Having Your Cake and Eating it Too: Equity Swap Contract

Good to Know

Think about this situation. You have a client who has a significant amount of their wealth in a concentrated position. This might be because they are an executive with a company and have received equity-based compensation over the years or simply have accumulated the position through an inheritance or other means. Regardless of how the position is acquired, let’s say the client feels that there might be a downturn in the stock. They want to maintain ownership of the position but want some downside protection. In this scenario, an Equity Swap might be a possible solution to consider.

An Equity Swap Contract is a performance diversification strategy. The contract swaps the cash flows — not the shares — of a client’s concentrated stock position in exchange for the performance of an index (e.g., S&P 500 or LIBOR). We will review this intriguing strategy's operation, provide an example, and summarize the pros and cons.

Operation

The goal of the Equity Swap Contract is to “swap” the cash flows of a concentrated position for a more diversified position or benchmark index. Counterintuitively, no actual swapping of shares takes place. This strategy is both flexible and sophisticated. It can be fashioned in several structures, but there are at least two parties, including:

  • Your client, the owner of the concentrated position, and
  • A counterparty (typically a financial institution).

What would motivate a client to consider this strategy? An example follows.

Example

Your client believes in the long-term growth potential of her concentrated position, currently valued in the market at $2,000,000. She wants to retain the stock but is concerned about short-term returns. An Equity Swap Contract could address her concern. The agreement could be structured as a $2 million contract with a duration of one year as follows:

  • Your client pays the counterparty the return of the concentrated position, and
  • The counterparty pays your client the return of the S & P 500 index.

Remember that no shares trade hands. The $2 million in this example is used solely to determine the amount of return “swapped,” which is referred to as the “Notional Amount” of the swap.  During the defined term of the swap, assume the annual return of the S&P 500 was 6%, and your client’s concentrated position returned 4%.

  • Your client receives $120,000 ($2,000,000 x 6%).
  • The counterparty receives $80,000 ($2,000,000 x 4%).

Pros and Cons

 

Equity Swap Contract
Performance Diversification Strategy
Client Pros Client Cons
Performance diversification Potential that the concentrated position will outperform the index
No capital gains tax Not for small investors — $1 million or more in concentrated position generally required
Client continues to own and vote the stock
Not locked into a long-term contract

Crucial Balance

The crucial balance here is structuring an Equity Swap Contract that weighs your client’s need for downside performance protection against the potential that their concentrated position will outperform the index. While an Equity Swap Contract can be an effective solution for clients with the needs defined in the example, it is but one in a comprehensive suite of concentration risk management solutions that are available to a client in this situation.

For more on the range of solutions available to help clients manage concentrated wealth positions, click here to view our philosophy on Wealth Management.