Prepaid Variable Forwards

Similar to exchange funds (which we wrote about last month), prepaid variable forwards (PVFs) represent a strategy for investors to mitigate the risk, unlock liquidity, and defer capital gains tax. The below is purely educational and should not be considered investment advice or relied upon to make investment decisions.

PVFs Explained

PVFs are essentially a collar strategy that is created and borrowed against by a financial institution. For those unfamiliar with a collar, it is when a stockholder sells a call option and buys a put option. Selling a call option gives up potential upside, while buying a put option protects against potential downside. Thus, stockholders can mitigate the impact of a fluctuating stock price without actually selling the stock. Investors can also borrow against this combination of three positions (stock, call, and put). While some investors have the ability to implement and borrow against a collar strategy using publicly-traded options, many investors do not have the expertise to do this themselves.

Enter the PVF, which many financial institutions offer using capital from their own balance sheet. Investors can transfer their stock to the institution, who will apply a collar and borrow against the position. Most of the borrowed proceeds are then forwarded to the investor immediately, with the balance forwarded later. Thus, an investor is able to mitigate the risk of holding a concentrated position AND is able to receive some cash prior to actually selling the stock.

Why Utilize a PVF?

If the above seems overly complicated, the reason investors utilize PVFs is to defer capital gains tax liability. If an investor sells a position with a capital gain, then the investor will owe capital gains taxes for that tax year. However, entering into a two-year (for instance) PVF contract could allow the investor to mitigate risk in the stock (without selling it) and receive some cash (from borrowing against the collared position) while deferring the realization of any capital gains until the stock is sold in two years. Of course, collars and PVFs can be structured for various lengths of time. Implementing a collar or PVF strategy will reset a stock's holding period, so it may be advantageous to do it for at least one year (to qualify for long-term capital gains, which are currently taxed at a lower rate than short-term capital gains). 

Cost Considerations

Of course, the benefits of any tax deferral strategy must be weighed against the costs of the strategy. For collars and PVFs, the relevant costs are:

• The proceeds received from selling a call option or the potential upside appreciation (a negative cost)

• The cost of buying a put option or the potential downside appreciation.

• The borrowing costs to borrow against the hedged position, which is determined by prevailing interest rates at the time.

The cost of the collar portion of the trade (selling the call and buying the put) could be positive or negative, depending on a variety of market and investor-specific factors. However, borrowing against the position will almost certainly cost money.

Conclusions

PVFs can make sense for investors who want to mitigate risk and unlock liquidity from a stock position, while also deferring capital gains tax liability. We should also note that the minimum investment for PVFs is typically around $5 million. Lastly, the potential benefits of PVFs need to considered in the context of their total cost. We encourage interested investors to consult with their advisors, accountants, and attorneys before engaging in such strategies.