Tens of thousands of privately owned small businesses are expected to change hands in the next decades as Baby Boom business owners retire. They're left with a wealth management challenge: how to invest the proceeds and plan for the new money in their estates. Crain's Wealth asked David Post, partner and investment committee chair at Detroit-based Telemus Capital, LLC, to run through a typical scenario for readers.
The story A 60-year-old couple with three grown children and four grandchildren sells its California-based auto supply business to a regional company for $8 million. The sale is structured as an installment sale with $5 million paid up front and $3 million deferred and paid in three equal installments over the next three years.
The taxes: After paying capital gains tax of $1.65 million on the initial $5 million payment, the Smiths have net proceeds of $3.35 from the first leg of the installment sale.
Their existing estate: The Smiths were diligent over the years and the modest home they bought 20 years ago is now worth $1 million. They have contributed to a retirement plan, accumulated a nice nest egg, and paid for their kid's college educations. With the net proceeds from the initial installment sale the Smiths now have just over $5 million to invest. Their only meaningful expenses are the payments on their $200,000 mortgage, a couple of vacations a year, and spoiling their young grandchildren.
The Smiths shared with their financial advisor very clear objectives:
• They want to retire and not worry that they would ever need to work again.
• They want to help provide educational expenses for their grandchildren.
• They are willing to take enough risk to allow the portfolio to grow over the next few decades.
The financial plan: Let us pretend for a moment that the Smiths situation is happening in real time and that we were selected as their advisor. That being the case, we would first suggest that they establish a 529 College Savings Plan for each grandchild and fund each with $28,000, the maximum annual contribution.
Subsequent contributions to the grandchildrens' 529 plans would be determined by the individual circumstances of each grandchild and their educational needs. Additional 529 contributions should be funded out of the after-tax proceeds from the next three installment sale payments.
The portfolio: Given the Smiths' straightforward goals and objectives for their initial $5 million is it $5 million? yes of investible assets, we would suggest the following allocation:
• 30% equities
• 30% alternative assets
• 35% fixed income
• 5% cash
Given the Smiths' moderate living expenses, as well as the forthcoming $3 million of installment payments, our suggested allocation would provide current income in the range of $175,000 per year, as well as an opportunity for the portfolio to grow in the years ahead. This portfolio allocation, along with expected installment sale proceeds would provide more than sufficient liquidity for the Smiths in case of an emergency. What kind of income are they generating?
The equity allocation: Within the equity sleeve of the portfolio, we would recommend a 55% allocation to international equities and 45% to domestic equities. Given the current stage of the bull market, we would suggest tilting the allocation toward equities with value characteristics, including a very healthy allocation to dividend paying stocks. We would also favor an over- allocation to international equities, with a tilt toward Europe and the Emerging Markets. In the case of Europe, the economy has not yet turned the corner and valuations are attractive. Equity allocations would be spread among large, medium, and small capitalization companies.
As for Emerging Markets, the prospects for long-term economic growth are greater than almost any other market. On the domestic front, we would recommend a tilt toward dividend paying companies with strong balance sheets and energy-related MLPs.
Alternative investment allocation: Our recommendation for the alternative investment sleeve of the portfolio would be to allocate among multi-strategy hedge funds, income producing real estate strategies, and insurance-related assets. Insurance related assets, such as participations in reinsurance, catastrophe bonds, and life settlement contracts are non-correlated to the financial markets. A combination of these alternative investment strategies will provide meaningful portfolio diversification and dampened portfolio volatility (reduce risk).
Our recommendation for the bond portion of the portfolio would be a mix of open and closed-end municipal bond funds combined with credit sensitive taxable bond funds, such as distressed debt and other non-traditional strategies that are more dependent on improving prospects for the economy and the underlying companies rather than changes in interest rates.
Future: The portfolio needs to be regularly rebalanced and, at least on an annual basis, the couple's risk tolerance should be reassessed. Cognitive bias can be a tricky thing. The couple's assessment of their risk profile may change substantially in the case of a stock market downturn or life event.
If, after getting to know the Smiths better, we determine that their risk profile is less tolerant than they had assumed, we would use the after-tax proceeds from subsequent installment sale payments to shift the portfolio allocation appropriately.