Exchange fund
Encyclopedia
An Exchange Fund or Swap Fund is a mechanism specific to the U.S.
, first introduced in late 1990s that allows holders of large amount of a single stock
to diversify into a basket of other stocks without directly selling their stock.
The purpose of this arrangement is to diversify
their holdings without triggering a "taxable event
". Note that the tax
is not avoided, just postponed, when the diversified holdings are eventually sold tax will be due on the difference between the sales price and the original cost basis of the contributed stock.
by directors not disclosing their effective divestment in stocks for which they are privy to sensitive market information.
In addition there is general criticism that tax revenue that might otherwise have been generated is avoided. Many holders of these positions may elect to hold the concentrated position and borrow against it rather than sell and pay the associated capital gains tax.
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United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
, first introduced in late 1990s that allows holders of large amount of a single stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
to diversify into a basket of other stocks without directly selling their stock.
The purpose of this arrangement is to diversify
Diversification (finance)
In finance, diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of...
their holdings without triggering a "taxable event
Capital gains tax
A capital gains tax is a tax charged on capital gains, the profit realized on the sale of a non-inventory asset that was purchased at a lower price. The most common capital gains are realized from the sale of stocks, bonds, precious metals and property...
". Note that the tax
Tax
To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...
is not avoided, just postponed, when the diversified holdings are eventually sold tax will be due on the difference between the sales price and the original cost basis of the contributed stock.
Criticism
The U.S. Securities and Exchange Commission is investigating the use of these arrangements with reference to the potential for market abuseMarket abuse
Market abuse may arise in circumstances where financial investors have been unreasonably disadvantaged, directly or indirectly, by others who:* have used information which is not publicly available...
by directors not disclosing their effective divestment in stocks for which they are privy to sensitive market information.
In addition there is general criticism that tax revenue that might otherwise have been generated is avoided. Many holders of these positions may elect to hold the concentrated position and borrow against it rather than sell and pay the associated capital gains tax.
Providers
There are exchange funds for publicly held stock and private stock (pre-IPO). Eaton Vance is the largest of the public stock exchange fund providers and many of the large brokerage houses such as Goldman Sachs, Morgan Stanley etc. have exchange funds as well. Startup Exchange Fund and EB Exchange are the best known companies that specialize in exchange funds for privately held equity (stock of private companies).Detailed Structure
- Fund holding requirements: The fund needs to have at least 20% of its assets in "non-publicly traded" securities or real-estate.
- For public exchange funds, at least 7 years have to elapse between when an investor deposits their stock and when the basket of stocks is available for them to sell without realizing a step up in basis (paying taxes). However, this is not an issue with private stock exchange funds as the point is diversification, not tax deference.
- Liquidity: Public funds are generally not marginable. Private funds increase a participants odds of liquidity.
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Public vs. Private Equity Exchange Funds
Private equity exchange funds (those comprising stock in non-public companies) differ from public exchange funds in a few regards:- A main objective of private equity exchange funds is providing participants with downside risk protection, in case their own stock becomes worthless before they achieve a liquidity event (an IPO or acquisition.) The need for diversification is much more heightened than it is with public stock which may be sold at any time, if the holder wishes to bear the tax consequences.
- When liquidity events occur within a private equity fundPrivate equity fundA private equity fund is a collective investment scheme used for making investments in various equity securities according to one of the investment strategies associated with private equity....
, proceeds are immediately distributed to limited partners, rather than being held or reinvested. The objective of these funds is liquidity as well as diversification. - Fund management fees are assessed on the basis of an expense budget, rather than a percent of the value, since valuation of the private equity holdings is uncertain.