This article appeared in the February 2019 edition of Nevillewood Living.
At H&A, we are well aware of how extremely fortunate we are to have such a wonderful clientele that hail from all walks of life. Among the most interesting of our clients, we would certainly include entrepreneurs and public company executives (PCE’s). These individuals all have great stories of how they started out with a dream and a vision, and then went on to build something of great value.
Many of these individuals also have the shared experience of attaining a high income and net worth. With this generally comes the subsequent challenge of the concentration of investment and income risk in one enterprise (a “good” problem to have, most would agree).
Entrepreneurs and PCEs have gotten where they are in life due to determination and a willingness to assume risk. At some point, however, they will face the reality that, although the concentration is what enabled them to build wealth, without adequate diversification all that they have created will be at risk of loss.
In our experience, as compared to entrepreneurs, PCEs at the pinnacle of their careers seem to be a bit more focused on diversifying their total investment portfolios to better manage risk. Perhaps it is the (frightening for many) mark-to-market experience of seeing their net worth fluctuate dramatically day-to-day as a result of stock market moves. Perhaps it is because their diversification kit contains more tools, i.e., they can sell or hedge company stock they have accumulated on the open market.
Of course, entrepreneurs who have accumulated substantial wealth through the ownership of a private business face the same investment concentration risks. And, although they cannot sell or hedge their stock on the public markets, there are tools and techniques that entrepreneurs can use to de-risk and diversify their holdings:
- Recapitalize. The closely held business can leverage up and then pay out a substantial dividend to the owner(s). The proceeds of this dividend can then be invested in a diversified portfolio. This enables diversification while still retaining ownership of the business and preserving full participation in its future growth.
- Focus on other industries. Once entrepreneurs begin to diversify away from privately held stock, they too often invest in public companies that operate in similar industries because they feel that they understand them better. A better course would be to focus on sectors that are counter cyclical to the private business. For example, an owner of an industrial company might place more focus on health care and financial companies in his diversified liquid portfolio.
- Own more fixed income in diversified portfolio. When setting the asset allocation targets within the diversified portfolio, entrepreneurs should be sure to employ a “global” or “total” portfolio approach. This may require higher targets for fixed income within the diversified portfolio to provide better overall balance and risk management given the equity concentration risk within the closely held business.