Marketability Discounts, Fair Value and the Forgotten Market Participant

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It common to see valuations where the initial assessments of value of a risky asset are discounted by 30 percent or 40 percent for one potential downside risk or another. In this section, we will examine perhaps the most common of these dIscounts-for illiquidity or lack of marketability-in detail and the dangers associated with the practice. When you invest in an asset, you generally would like to preserve the option to liquidate that investment if you need to.

The need for liquidity arises not only because your views on the asset value change over time-you may perceive it as a bargain today, but it may become overpriced in the future-but also because you may need the cash from the liquidation to meet other contingencies. Some assets can be liquidated with almost no cost-Treasury bills are a good example-whereas others involve larger costs-such as stock in a lightly traded over-the-counter stock or real estate.

With investments in a private business, liquidation cost as a percent of firm value can be substantial. Consequently, the value of equity in a private marketability and value measuring the liquidity discount in valuing may need to be discounted for this potential illiquidity.

In this section, we will consider measures of illiquidity, how much investors value illiquidity, and how analysts try to incorporate illiquidity into value. You can sell any asset, no matter how illiquid it is perceived to be, if you are willing to accept a lower price for it. Consequently, we should not categorize assets into liquid and illiquid assets but allow for a continuum un liquidity, where all assets are illiquid but the degree of illiquidity varies across them.

One way of capturing the cost of illiquidity is through transactions costs, with less liquid assets marketability and value measuring the liquidity discount in valuing higher transactions costs as a percent of asset value than more liquid assets.

With publicly traded stock, some investors undoubtedly operate under the misconception that the only cost of trading is the brokerage commission that they pay when they buy or sell assets. Although this might be the only cost that they pay explicitly, they will incur other costs in the course of trading that generally dwarf the commission cost. When we trade any asset, there are three other ingredients that go into the trading costs. The second cost is the price impact that an investor can create by trading on an asset, pushing the price up when buying the asset and pushing it down while selling.

As with the bid-ask spread, this cost will be highest for the least liquid stocks, where even relatively small orders can cause the price to move. It is the sum of these costs, in conjunction with the commission costs, that makes up the trading cost of an asset. If the cost of trading stocks can be substantial, it should be even larger for assets that are not traded regularly, such as real assets or equity positions in private companies.

Real assets can range from gold to real estate to fine art, and the transactions costs marketability and value measuring the liquidity discount in valuing with trading these assets can vary substantially. The smallest transactions costs are associated marketability and value measuring the liquidity discount in valuing commodities-gold, silver, or oil-because they tend to come in standardized units and are widely traded. With commercial real estate, commissions may be smaller marketability and value measuring the liquidity discount in valuing larger transactions, but they will be well in excess of commissions on financial assets.

With fine art or collectibles, the commissions become even higher. If you sell a Picasso through one of the auction houses, you may have to pay J percent of the value of the painting as l commission. Why are the costs so high? The first reason is that there are far fewer intermediaries in real asset businesses than there are in the stock or bond markets. In other words, one Picasso marketability and value measuring the liquidity discount in valuing be very different from another, and you often need the help of experts to judge value.

This adds to the cost in the process. We will put the conventional practice of applying percent illiquidity discounts to the values of private businesses under the microscope. The difficulties associated with selling private businesses can spill over into smaller equity stakes in these businesses. In summary, the costs of trading assets that are usually not traded are likely to be substantial. Assume that you are an investor trying to determine how much you should pay for an asset.

In making this determination, you have to consider the cash flows that the asset it will generate for you marketability and value measuring the liquidity discount in valuing how risky these cash flows are to arrive at an estimate of intrinsic value. You will also have to consider how much it will cost you to sell this asset when marketability and value measuring the liquidity discount in valuing decide to divest it in the future. In fact, if the investor buying the asset from you builds in a similar estimate of transactions cost she will face when she sells it, the value of the asset today should reflect the expected value of all future transactions cost to all future holders of the asset.

This is the argument that Amihud and Mendelson used inwhen they suggested that the price of an asset would embed the present value of the costs associated with expected transactions costs in the future. In their model the bid- ask spread is used as the measure of transactions costs, and even small spreads can translate into big illiquidity discounts on value, if trading is frequent.

The magnitude of the discount will be a function of investor holding periods and turnover ratios, with shorter holding periods and higher turnover associated with bigger discounts. What is the value of liquidity? Put differently, when does an investor feel the loss of liquidity most strongly when holding an asset? Some would argue that the value marketability and value measuring the liquidity discount in valuing liquidity lies in being able to sell an asset, when it is most overpriced; the cost of illiquidity is not being able to do this.

In the special case where the owner of an asset has the information to know when this overpricing occurs, the value of illiquidity can be considered an option.

Longstaff presents an upper bound for the option by considering an investor with perfect market timing abilities who owns an asset on which she is not allowed to trade for a period t. In the absence of trading restrictions, this investor would sell at the maximum price that an asset reached during the period. The value of the look-back option estimated using this maximum price should be the outer bound for the value of illiquidity.

The results are graphed in figure 1. If we accept the proposition that illiquidity has a cost, the next question becomes empirical one. How big is this cost, and what causes it to vary across time and across assets? The evidence on the prevalence and the cost of illiquidity is spread over a number of asset classes.

Bond market -There are wide differences in liquidity across bonds issued by different entities, and even across bonds issued by the same entity. Amihud and Mendelson compared the yields on treasury bonds with less than six months left to maturity with Treasury bills that had the same maturity. They concluded that the yield on the less liquid Treasury bond was 0.

A study of more than 4, corporate bonds in both investment-grade and speculative categories concluded that illiquid bonds had much higher yield spreads than liquid bonds. Comparing yields on these corporate bonds, the study concluded that the yield increases 0.

Looking across the studies, the consensus finding is that liquidity matters for all bonds, but it matters more with risky bonds than with safer bonds. Publicly traded stocks -It can be reasonably argued that the costs associated with trading equities are larger than the costs associated with trading Treasury bonds or bills. It follows, therefore, that some of the equity risk premium, has to reflect these additional transactions costs.

Put another way, investors are willing to pay higher prices for more liquid investments relative to less liquid investments.

Restricted securities are securities issued by a publicly traded company, not registered with the SEC, and sold through private placements to investors under SEC Rule They cannot be resold in the open market for a one-year holding period, and limited numbers can be sold after that. The results of two of the earliest and most quoted studies that have looked at the magnitude of this discount are summarized here.

Maher examined restricted stock purchases made by four mutual funds in the period to and concluded that they traded an average discount of Silber examined restricted stock issues from to and found that the median discount for restricted stock is He also noted that the discount was larger for smaller and less healthy firms and for bigger blocks of shares. Other studies confirm these findings of a substantial discount, with discounts ranging from percent, although one recent study by Johnson did find a smaller discount of 20 percent.

These studies have been used by practitioners to justify large marketability discounts, but marketability and value measuring the liquidity discount in valuing are reasons to be skeptical. First, these studies are based on small sample sizes, spread out over long periods, and the standard errors in the estimates are substantial. Second, most firms do not make restricted stock issues, and the firms that do make these issues tend to be smaller, riskier, and less healthy than the typical firm.

This selection bias may be skewing the observed discount. Third, the investors with whom equity is privately placed may be providing other services to the firm, for which the discount is compensation. Private equity -Private equity and venture capital investors often provide capital to private businesses in exchange for a share of the ownership in these businesses.

Implicit in these transactions must be the recognition that these investments are not liquid. If private equity investors value liquidity, they will discount the value of the private business for this illiquidity and demand a larger share of the ownership of illiquid businesses for the same investment. Looking at the returns earned by private equity investors, relative marketability and value measuring the liquidity discount in valuing the returns earned by those investing in publicly traded companies, should provide a measure of how much value they attach to illiquidity.

Ljungquist and Richardson estimate that private equity investors earn excess returns of 5 to 8 percent, relative to the public equity market, and this generates about 24 percent in risk-adjusted additional value to a private equity investor over 10 years. They interpret it to represent compensation for holding an illiquid investment for 10 years.

Das, Jagannathan, and Sarin take a more direct approach to estimating private; company discounts by looking at how venture capitalists value businesses and; the returns they earn at different stages of the life cycle.

They conclude that the discount is only 11 percent for late-stage investments but can be as high as 80 percent for early-stage businesses.

These studies found that restricted and therefore illiquid stocks traded at discounts of percent, relative to their unrestricted counterparts, and private company appraisers have used discounts of the same magnitude in their valuations.

They have used option pricing models and studies of transactions just prior to initial public offerings to motivate their estimates and been more willing to estimate firm-specific illiquidity discounts. Although illiquidity discounts are the most common example of post-valuation discounts, other risks also show up as post-valuation adjustments.

Just as analysts try to capture downside risk that is missed by the discount rates in a post valuation discount, they try to bring in upside potential that is not fully incorporated into the cash flows into valuations as premiums. In this section, we will examine two examples of such premiums-control and synergy premiums-that show up widely acquisition valuations. The value of controlling a firm derives from the fact that you believe that you or someone else would operate the firm differently from the way it is operated currently.

When we value a business, we make implicit or explicit assumptions about both who will run that marketability and value measuring the liquidity discount in valuing and how they will run it.

In other words, the value of marketability and value measuring the liquidity discount in valuing business will be much lower if we assume that it is run by incompetent managers rather than by competent ones. When valuing an existing company, private or public, where there is already a management in place, we are faced with a choice.

We can value the company run by the incumbent managers and derive what we can call a status quo value. The difference between the optimal and the status quo values can be considered the value of controlling the business.

If we apply this logic, the value of control should be much greater at badly managed and run firms and much smaller at well-managed firms. In addition, the expected value control will reflect the difficulty you will face in replacing incumbent management.

Consequently, the expected value of control should be smaller in markets where corporate governance is weak and larger in markets where hostile acquisitions and management changes are common. Analysts who apply control premiums to value are therefore rejecting the path of explicitly valuing control by estimating an optimal value and computing a probability of management change in favor of a simpler but less precise approximation.

To prevent double, counting, they have to ensure that they are applying the premium to a status quo value and not to an optimal value. Implicitly, they are also assuming that the firm is badly run and that its value can be increased by a new management team. Synergy is the additional value that is generated by combining two firms, creating opportunities that would not have been available to these firms operating independently operating synergies affect the operations of the combined firm and include economies of scale, increased pricing power, and higher growth potential.

They generally show up. Financial synergies, on the other hand, are more focused and include tax benefits, diversification, a higher debt capacity, and uses for excess cash. They sometimes show up as higher cash flows and sometimes take the form of lower discount rates.

Because we can quantify the impact of synergy on cash flows and discount rates, we can explicitly value it.

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