Yes, the rich are different from you and me, most notably in terms of the financial advice they seek. If you aspire to serving these folks — and who doesn't these days? — be prepared to bone up on the special issues and problems of the ultra-wealthy.
Until you've acquired the knowledge, you won't land them as clients.
“There are two things necessary for success for reps going after this market,” says John Nersesian, managing director for Nuveen Investments, wealth management services, who lectures around the country on how to serve the ultra-rich. “You have to be very well educated, and you have to be good at describing what you do.”
The Protection Racket
What are the needs of those with more than $5 million in investable assets? First, “Understanding that they're already wealthy and their goal is to stay wealthy, so controlling risk is a primary focus,” says Craig Bloom, a senior investment manager at Smith Barney in Los Angeles. “Wealth preservation is about diversification between asset classes and about style and management.”
Because many wealthy individuals come to advisors with positions acquired through one company, diversification is a particularly important issue. The important thing is getting out of a concentrated position — whether the wealth be in stock, stock options or restricted stock — while minimizing the adverse tax consequences.
Of course, the easiest way to diversify is to sell the stock outright and build a diversified portfolio with the proceeds. At a 15 percent capital gains rate, a client's tax liability is substantially lower than it used to be.
Nonetheless, there are a number of moves that can help avoid the taxes outright or make the sale of the stock unnecessary. The details of the diversification depend on the client's short- and long-term objectives, which might include liquidity, asset protection, wealth transfer, tax minimization or all of the above.
If the client doesn't need liquidity, one strategy is to invest a portion of their assets in an exchange fund. This is a fund in which a number of people, each with a concentrated stock holding in a different company, pool their assets to create a diversified portfolio. These usually carry a $1 million minimum, and investors are required to have $5 million in other investments. In addition, the investor must stay put for at least seven years, after which he can redeem a diversified basket of shares determined by the fund manager. The investor is only liable for capital gains on the shares as they are sold.
The government was toying with the idea of changing the tax law to eliminate exchange funds, but they have managed to survive regulatory meddling for now. Not surprisingly, financial services companies aren't setting up exchange funds at the rate they were during the market boom, and this matters because they only accept investments as they're being organized.
If the client needs liquidity as well as diversification, one solution is a variable prepaid forward. In this investment vehicle, a stock position is collared, or locked in, within a certain trading range, which provides downside protection but also limits potential gains. The investor receives 90 percent of the stock value in cash as prepayment for its future sale. That cash can be reinvested in a diversified portfolio, and capital gains are deferred until the forward matures or ends.
Clients can also raise cash on stock positions they're reluctant to sell by writing covered calls on them. That is, the investor sells call options to buy the shares at a price above where you think they'll go. As long as the stock never reaches that price, the client keeps the stock and pockets the proceeds from the sale of the options. If, however, the price rises above that strike price, the client has to give up the shares.
For clients who own their own businesses, a good alternative is a recapitalization, or selling a minority stake in the business to a private equity fund. Brian Katz, Craig Bloom's partner at Smith Barney, helped one client recap $15 million of a company valued at $50 million. “He still had a majority position, but he knew that no matter what happened to his business, at the end of the day, he had $15 million, and it gave him a potential exit strategy,” says Katz.
Clients who plan to eventually donate money to charity, but in the meantime need diversification and liquidity, should consider a charitable remainder trust. Contribute some stock to a trust where it can be sold free of capital gains and the proceeds reinvested in a diversified portfolio. That portfolio is designed to pay an income stream to the donor for a preset number of years. When the trust ends, whatever is left over goes to charity.
Between the Hedges
If an executive or business owner is planning to sell a company or to retire in a few years and wants to protect a stock value until then, the best strategy might be to simply hedge the concentrated stock position. Clients can use a straight put option, which provides maximum downside protection with no upside limitation. But, of course, the option requires cash up front for the premium.
An alternative that eliminates this out-of-pocket cost is a zero-premium or cashless collar. In a collar, the client writes a call option to sell the stock above a certain price level and uses the proceeds from that sale to cover the cost of the put option. The put option provides downside protection, but the call option allows a certain amount of upside potential, up to a cap.
Although hedges can be put in place for many years and renegotiated each time they mature, they're usually best used as a short-term strategy. “Hedge and carry is a cost like insurance,” says Larry Elkin, head of Palisades Hudson Asset Management in Scarsdale, N.Y. “It's unlikely you'll have an investment that will outperform the cost of hedging over the long term.”
When Restrictions Apply
Of course, many executives are compensated through restricted stock and stock options. Reps who work with high-net-worth clients will run into both, and will have to understand the ins and outs of weaving their benefits into an overall financial plan.
Options were preferred compensation during the technology boom. But since then, companies are increasingly switching to restricted stock to reward top employees. “Restricted stock has advantages over options,” says Nersesian. “If it goes down by 10 percent you still have 90 percent of your value. Options on stocks that are down 10 percent are usually worthless.”
Restricted stock, or letter stock, hasn't been registered with the SEC. It can be sold privately at a discount or publicly under certain circumstances, determined by SEC Rule 144. That rule requires, for example, that the shares are held for at least a year, and the issuer has been reporting all the appropriate documents to the SEC for 90 days before the sale. There are limitations on how many shares can be sold in any three-month period, and the seller must file a notice of proposed sale if the sale is going to exceed 500 shares or $10,000. After two years, restricted shareholders who aren't affiliates (directors, officers, or those owning 10 percent or more of the shares) can sell their shares publicly without regard to Rule 144 restrictions.
Whether registered or not, “control shares” owned by affiliates are considered restricted because the owner has substantial control over the issuer. Affiliates have to file any sales with the SEC and may be subject to blackout periods when they can't sell; for example, around the time of company's earnings announcement. One way to get around these blackouts is to set up a 10b5-1 trading plan with the company and a broker to sell preset amounts of stock at specified prices and dates. “There can be negative publicity that comes with an affiliate selling shares of a company,” says Nersesian. “The 10b5-1 plans are prearranged schedules to sell stock, so it doesn't look like the executive is jumping ship, but driven by need to diversify.” For example, every quarter, Gates sells some shares of Microsoft.
Unlike stock options that only become liable for taxes when they're exercised — and later sold — executives have to pay ordinary income taxes on restricted shares in the year they vest, even though they may not be able to collect or sell them right away. The shares also can pay dividends before they vest, which are also taxed as ordinary income. But after shares vest, any increase in gains is treated as capital gains.
Clients who think there is significant upside in a stock can elect an 83(b) within 30 days of the grant of the shares and pay ordinary income taxes then — and a lower rate on any dividends. This was a popular strategy when stocks were booming, but these days, it's risky. You have to come up with the cash to pay the taxes, but you don't get the shares until later and should you leave the company, or the shares fall in value, you'll be out those tax dollars.
“These were great in a very hot market,” says Nadine Gordon Lee, head of Prosper Advisers in Armonk, N.Y. “You don't know anymore that a stock is going to jump in this market. It can still be used in the right situation.” But the rep has to run the numbers to show clients how much their stock will have to appreciate to make an 83(b) election worthwhile.
Many Options
The great thing about options is that you don't have to put any money down — until you are ready to exercise them. Few would recommend exercising and going long. “We would never advise an investor to exercise options unless he's looking to sell,” says Lee. “We're suggesting that unless your interest is in selling the stock, there's no benefit to exercising your options.”
Likewise, while Lee urges clients to sell restricted stock early, she tends to advise those who still have many years to retirement not to exercise options until they're close to expiration. That way the underlying stock has maximum opportunity to grow and the executive assumes no tax liability until he has the money to pay for it.
“If an executive has a long-term career ahead of him, and he's getting paid from a risk perspective to hold on to the options, he's not paying anything to purchase the stock at a fixed price,” she says. “So we generally adopt a strategy of holding onto options until near expiration.”
Although reps who want to work with wealthy clients have to get up to speed on these strategies and products, experts agree that they are only a small part of the overall picture when it comes to building relationships with high-net-worth clients.
Spending a lot of time interviewing clients, understanding and anticipating their needs and helping them understand and express their goals is critical.
“The reasons that high-net-worth clients leave financial advisors are poor service, inadequate communication and lack of proactive advice,” says Nersesian.
“Clients are willing to accept problems but they won't accept inappropriate solutions and investment errors.”