Study: Variable prepaid forwards beat collar-plus-loan

A new paper finds that variable prepaid forwards (VPFs) generally outperform options collars paired with margin loans for wealthy investors holding concentrated, highly appreciated stock. The study was posted in March, revised last month and has been accepted for publication in the Journal of Wealth Management. Authors are Brent Sullivan and Fort Point Capital Partners executives Roy Haya and Ralph Dryborough.

The paper compares two ways to get liquidity and downside protection while capping upside. In a VPF, an investor receives a prepayment by pledging shares and agrees to deliver a specified number of shares or cash at maturity within a floor and a ceiling. In a collar with a margin loan, the investor borrows against the stock, buys a protective put and sells a call, receiving cash up front while each option leg is tested for tax separately.

The authors identify three tax and financing differences that favor the VPF: character degradation, phantom income and financing spread. Character degradation occurs when a tax offset is converted into a change in stock basis that yields less after-tax value than a current loss would. Phantom income is taxable income that does not reflect a corresponding cash economic gain. Financing spread is the difference in funding costs between structures. The study states the VPF’s integrated contract avoids phantom income and reduces character degradation through internal netting, while a collar with a loan can create current taxable income from option trades that must be offset by external capital losses.

The two approaches also differ in how they are implemented. Collars and margin loans can be arranged through standard brokerage platforms at lower transaction sizes and may suit investors willing to deliver shares at maturity. VPFs usually require specialized execution, larger minimums and eligibility checks. The paper models transactions of at least $1 million and notes that VPFs of the type analyzed generally require participants to be “qualified purchasers,” a regulatory category that typically requires at least $5 million in liquid net worth.

Haya and Dryborough provided technical review and options execution experience for the paper. Sullivan described the VPF as “a very powerful solution.” The authors note that investors with external capital losses could use those losses to offset collar-related phantom income, but doing so reduces the pool of losses available to shelter other gains.

Interest in tax-focused planning tools has increased as public listings and private liquidity events create large concentrated positions with potential capital gains. A recent planning conference drew about 350 attendees, reflecting growing attention from advisors and family offices. Shang Chou, a co-organizer of that conference, advised that investors should be patient when handling IPO-related holdings and work with skilled planners to decide on timing and strategy.

The paper provides technical comparisons of tax testing and financing mechanics for advisors and clients to consider when choosing between hedging and liquidity strategies. It notes a trade-off: collar-and-loan structures are more accessible, while VPFs can produce different tax results for eligible investors.