0E17E4/ada61cc296cb471b8ddda90420077cbf/html/2/?lang=en&a=1
3. https://d.newsweek.com/en/file/459599/newsweek-vantage-future-esg.pdf

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