Cashing out with Variable Paid Forwards

One interesting tool made available to high net worth individuals is called a Variable Paid Forward, or VPF. Their intended use is to take cash out of your current investment that for some reason you may not want to sell right away.

The way they work is to use a collar options strategy to guarantee a future value of the investment. Since the value is guaranteed, the brokerage is comfortable loaning you the equivalent present value at a risk-free interest rate.

A collar means that you're buying a protective put, which protects your investment against future loss. You are buying this insurance, and to offset the cost, you can write a call option, which puts a maximum price at which you can sell. In effect, for roughly no cost other than fees, you're guaranteeing that your investment won't lose value; however, if it goes above the maximum price set by the call, you miss out on those gains.

Because you're guaranteed that your investment has a minimum future value, there is no risk that you won't be able to pay off a loan at that amount. Since there is no risk, the interest rate on the loan should have no risk premium; it is a risk-free interest rate.

For example, if you have 10,000 shares of a stock that are worth $100, then you can either take out a margin loan for up to $500,000 with an interest rate that's probably around 7%, or you can get a VPF. Let's say that a put option for a year from now and a call option for a year from now cost the same, but the put option's strike price is $100 and the call option's strike price is $120. This means that you can buy the put option and sell the call option and come out net even, and a year from now you are guaranteed that you can sell your stock for somewhere between $100 and $120. Those 10,000 shares are now guaranteed to be worth at least a million dollars a year from now, and with a risk-free rate of 5%, the present value is $952,380.95. So your brokerage will give you that amount, minus fees, right now.

A year from now, if the stock is at $100, you give them all 10,000 shares of the stock to pay off the million dollars you owe; if the stock is at $120, then you only need to give them 8,333 shares, since that will pay off your debt, and you get to keep the other 1,666 shares. If the price is less than $100, it doesn't matter, because your put option guarantees that you can sell at $100 no matter what. If the price is more than $120, then the way it would normally work is that all of your shares would be sold for $120, and you'd use the money to pay off the million dollar loan and still have $200,000 left; but since the VPF is through your brokerage they probably have a clause that says you can keep $200,000 worth of stock so that those shares aren't treated as a sale, and they'll take the remainder.

You're limited by law to only borrowing up to 50% of your portfolio's value, which presents a small problem when you try to borrow against the entire thing. So the way to get around the limitation is to treat the VPF as a sale of stock with a future delivery date. The brokerage gives you the proceeds now, and you agree to give them the equivalent future value at a later date. Typically they give you the option of either settling with stock or cash, so you're not obligated to sell.

Because you don't know the future value of the shares, you don't know how many shares you'll have to deliver when the options expire, and because of that, it's not considered a taxable sale until you actually hand over the shares.

So you get a low interest rate and tax deferral, and still have some upside participation.