18 September 2006
With strong-performing share incentive schemes and a buoyant stock market, lawyers are increasingly seeing some of their more affluent clients becoming overexposed to a single equity position. In such circumstances investors either requiring liquidity or wanting to diversify their risk over a spread of assets may find that there are a number of obstacles. The simplest way of raising liquidity to diversify into a spread of assets is to sell the underlying equity position.
However, there are a number of reasons why this course of action may not be beneficial to the investor, such as not wanting to send a negative signal to the stock market. There may be tax considerations, and they may also not want to lose the rights associated with their equity position, such as dividends payment or voting rights at the annual general meeting.
So what are the alternatives open to these clients and their advisers?
A bank advances a loan to the investor holding a concentrated equity position and takes a legal charge over the shares. In return the bank will charge a margin on the loan and often an upfront fee. Generally, banks tend to only lend a portion of the market value of the shares given as security. Factors affecting the loan amount include the liquidity and volatility of the underlying share and whether the bank will have recourse to other assets held by the borrower. The bank will normally monitor the loan-to-value ratio on a daily basis. Falls in the share price could result in the bank requiring additional collateral (a margin call), requiring repayment of all or a portion of the loan, or selling the shares.
This strategy provides a certain level of risk and reward. It provides immediate liquidity to the investor and the cash generated can be used to diversify into other assets. However, the fact that the borrower could be subject to a margin call might not make this strategy appropriate for investors looking to diversify into long-term illiquid investments, such as hedge funds, property or other alternative investments.
Buy a protective put option
Buying a put option gives the holder of the option the right, but not the obligation, to sell a number of shares at or before a particular date at a specified price to the bank.
This gives the holder protection against a drop in the share price. The seller of the put option (the bank) will require an upfront premium, although it is possible to defer payment of this.
For holders who are unwilling or unable to sell their shares, or who are worried about a fall in the share price, this strategy buys temporary protection.
Sell a covered call option
The buyer of the call option pays an upfront premium to the writer (seller). The buyer is taking credit risk on the writer and will often require security over the underlying shares.
The writer of the call option is effectively giving up the right to the upside in a share above the specified level. Where the writer of the call option owns the shares over which they are writing the option, this is known as selling a 'covered' call.
This strategy can be useful to holders of shares who are looking for cash income and do not believe there is likely to be much appreciation in the share price over the term of the option agreement.
Funded covered call
The bank advances funding to the holder of the shares. The client agrees to give the bank the upside in shares above a certain level. Put another way, the holder of the shares writes a call option in favour of the bank. This call option, or forgone upside, has a value to the bank and this value can be passed on to the holder of the shares via a reduced interest rate on the loan.
This strategy can be useful to holders of shares who believe there is little upside in the share and who are looking to raise cheap funding.
The bank writing the put option is saying to the investor that it is happy to take the shares off the investor's hands at a specified price in the future, irrespective of how low the share price has fallen. For investors requiring liquidity, the bank will lend them the present value of the put amount. As the bank is taking its own credit risk and not the client's credit risk, there should be no credit margin on this loan funding.
This strategy could be suitable for investors requiring protection against falls in the share price and immediate liquidity. It has the added attraction that the investor can never be subject to a margin call. The investor retains all the upside in the share. There is no upfront cash cost to the investor, nor is there recourse to the investor's other assets. In the event the shares became worthless, the investor could simply walk away from the loan without any adverse consequences.
This strategy may be suitable for investors looking to raise liquidity to diversify into long-term, illiquid assets.
A collar strategy is simply a combination of buying a protected put and selling a covered call. The investor buys protection against a fall in the share price and gives up the upside in the share price above a certain level.
For example, if the share price is currently £10, the strike prices of the put and call could be £9 and £11 respectively. The investor thus has the risk and reward within the £9-£11 band, but outside this band the risk and reward would be for the account of the bank.
As the investor would pay a premium for buying the put and receive a premium for writing the call, it is possible to structure the transaction so that the premiums are equal and no upfront cash is required from the investor. This is known as a zero-cost collar.
This strategy might be suitable for an investor who requires protection against a fall in the share price, but who is unwilling to incur an upfront cash expense.
This is identical to the collar approach, but in this case the client receives cash upfront.
A bank will be happy to advance a loan to the investor equal to the present value of the strike price of the put option component of the collar. As the bank is not taking any credit risk on the investor, there should be no margin charged by the bank as compensation for credit risk.
This method results in a higher cash advance compared with a protected loan, as the upfront cost of the put option premium is offset by the upfront income earned by the investor from writing the covered call option.
It is particularly useful for investors looking to raise term liquidity. Under this strategy the investor can never be subject to a margin call. Additionally, should the value of the shares be insufficient to settle the loan at the end of the transaction term, the investor can simply walk away from the loan without any adverse consequences.
This approach is also suitable for investors who require protection against falls in the share price and who are looking to raise term liquidity. By giving up the upside in the share price above a certain level, the investor can raise more upfront cash under the funded collar than under the protected loan.
Lawyers helping clients with concentrated equity positions have a number of powerful strategies available to them, which can be used to release liquidity and facilitate diversification into other assets. The use of a derivative strategy can provide the investor with a number of benefits, including increasing the funding amount, reducing the cost of funding and providing the investor with protection against falls in the share price. n
David Drewienka is head of specialised finance at Investec Private Bank