Concentrated positions can often be the original source of ultra-high-net-worth individuals’ wealth, but they come with risks.
Great wealth may come from a concentrated position.
A classic example is when an entrepreneur starts a business which then grows rapidly. The result is a large shareholding that makes up a significant chunk of their total wealth.
It’s the same story when employees or executives receive a large stake in the business they work for, typically via an initial public offering. Other times, a concentrated holding is passed on as an inheritance.
But while such a position may have made the owner wealthy, it is much less likely to help them remain so. Without care, a concentrated position may see their owners lose wealth or miss out on other opportunities.
For this reason, concentrated positions need to be understood.
What is a concentrated stock position?
Before we get into the management of concentrated positions, let’s define what we mean.
While there’s no hard-and-fast definition, a good rule of thumb is any single position that accounts for 10% or more of its owner’s total wealth.
That said, a concentrated position could be less than 10% if it has the potential to have a material impact on its owner’s wealth, such as when the position is also used as collateral for a loan.
The risks of concentration
Having created great wealth, the challenge becomes how to preserve and grow it. Owning a concentrated position can complicate this task, even where it was the original source of wealth.
A concentrated position can make the owner’s wealth more volatile. An individual company’s value will most likely fluctuate a lot more than a broad-based portfolio of equities.
Some publicly traded companies’ share prices may experience larger falls than others when the stock market goes down.
Also, individual companies may face specific risks to their business, such as disruption from a competitor, management issues or litigation. In a disaster scenario, a company can even become worthless. After all, long-lived companies are the exception, not the rule.
Apart from volatility and a complete loss of capital, another risk is illiquidity.
Concentrated positions are typically hard to exit. For publicly traded companies, selling a big block of shares may not be possible without driving down the share price. For privately owned companies, it can take a long time to find a buyer and agree on terms.
Approaches to concentrated positions
Left to themselves, concentrated positions have the potential to create a significant risk to their owner’s wealth.
Rather than simply hoping for the best, though, investors with concentrated positions can seek to manage them.
There are several broad approaches discussed here: reducing, hedging, retaining and monetizing.
First, though, it’s worth considering the important question of why to not simply sell a concentrated position altogether.
From the perspective of preserving and growing wealth, selling a concentrated position and reinvesting the proceeds in a globally diversified multi-asset portfolio may seem the most logical approach.
However, this may not be possible or even desirable.
It may well be that the owner expects with good reason that the company may gain further in value so wants to participate in that potential upside.
Perhaps the concentrated position is in a family business, which plays a key role in family identity and culture.
Legal or regulatory barriers – such as contractual “lockup” periods – may prevent an investor from exiting.
That said, there may also be less sound reasons for holding on to a concentrated position. These are generally behavioral issues such as overconfidence, aversion to crystallizing a capital gain and sentimentality.
Reducing concentrated exposure risk
For those willing and able to sell a concentrated position, it may be better to sell it bit by bit.
The proceeds can then be invested gradually into a globally diversified investment portfolio, which seeks a better balance between risk and return.
Selling shares in a publicly traded company gradually is a way of reducing exposure while hitting the price less than selling a large stake in one go.
For private companies, selling off bit by bit may not be possible, however.
In the case of owners who want to benefit philanthropic causes, another possibility may be giving away some or all of their shares.
Depending on jurisdiction, this may eliminate capital gains tax liabilities and even create tax deductions in the future.
Hedging exposure to a concentrated position
What about when the owner isn’t allowed or doesn’t want to sell?
In such cases, hedging may offer a way forward.
By pursuing a strategy whose potential returns are structured to be negatively correlated to those of the concentrated position, owners may be able to preserve the value of their position.
However, such hedging strategies cost money to enter, in addition to transaction costs and fees, while they also require a lot of oversight. On cost grounds, such strategies are unlikely to be suitable for longer term purposes. They may only possible with highly liquid equities. Tax and regulatory issues may pose further restrictions.
While meant to mitigate risks, hedging strategies can also be risky themselves, and may require the investor to forego potential upside. Additionally, hedging strategies involve a higher level of risk and may have a collateral requirement and eligibility requirements.
For example, if the party supplying the hedge suffers financial distress, they may fail to keep up their end of the deal.
Maintaining a concentrated position
For those planning to maintain a longer-term concentrated position, it may be possible to seek to mitigate risks by creating a customized asset allocation.
This involves analyzing the particular risks of the position and then seeking to invest in asset classes and sectors that have little, zero or ideally negative correlation with that position.
So, any decline in the value of the concentrated position may coincide with gains or stability on the investment portfolio and vice versa.
As well as seeking to diversify away some or all of the concentrated position’s risk, this approach also seeks competitive risk-adjusted returns.
Of course, there is no guarantee that an asset allocation can be found that will perform both roles.
Monetizing a concentrated position
By definition, concentrated positions tie up a lot of an investor’s capital.
That said, it may be possible to gain liquidity from such a position by borrowing.
This could involve taking out a margin loan, using the shares as collateral.
The proceeds could then be used to make other investments or for whatever other purpose was needed.
One risk here is that the shares decline in price, after which the investor has to post further collateral under the terms of the loan.
Bespoke is best when managing concentrated positions
Concentrated positions can represent potential opportunities but also complex challenges and risks.
There is no one-size-fits-all approach here. Each situation requires bespoke management.
While managing a concentrated position doesn’t eliminate risks – and can even create risks of its own – it seeks to yield better results over time than doing nothing.