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Where Advisors Are Turning to Manage Concentrated Holdings and Invest in Pre-IPO Companies

These platforms may be quite handy during a booming bull market.

The S&P 500 Index — which has roughly doubled in value since the start of 2017 — surged another 21 percent through the first eight months of 2021 and many individual stocks have tripled or quadrupled in that time. Those gains have been mirrored or bested by shares of privately held companies achieving ever-higher valuations through serial capital raising.

For workers who have seen their net worth surge along with their employer’s stock, the gains have been a blessing and a curse. It’s great the shares are worth more. But too much net worth tied up in one company can be a challenging risk to manage, even with a financial advisor. Concentrated private holdings can be even more challenging.

Fortunately for advisors, several new exchanges and investing platforms are gaining traction, helping them reduce concentrated ownership (or at least carve out ample downside risk protection for a stock). Or, helping get clients access to shares of private companies with more growth opportunities.

Protecting the Downside

Ron Guay, an advisor at Sunnyvale, California-based Rivermark Wealth Management, has found that some clients will balk at the notion of selling company stock. Most are concerned about the tax implications, or they are bullish on their employer and don’t see any reason to sell shares.

“I first help them understand how important it is for them to trim that risk exposure (embedded in owning a lot of just one stock),” Guay says. “Reframing the issues is among the most important roles an advisor can play.” 

Once the client better understands the importance of risk mitigation, Guay talks to them about a methodical process to lower any risk they need to, including potentially how and when to sell their shares.

Solutions for concentrated stock positions (generally, a single holding that accounts for 10 percent or more of an overall portfolio) have existed a long time but each comes with their own caveats.

Exchange funds are costly and complex. Some advisors hedge the risk by buying options contracts and other equity derivatives to cushion a falling stock, or the broader market. But option overlay strategies can be cumbersome and time-consuming, requiring advisors to continually re-price contracts as they roll over. Advisors can hire managers to run options strategies on their behalf, but that, of course, comes at a price.

Wall Street firms also offer a complex and expensive solution through a financial instrument known as a variable prepaid forward contract. The contracts enable investors to get liquidity and defer taxes, but they only receive anywhere from 75 percent to 90 percent of the current market value of the stock, in exchange for a basket of other stocks to be paid in installments in the future.

To trim the risk associated with concentrated stock ownership, stock protection trusts (SPTs) may be a good option. Clients don’t sell their stock but instead contribute the equivalent of 1 percent to 2 percent each year of their company stock’s value into a risk pool of 20 stocks that represent a cross-section of industries. Each SPT terminates after five years. That’s often-enough time to ride out a bear market.

Brian Yolles, founder and CEO of StockShield, was one of the pioneers of the SPT approach. He launched his firm back in 2003 with a goal of helping investors “preserve their stock’s unlimited upside potential while gaining strong long-term downside protection.”

“Seeing how complex the Wall Street solutions were, I wanted to come up with a simpler and more cost-effective solution,” Yolles said.

In the May, 2017 issue of the Journal of Estate & Tax Planning, in an article titled “The Renaissance of Single-Stock Concentration Management,” authors Thomas Boczar and Elizabeth Ostrander, wrote that “the foundation of Protection Funds is rooted in the principles of both modern portfolio theory (MPT) and risk-pooling/insurance; by combining these principles it’s possible to replicate the economic equivalent of either at-the-money or slightly out-of-the-money put protection at just a fraction of the cost.”

MPT suggests that as individual stocks are added to a portfolio (as they are in a multi-industry SPT), a portfolio’s average covariance will decline. “Most investors and researchers agree that 20 disparate and equal-sized stocks are sufficient to maximize the benefits of diversification,” Boczar and Ostrander said.

Yolles likens an SPT to preventative medicine, especially when it comes to avoiding the impact of a large loss in an employer’s stock. “It’s a good idea to take the catastrophic risk off the table,” he says. “It’s like a vaccine for a stock position.”   

In a bull market, all 20 of those stocks may rise in value during the STP holding period, in which case those upfront 1 percent to 2 percent cash contributions would be remitted back to the client. And in a sharply down market, the value of the SPT tends to fall a lot less (or not at all) when compared to broader market indices.

Those just-noted cash contributions support a risk pool that helps underwater investors to be made whole (or at least mostly so). Losses are reimbursed until the cash pool is depleted. And if total losses exceed the cash pool, large losses are substantially reduced.

How have SPTs performed during times of market and economic stress? According to a study completed by Intelligent Edge Advisors in 2011, a basket of 20 blue-chip stocks spanning a range of industries delivered five-year returns ranging from -37 percent (Best Buy) to a 100 percent gain (Dow Jones). That period represents a significant recent market drawdown cycle. Eight of the stocks in that basket posted negative returns over that five-year period. Yet within an SPT, the basket of stocks delivered no losses when the funds from the stock risk pool were deployed.

The Pivot to Private

More large companies are staying private longer, rather than going public and so a growing number of advisory clients are stuck in a sort of limbo. They are waiting and hoping for an eventual opportunity to sell some or all their equity in their employer after an initial public offering (IPO), or a buyout, but those liquidity events are never guaranteed.

In response, many employers are coming around to the idea of letting employees sell pre-IPO shares through purpose-built private share stock exchanges.

EquityZen, founded in 2013, has worked with more than 300 privately held companies and their key employees, connecting them with accredited investors that are interested in buying shares of hard-to-acquire stocks.

It’s not a direct match between buyers and sellers. Instead, privately held shares are placed into an EquityZen fund, and shares of the fund are then sold to private market investors. The fund model allows the company to offer access to accredited investors with minimums as low as $10,000.

“EquityZen also offers direct matches between buyers and sellers for larger investors looking to sit directly on the cap table of a given private company,” Brianne Lynch, head of Business Development and Partnerships at EquityZen, said.

What happens to shares when a liquidity event transpires?

“Our fund will hold the shares until the IPO or sale of the company, at which time proceeds of the transaction are returned to fund investors on a prorated basis,” Lynch said.

While the trading platform has been quite helpful to key employees that seek to reduce a heavy degree of specific stock ownership, it has also been quite profitable for investors in the funds. As of the end of the first quarter of 2021, investors have garnered a cumulative 145 percent return, with an annualized internal rate of return (IRR) of 47 percent, according to Lynch. That handily outperforms any major public equity index.

The cost of entry, though, doesn’t come cheap. Both buyers and sellers pay from 3 percent to 5 percent in one-time fees to either sell shares into, or buy shares from, the fund.

To invest client money in pre-IPO shares, more RIAs are creating their own special purpose vehicle (SPV) and using exchanges like Forge Global to buy baskets of private stocks.

After merging with SharesPost in 2020, Forge has become the largest trading platform for private market transactions. Unlike EquityZen — which places privately-held shares into a proprietary fund — Forge makes direct connections between buyers and sellers, with minimum deal sizes of $100,000 and transaction fees ranging up to 5 percent.

In the first quarter of 2021, Forge completed 1,400 transactions that were collectively worth more than $730 million.

Advisors who have used platforms to match counterparties buying and selling private shares say facilitating the right transaction is still not easy. 

“The logistics of finding buyers and sellers that can participate simultaneously seems to be more of a challenge [for these exchanges],” Guay said. “The way the process has been developed is very well-conceived, but it can be very time-consuming.”

Forge estimates that there are now more than 600 private companies worth more than $1 billion (based on their most recent round of financing), and those firms represent more than $2 trillion in untapped shareholder wealth.

Simon Tryzna, chief investment officer at San Francisco-based ClearPath Capital, works solely with company founders, early employees, and senior executives in the tech sector. One of his concerns with share exchanges like Forge is that they can be inefficient markets. 

“The buyer has a price in mind, accounting for the fact that [privately-held] shares may remain illiquid.” 

Tryzna stresses that it’s important for the advisor to know the employer policies regarding the sale of privately held stock. Some companies welcome the financial planning tool that such exchanges provide, while others dislike the idea that their shares would no longer be closely held.  

He also said advisors should coordinate sales discussions with a client’s accountant to prepare for onerous tax bills and avoid surprising a client.

Telling a client that they simply need to wait until their employer goes public (or sells out) is no longer the first answer. Solving the conundrum of client concentration is growing ever easier as new trading platforms and investment vehicles emerge and expand. 

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