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An Exchange Fund is
a private investment fund to which the holder of a block of eligible shares may contribute
the shares in exchange for an interest in the investment fund.
With appropriate fund structure, recognition of taxable gain on the
contributed shares is deferred until the interest in the Exchange
Fund is sold.
Most
large and mid-cap shares are acceptable to managers of Exchange Funds. Restricted
shares may be eligible for acceptance by an Exchange Fund at a
discounted price. The Exchange Fund acquires all dividend rights to
the shares it accepts. Some funds permit the return of the originally contributed shares
after seven years.
Though some
Exchange Funds are quite large, new contributions to them are
considered a private placement of a security, and the contributing
investor typically must have a net worth of at least $1.5 million or
have invested at least $750,000 with the manager. The minimum contribution of shares is
often $1
million.
For regulatory
purposes, investing in an Exchange Fund is a
sale of securities. Tax deferral typically depends on the Exchange
Fund maintaining a 20% level of investments in qualifying assets,
such as real estate assets, which are financed through non-recourse borrowings.
One example:
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A
mutual fund company
operates a large, open-ended,
private Exchange Fund
that
at
one point in time
had over 600 different stocks with a value of over $14
billion.
The highest
individual stock concentration
at that time was a diversified insurance company
at 2.1% of the portfolio value.
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Contributing shares
to an Exchange Fund is in substance a tax-deferred sale of the
concentrated stock position. The shares may or may not be
returnable.
In evaluating an exchange fund, one should consider not just the value of the tax
deferral, but also the portfolio composition and investment strategy
of the fund, the transaction costs (which are generally higher than
with normal mutual funds), and in the case of a hedge fund-based
product, the trading strategies to be employed and management's incentive
compensation structure.
Request
a "Single-Stock Strategies Report."
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