ADVISERS FORUM

How to develop a strategic plan for investments

By Anne B. Shumadine Back in the 1990s, a seller of a closely held business generally expected that investing the proceeds in public markets would provide enough income to support his family’s lifestyle and enough growth to keep up with inflation and to supply a nice legacy for younger generations. A seller’s major considerations were how much to reserve to invest in a new business and how to diversify low basis stock received in the sale without paying taxes. Then came 2008 and the Great Recession. Business owners who sold their companies in 2008 had very different concerns than their counterparts of the ’90s. Global markets continue to be volatile today, with dramatic fluctuations this past August. Sellers whose transactions closed on favorable terms have been grateful, but since the proceeds are current or deferred cash, they worry about how to invest those assets safely. Despite the uncertainties since the Great Recession, people are still selling businesses and receiving liquid assets in exchange. Those assets must be invested somewhere; hiding cash under the mattress is not safe, and storing gold is cumbersome. What do you need to consider if you are about to sell your business? How will you structure the deal? During the technology boom, stock was the currency of choice for both sellers and acquirers. Stock prices were soaring, and interest rates were high enough to make acquirers think hard about borrowing capital. Taxes were also high (28% capital gains rates), and tax-free stock-for-stock mergers were attractive to sellers. The downside for the seller was a concentrated position in stock of the acquiring company, often accompanied by restrictions on sales. In order to diversify without a high tax burden, the seller needed to institute complicated structures and hedges against price fluctuations. The environment today is different. Cash and highly structured earn-outs are usually the currency of choice. Seemingly depressed stock prices are not attractive currency for acquirers, and cost of capital is low; interest rates are at historic lows and many corporations have a lot of cash on hand. Fortunately, capital gains rates are also low (15% federal rate), making cash a more attractive currency for sellers. Cash deals offer immediate benefits, such as instant liquidity and known valuations. Cash deals also present questions. Occasionally such deals, particularly those involving private equity purchasers, require reinvestment by the seller into the new entity. Cash deals often involve deferred payouts that depend on continued performance by the purchased entity, and they usually involve tax liabilities that must be funded at least by April 15 of the year following the sale. Sellers should set aside enough cash for taxes in a safe and very liquid investment, even though those investments today pay almost no interest. How will you replace your paycheck? Low interest rates make it difficult to replace a paycheck with interest alone. The specter of future inflation also means that some part of the proceeds should be invested for growth. If cash flow is a concern, think about investments in two tranches, one to fund necessary expenditures and one to fund discretionary spending. The tranche that funds necessary expenditures should be invested in “safe” liquid securities and, if possible, should produce constant yield. However, in some cases, it might be necessary to spend principal in this tranche, with the idea that the other tranche will grow enough to replenish the first fund. The tranche that funds discretionary spending should be invested in assets that are expected to grow over a full market cycle. Many people are comfortable with volatility in this tranche because lifestyle funding has been taken care of in the other tranche. Many business sellers are anxious to build another business. If you want to reserve a portion of the proceeds to buy a new business that you will operate or oversee, timing is important. Ensure that the economic climate is favorable for the new venture and that you have the necessary energy so soon after selling your previous business. It’s also important to estimate how much you will need to fund the new venture. What should you think about in formulating an investment strategy? Being an investor is different from being a business owner. As an owner, you knew and understood the risks inside your business and learned to hedge them and use them to your advantage. Investing presents different risks and involves different management tools. Here are some points to consider: • Take your time. You will be bombarded with investment opportunities. Remember that you don’t have to invest in everything; it’s better to miss a good opportunity than to invest in a bad one. • Don’t commit to anything until you have developed a strategy for the future. In addition to writing down your investment goals and strategies (an investment policy statement), think about creating a strategic plan for three to five years that includes broader financial and lifestyle goals, timelines and measurements. • Learn about investing. Serving on the investment committee of a well-run institutional endowment (such as a university, hospital or foundation) is one of the best ways to learn both the practical and theoretical aspects of investing. Reading is also important; David Swenson’s Pioneering Portfolio Management is a favorite, but there are many more. • Manage your expectations. Most investment professionals will counsel you to diversify your portfolio as a way to manage risk. A diversified portfolio should produce returns over a full market cycle equal to inflation (in order to protect purchasing power) plus enough growth to replace reasonable spending. A diversified portfolio typically will not “beat the market,” or be interesting enough to make you the star of the cocktail party circuit. As an investor in public markets, you are subject to the whims of other investors whose interests are not necessarily aligned with yours. Accordingly, values will fluctuate, and you should be comfortable with volatility and the asset allocation that you have chosen. b>• Manage risk. Risk means different things to different people. You must define risk for yourself and determine how comfortable you are with the level of risk you are taking. In today’s environment, the investments that have historically been considered “risk-free” may entail more risk than before; consider the current conversations about default risk in municipal bonds. Investments that were considered risky in the past may be less risky than other more conventional choices. For instance, stock in well-capitalized companies that pay dividends may be less risky today than some government bonds. You must still take risk in order to get returns, but taking risk does not guarantee returns. Therefore, it is important to understand where the risks lie, the magnitude of the risk, how the environment might affect the risk and what the upside is for taking that risk. How much are you willing to delegate? How much assistance do you want with managing investments? Unless you are an investment professional, you will probably want to delegate at some level. How do you choose the people you work with? Although integrity and aligned interests are key ingredients, successful relationships are generally based on shared values and mutually respected behaviors. Think about who will handle the day-to-day items. When you owned an operating company, you had a staff that managed the affairs of the business. When the proceeds of the sale become your “business,” your staff may no longer be available to help, or they may not have the appropriate skills to manage the new issues. Perhaps you plan to create your own family office, or maybe you want to be a part of a larger multi-family office structure. Alternatively, you might prefer to handle everything by yourself. There are benefits and problems associated with each structure. Anne B. Shumadine, Esq., is chairman of Signature, a multi-family office and high-net-worth wealth management firm advising families, foundations and endowments. Signature is located in Norfolk, Va., and serves more than 150 clients from across the country (http://signatureus.com).