8/2/2019 Are You Overlooking Your Clients Illiquid Assets- CFA Institute Magazine

1/2

PRIVATE WEALTH M A N A G E M E N T

2011 CFA INSTITUTE 1

BYTHOMASBOCZAR, CFA, ANDELIZABETHOSTRANDER

Comprehensive Wealth Management:Are You Overlooking Your Clients Illiquid Assets?

Advisors must address their clients their illiquid and concentrated assets to provide

holistic service. In doing so, financial advisors can help their clients compare the risk/

reward of continuing to own their businesses or real estate versus monetizing and

diversifying into other asset classes.

o offer truly holistic wealth management, financial

advisers must address not only their clients liquid,investable assets but also their illiquid, concen-

trated assets. After all, most of the wealth in the United

States is in the form of privately held businesses and

commercial real estate, yet most advisers are not involved

in their clients decision making regarding these asset

classes. Clients typically work separately with a local

investment banker or real estate broker who is unaware

of the clients personal, long-term, wealth-planning

goals. Naturally, this arrangement can result in decisions

and transactions that impede, rather than fulfill, the

clients financial objectives. By proactively addressing

clients illiquid assets, advisers can help their clients com-

pare the risks and rewards of continuing to own their

businesses and real estate versus monetizing and diversi-

fying into other asset classes.

Investors can use a wide range of tools and tech-

niques to monetize their private business equity and real

estate investments tax-efficiently in order to manage con-

centration risk. Although the financial tools and the tax

road map differ depending on the asset class, the mission

remains the same:

Reduce the risk associated with having wealth con-

centrated in one asset Generate liquidity (cash) in order to diversify into

other asset classes

Achieve optimal tax efficiency

In this article, we consider (for owners of commer-

cial real estate) an outright sale, a 1031 exchange, anddonor-advised funds and (for business owners) leveraged

recapitalizations.

COMMERCIAL REAL ESTATE

Clients of wealth managers often own a significant

amount of commercial real estate, perhaps as part of a

privately held business or as a stand-alone investment.

Typically, it has been owned for a long time, has appreci-

ated significantly in value from its original purchase price,

and has a low cost basis for tax purposes. And yet, real

estate owners are increasingly interested in diversifying

into other asset classes, especially in the aftermath of therecent financial crisis.

Given the historically low capital gains tax rate and

depreciated property values, some property owners have

decided to sell their properties outright. Depending on the

property s acquisition date and how much depreciation has

been deducted for tax purposes, however, a significant

portion of the gain from the sale of the property could be

treated as ordinary income (depreciation recapture) and

subject to both federal and state income tax.

A monetizing tax-free 1031 exchange can be a more

tax-efficient approach. The investor sells her property,

invests the sales proceeds in an income-producing

replacement property of approximately the same value,

and leases it (via a long-term, triple-net lease) to a large

corporation with an investment-grade credit rating. This

T

8/2/2019 Are You Overlooking Your Clients Illiquid Assets- CFA Institute Magazine

2/2

2 WWW.CFAINSTITUTE.ORG

triple-net-leased property generates a bondlike income

stream. The investor can then access the capital markets

to borrow approximately 90 percent of the propertys value

on a nonrecourse basis. Economically, its as if the investor

has purchased a put struck at 90 percent of the value of the

property and the put has been 100 percent monetized.

Because the income from the lease is used to service thedebt, this form of borrowing is very inexpensive. And the

investor receives 100 percent of the appreciation of the

property. From a tax perspective, this strategy enables the

investor to defer the capital gains tax (the replacement

property has the same basis as the property that was sold).

If the property is held until death, the capital gains tax is

eliminated because the investors tax basis in the property

will be stepped up to fair market value.

A donor-advised fund (DAF) can be an attractive

exit strategy for charitably inclined real estate investors

who believe that the growth prospects for such asset

classes as publicly traded equity securities are more attrac-

tive than those for their property. From a tax perspective,

this strategy allows for a realization event (the property is

ultimately sold) that is also a nonrecognition event (no

taxable event is triggered by the sale). The strategy also

permits real estate to be sold tax free, with 100 percent of

the sales proceeds invested in publicly traded securities

within the DAF, where the proceeds can grow tax free for

years. A significant additional advantage is that the inves-

tor qualifies for an immediate charitable contribution

deduction (worth 35 percent at todays top marginal tax

rate) that can be carried forward for five years, regardlessof when the actual grant is made, which may be years after

the contribution of the real estate to the DAF. Moreover,

the donor, unlike private foundations, is not required to

make a minimum annual grant. Many DAFs allow the

donor to authorize his investment adviser to oversee the

funds in the account, and some DAFs even allow the

securities to be custodied wherever the donor prefers.

PRIVATELY OWNED BUSINESSES

Monetizing ones business is a tremendously significant

and emotionally trying event. Most owners have spent

their adult lives building their businesses and have a verydifficult time exiting. Few owners, however, are aware of

the many available monetization strategies.

A leveraged recapitalization (recap) is a timely strat-

egy that is particularly attractive to middle-market busi-

ness owners who are interested in both reducing the risk

of their wealth concentration and generating liquidity but

who are not yet ready to exit entirely. A leveraged recap

is a retooling of a companys balance sheet, usually accom-

plished through a partnership with a private equity (PE)

firm. The PE firm generally invests equity and provides

or arranges debt with senior and mezzanine lenders. The

owner swaps her stock for cash and part of the freshlycapitalized entity, which allows her to monetize a large

portion of her business equity (up to 80 percent) and

retain significant upside potential. The owner does relin-

quish overall control of the company but maintains day-

to-day responsibility for operations and keeps her title,

salary, benefits, and reputation in the community as a

successful entrepreneur. The owner can capitalize on the

historically low capital gains tax rate and get a second

bite at the apple in three to five years, when the PE firm

and the owner can execute another monetization event

(IPO, sale to another buyer, or another recap). Further-

more, backed by a resource-laden PE firm, the owner can

watch her business thrive and need no longer personally

guarantee bank debt.

Many PE firms have unused committed capital that

they raised in 20062008, and little time remains before

they must either invest the committed capital or return it

to their investors. Although the credit markets have

improved, they still cannot support the huge deals that

many firms had become accustomed to. As a result, PE

firms are increasingly investing in middle-market com-

panies and the recap has become their vehicle of choice.

WIN-WIN

For financial advisers to act solely as investment managers

is no longer sufficient. Rather, advisers must manage their

clients overall balance sheets, including both their assets

and their liabilities. By proactively addressing the com-

mercial real estate and private business equity that their

clients own, advisers can enhance the value proposition

for their clients, position themselves to capture the pro-

ceeds of their clients liquidity events, and extend the

longevity of their client relationships.

Thomas Boczar, CFA, is CEO and Elizabeth Ostrander is Directorof Business Development at Intelligent Edge Advisors, an invest-

ment banking and real estate advisory firm in New York City that

works exclusively with financial advisers to plan, structure, and

execute liquidity events on behalf of their clients who own busi-

nesses, commercial real estate, and concentrated positions in

publicly traded securities.