Once Established, Capital Preservation Becomes Focus

By ANTHONY PALAZZO

Staff Reporter

Call them the nouveau riche, the dot-com denizens, or just plain lucky. Whatever you call them, Los Angeles has its share of newly minted millionaires whether it's once-struggling actors suddenly hitting the big time or aging entrepreneurs selling their business.

But becoming one creates a new set of issues and concerns. Specifically, keeping it and growing it.

"Their concerns are protecting and preserving the capital that they worked so hard to build," said Tom Frank, L.A. managing director of Bessemer Trust, a privately held trust company based in New York. "They want to make sure they're doing the right things."

It's a complicated world. All of a sudden, folks whose personal finances were fairly straightforward have tax issues, estate-planning issues, a host of investment decisions. And as always the case in financial planning, a lot depends on the person's specific situation, from age to spending habits. A financial plan for a couple in their 40s with two kids and many long-term spending needs will be a lot different than one for a retired widower in his 70s.

"They may not have a tremendous amount of experience in the financial markets," said Frank, whose firm manages just over $35 billion for families with a minimum of $10 million in liquid assets (two-thirds of them are first-generation wealthy). "They're facing an array of choices that they might not be familiar with."

Help available

There are hordes of tax attorneys, estate planners and money managers to help out the newly elite for a fee (typically between .75 percent and 1.5 percent of the portfolio).

Since 1986, this industry has grown dramatically in Southern California. At that time, changes in state laws allowed competition for the first time from financial institutions that were based out of state. East Coast institutions set up shop, and many California-chartered banks were acquired. At the same time, the stock market was starting to see the results of the bull market that began earlier in the decade.

U.S. Trust Co. opened its first office in Los Angeles in 1987. "We had $300 million (under management), which has gone to $5 billion," said Greg Sanford, president and chief executive of US Trust Co. N.A., the Western U.S. subsidiary of U.S. Trust. Portfolio sizes average $3 million to $4 million. Los Angeles is the No. 2 market for wealth management in the U.S., after New York, he said, and virtually every financial services firm, bank and trust is active here. "There is no dominant player."

Beginning even before the "liquidity event," professionals begin nudging their clients into a number of strategies. When a business is sold, for example, a major goal is to minimize the tax drain.

"One thing we like to talk to our clients about is pre-deal planning," said Leonard Brisco, private wealth adviser at Merrill Lynch & Co. Before selling a business, an owner may set up a family limited partnership, transferring minority interests to other family members at a discount of up to 30 percent of its value. The Internal Revenue Service generally allows such a discount on a gift that's not liquid, such as a privately owned business, if the gift doesn't transfer voting control, he said.

The move won't cut down the taxes due when the business is sold, but it will allow more wealth to be transferred tax-free under inheritance tax laws. These laws allow individuals to give up to $11,000 per year, tax-free, to family members. Additional gifts count against an inheritance-tax allowance of $1 million, or $2 million for a couple, that can be passed down tax-free. By transferring the assets at a discount, and selling later, an individual can avoid estate taxes on as much as $300,000.

Super-voting shares

Some business owners will go further and create two different classes of stock for a privately owned business. If the owner retains voting control through a class of super-voting shares, as much as 90 percent of the company can be transferred in such a way.

Often times, a business owner will sell out to a publicly held company and receive stock in return. Generally, these agreements require the seller to hold onto the stock for one year. Some of these agreements will, however, allow the seller to hedge the stock by setting up a "collar." The collar is a hedging mechanism that limits losses on the stock in exchange for limiting potential gains.

If a stock is trading at $100, for instance, the collar may be set at $90 on the low side, and $115 on the high side. If the stock stays within that range, the collar is inactive. If it goes to $120, the seller gives up that final $5 in profit, but if it goes down to $85, the seller takes the first $10 in losses and the counterparty, usually a brokerage firm, will absorb the additional $5.

Another instrument, called an exchange fund, is a tax-driven strategy that helps reduce risk by diversifying a concentrated stock position.

An exchange fund works like a mutual fund. The owner of a concentrated position contributes his or her holding to the fund, which includes other individuals who have contributed their large holdings. "In a big exchange fund you could have 400 or 500 different stocks," Brisco said.

The contribution isn't taxable; meanwhile, the owner has diversified. The commitment is from five to seven years. "If you want to get out early, you would take back your stock, plus or minus whatever happens (to the portfolio) during the time you're in," he said.

Providing incentives

There are times when people want to take some money out of their businesses without selling. Borrowing against a company can fund a legitimate diversification strategy, but it can also lead to trouble. Tycoons such as Bernie Ebbers, former chief executive of Worldcom Inc., and local golf impresario David Price borrowed heavily before their companies' market value unexpectedly declined.

The newly wealthy have a number of issues that go beyond the strictly financial.

Many want to make sure the money doesn't warp their children's outlook. They want to provide them with some comfort, educational opportunities even seed money to start their own businesses. But they don't want to make it so easy for them that there isn't any incentive to live a productive life.

"I would say that is the single biggest concern that our clients have," Frank said. "They're concerned that this newfound liquidity will lead to somebody who's just sitting by a mail box waiting for a check."

Individuals will use structural means, such as limited partnerships or family trusts, to act as asset-protection devices, keeping the money safe from creditors or ex-spouses. "They can be extremely useful in protecting kids from themselves, if they're going through a distressed period or they're really young," Frank said.

Some families will turn to attorneys and psychologists who will devise a "family mission statement" or a policy statement that sets out guidelines. For the super-rich, with $30 million or more, there is the option of setting up a "family office" that formalizes the approach to such issues as education, philanthropy, tax planning and money management. These offices, which bring an additional measure of privacy to a family, often have charters that set out voting procedures for family issues.

There are 2,500 to 3,000 such family offices in the United States, said Mark Jarasek, a spokesman for Family Office Exchange LLC in Oak Park, Ill., a nationwide resource center.

Despite all the professional help available, it's sometimes difficult for the newly wealthy to follow the advice of the people they have hired. The rich are a confident, hardheaded breed, but preserving the wealth for future generations requires a different strategy than the one that brought the wealth in the first place.

In a typical trust, the client signs over day-to-day decision-making to trust advisers, after agreeing to a plan that includes asset allocation, risk profiles, lifestyle requirements and other factors.

The plans are set up to work in all types of economic environments, and tend to act stodgily. During the frothy markets of the late 1990s, trust advisers got into tug-of-wars over investment decisions with their clients, who often wanted a more aggressive approach.

"Usually people that have a wealth event have concentrated their efforts in one area. It worked and they became wealthy and they sold," said Sanford. "The paradox is, in order to preserve that wealth, they must diversify."

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