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

BY THOMAS BOCZAR, CFA, AND ELIZABETH OSTRANDER

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, concentrated 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 compare the risks and rewards of continuing to own their businesses and real estate versus monetizing and diversifying into other asset classes. Investors can use a wide range of tools and techniques to monetize their private business equity and real estate investments tax-efficiently in order to manage concentration 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 concentrated 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 commercial real estate) an outright sale, a 1031 exchange, and donor-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 appreciated 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 the recent 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 propertys 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

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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 the debt, 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 attractive 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 investor qualifies for an immediate charitable contribution deduction (worth 35 percent at todays top marginal tax rate) that can be carried forward for five years, regardless of 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.

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 accomplished 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 freshly capitalized 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 relinquish overall control of the company but maintains dayto-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). Furthermore, 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 companies 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 commercial real estate and private business equity that their clients own, advisers can enhance the value proposition for their clients, position themselves to capture the proceeds of their clients liquidity events, and extend the longevity of their client relationships.
Thomas Boczar, CFA, is CEO and Elizabeth Ostrander is Director of Business Development at Intelligent Edge Advisors, an investment 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 businesses, commercial real estate, and concentrated positions in publicly traded securities.

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 very difficult time exiting. Few owners, however, are aware of the many available monetization strategies. A leveraged recapitalization (recap) is a timely strategy that is particularly attractive to middle-market business owners who are interested in both reducing the risk

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