We all know that it makes sense to diversify, but it’s not always as easy as it sounds. Clients with concentrated equity positions tend to have a low cost basis in those positions, which makes the tax cost of diversification unattractive at best. But continuing to hold a concentrated position to avoid paying the income tax required to diversify may end up being more costly than the tax bill itself.
There are plenty of lessons I can point to where the holders of concentrated positions saw the value of their investment plummet, for one reason or another (Enron being one of the most obvious). What if there were a way to help your clients diversify concentrated equity without the taxes associated with selling and subsequent reallocation? There is—it’s known as an exchange fund (a.k.a. stock swap fund).
An Exchange Fund Defined
An exchange fund is a private placement limited partnership that allows clients to contribute certain concentrated positions to the partnership in exchange for shares of interest in the fund. The contributed positions are pooled with other concentrated positions and assets. The shares of interest in the exchange fund represent a proportional share of all assets in the fund. To be considered an exchange fund, the fund cannot hold more than 80% of its assets in individual securities. The other 20% (or more) of assets must be held in qualifying assets (i.e., illiquid assets typically consisting of real estate).