Copyright © 2017 The Brattle Group, Inc.

Discount for Lack of Marketability

Fatih Fazilet

PRESENTED BY

Outline

§ Introduc*on

§ RestrictedStockStudies

§ PrivatePlacementTheories

§ RegressionModels

§ Controversies

§ Conclusion

What is Discount for Lack of Marketability

  Marketability:theabilitytoquicklyconvertpropertytocashatminimalcost

  DiscountforLackofMarketability:anamountorpercentage  deductedfromthevalueofanownershipinteresttoreflecttherela*veabsenceofmarketability

  Therearesomevalua*onbooksmakingadis*nc*onbetweenliquidityandmarketabilitybutinmostoftheliterature,thesetermsareusedinterchangeably.

Sources of Illiquidity

Amihudetal.2005outlinethesourcesofilliquidity:

1.  Exogenoustransac*oncostssuchasfeesortransac*ontaxes

2.  Notallagentsareinthemarketatall*mes

3.  Difficultyofloca*ngacounterpartyespeciallyifthereisnocentralmarketplace(searchfric*ons)

When to Use

Thevalua*onofclosely-heldfirmsisoUencarriedoutintwosteps:§ First,valua*onisdoneasifsharesofthefirmtradeonahighlyliquidexchange.

§ Second,thisvalueisreducedbythesizeofthees*mateddiscountforlackofmarketability(DLOM).

Valua*onofminorityinterestsaresubjecttoDLOMbutapplyingDLOMtoacontrollinginterestiscontroversial.

How to Estimate DLOM

§ BenchmarkApproaches-  RestrictedStockStudies(18.1%-33.5%)-  Pre-Ini*alPublicOfferingStudies(31.8%-73.1%)

§ Securi*esBasedApproaches(8.3%-69.2%))§ RegressionModels

-  Wruck1989(17.6%)-  HertzelandSmith1993(<13.5%)-  Bajajetal.2001(7.23%)

What is a Restricted Stock

§ Publiccompaniesmayraisecapitalthroughprivateinvestmentinpublicequity(PIPE)transac*onstoaccreditedinvestors.§ Companiescanissueregistered(freelytradable)orunregistered(restricted)stocksinPIPEs.§ Restrictedstockscannotbesoldtoanyinterestedinvestorortradedonthepublicexchangebutcanbesoldtosophis*catedinvestorsduringacertainholdingperiod,aUerwhichtheybecomeregistered.§ Restrictedstocksaretypicallysoldatadiscountcomparedtothepriceofthepubliclytradedstocks.Firmsdonotpaytheregistra*oncostandacquirethebenefitswhichwillbediscussed.

Restricted Stock Studies

  Thesestudiesarguethatlackofmarketabilitycanbequan*fiedbycomparingthesalepriceofpubliclytradedsharestothesalepriceofrestrictedsharesofthesamecompanythatareiden*calinallrightsexceptfortheirabilitytobefreelymarketed.

§ Usedataofcompanieswhichhavepubliclytradedsharesandalsohaveissuedrestrictedstocksthroughprivateplacements§ Measurethepricedifferencebetweenpubliclytradedsharesandrestrictedshares§ ReporttheaveragedifferenceasameasureofDLOM

priceofpublicshare

priceofrestrictedshareinprivateplacement

DLOM

Examples of Restricted Stock Studies EmpiricalStudy YearsCovered AveragePriceDiscount

SEC 1966-1969 25.8

Gelman 1968-1970 33.0

Trout 1968-1972 33.5

WilliameheManagementAssociate

1981-1984 31.2

Silber 1981-1988 33.8

ColumbiaFinancialAdvisers

1996-1997 21.0

TrugmanValua*onAssociates

2007-2008 18.1

Two Empirical Observations about PIPEs

1.  RestrictedsharesaresoldinPIPEsandsharesinPIPEsaresoldatadiscount,evenwhentheyarenotrestricted.Hencealackofmarketabilitycannotbetheonlyfactorbehindthediscountforrestrictedshares.

2.  Thesharepriceofthepre-exis*ngpubliclytradedsharesoUenincreaseaUeraPIPE–whetherrestrictedornot.Thisisincontrasttothestockpriceeffectofapublicoffering.

Private Placement Theories

Belowareseminalempiricalpaperssuppor*ngdifferenttheoriesaboutwhyfirmsissuesharesthroughPIPEsatasignificantdiscount.1.  Monitoring,Wruck1989,JournalofFinancialEconomics

2.  Cer*fica*on,HertzelandSmith1993,JournalofFinance

3.  ManagerialEntrenchment,Barclayetal.2007,JournalofCorporateFinance

Monitoring

§ Monitoringmanagementofacompanyiscostlyanditisworthtopaythiscostonlyforlargeshareholders.Soasthenumberoflargeshareholders(ownershipconcentra*on)increase,monitoringgetsmoreefficient.

§ Privateplacementsareassociatedwithincreaseinownershipconcentra*on.

§ Investorsarecompensatedforexpectedmonitoringbenefitssosharesaresoldatadiscount.

§ Duetothisexpecta*onofefficientmonitoring,marketreactsposi*velyandpriceofpre-exis*ngpubliclytradedsharesincrease.

Certification

§ Thereisasymmetryofinforma*onaboutthefirmvalueandprivateplacementinvestorsmustdocostlyduediligenceonthefirmbeforecommilngtosuchalargepurchase.§ Thefirmcompensatesinvestorsforduediligencecostsbyplacingsharesatadiscount.§ Themarketobservesthistransac*onandthinksthatthefirmmustbehighqualityotherwiseinvestorswouldneverhaveboughttheshares.So,stockpricesincrease.

Managerial Entrenchment

§ Recentresearchhasaccesstomoredetailsaboutinvestorcharacteris*csandtheirbehavioraUertransac*on.

§ Thistheorystatesthatprivateplacementsaremademostlytopassiveinvestorswhichhelpmanagementtosolidifytheircontrolofthefirm.

§ Privateplacementdiscountsarecompensa*onforblockpurchaserstobepassive.

§ Ini*alstockpriceincreaseisduetosystema*coverop*mismofthemarket.

How These Theories Reconcile

§ Thesedifferentexplana*onsarenotmutuallyexclusivebuttheyexplaindifferentmo*va*onsforprivateplacementsdespitethediscounts.§ HertzelandSmithsupportcer*fica*onhypothesisbutalsofindsomeevidenceformonitoring.§ Barclayetal.(2007)supportentrenchmenthypothesisbutstatethatmonitoringandcer*fica*onexplainaminorityofprivateplacements.

Monitoring Cer@fica@on Entrenchment

Discount + + +

Stockpriceincrease

+ + -

Eliminating the Effect of Private Placements

§ Sinceallprivateplacementsaresoldatadiscount,itistemp*ngtocomparethesharepriceinprivateplacementsofrestrictedandunrestrictedsharestomeasurethediscountduetorestric*on.§ Thisdifferenceises*matedtobe17.6%,26.4%,14.1%respec*velybyWruck(1989),HertzelandSmith(1993)andBajajetal.(2001).§ But,notethatcomparisonisnotbetweenrestrictedandunrestrictedsharesofthesamecompany.Forinstance,inHertzelandSmith:

AverageDiscount NumberofObserva@ons

RestrictedShares 42.0% 18

UnrestrictedShares 15.6% 88

Eliminating the Effect of Private Placements

publicshare restrictedshare

Step1

publicshare

restrictedshare

Step2,Wruck

DLOM

unrestrictedshare

DLOM

privateplacementdiscount

*Darkbluebarsrepresentshareprices

Why not take difference between average s

§ Forthedifferencebetweenaveragestomeasurerestric*ondiscount,allfirmcharacteris*csthatcontributetoprivateplacementdiscountmustbeiden*calacrossthetwosamplesofissues,restrictedandunrestricted.

§ Otherwise,inordertoassessthediscountsolelyduetorestric*onofshares,theeffectoffirmcharacteris*csneedtocontrolled.So,weneedtousearegressionmodel.

Regression in Hertzel and Smith 1993

Thedependentvariableisprivateplacementdiscount.

IndependentVariable PredictedSign Coefficient

Intercept 1.402***

Frac*onPlaced + 0.410**

FinancialDistress + 0.091

Book-to-MarketEquity - -0.141**

Logofproceeds - -0.078***

RestrictedShares + 0.135***

SingleInvestor -0.091*

ManagementBuyer 0.021

AdjustedR2 41.3%

***,**,*indicatesta*s*calsignificanceat1%,5%and10%respec*vely.

Regression in Bajaj et al. 2001

Thedependentvariableisprivateplacementdiscount.

IndependentVariable PredictedSign Coefficient

Intercept 4.91

Frac*onPlaced + 0.40**

Z-score - -0.08**

RestrictedShares + 7.23**

Std.ofReturns + 3.13***

AdjustedR2 32.3%

***,**,*indicatesta*s*calsignificanceat1%,5%and10%respec*vely.

Interpretation of Restriction Discount

§ H&SandBajajetal.es*materestric*ondiscounttobe13.5%and7.23%respec*vely.§ AUercontrollingallfactorsthatincreaseprivateplacementdiscount,istherestric*ondiscountsolelyduetoDLOM?§ H&Sarguesthatitisnotbecauseenforcedholdingperiodforrestrictedstocksincen*vesmoreduediligencebytheinvestor(moremonitoringaUerthepurchase)§ Consistentlywiththisargument,H&Sfindthatplacementsofrestrictedstocksareassociatedwithanaddi*onal7.8%stockpriceincreasecomparedtotheeffectofunrestrictedshares.§ Thisevidencesuggestthatrestric*ondiscountisonlyanupperboundforDLOM.

Evolution of Literature

publicshare restrictedshare

Step1

publicshare

restrictedshare

Step2,Wruck

DLOM

unrestrictedshare

DLOM

privateplacementdiscount

*Darkbluebarsrepresentshareprices

Evolution of Literature

Step3,Bajaj

publicshare

restrictedshare

Step4,H&S

unrestrictedshare

privateplacementdiscount

publicshare

restrictedshare

unrestrictedshare

privateplacementdiscount

DLOMrestric*ondiscount>DLOM

*Darkbluebarsrepresentshareprices

Practitioner’s View

§ Academicliteraturestudiesprivateplacementsandnotmuchinterestedinrestric*ondiscountorDLOM.§ Prac**onersmostlysupportrestrictedstockstudiesandcri*cizeregressionmodels.Forinstance,WillameheValua*on2014:-  LowR2-  Omihedvariablebias-  Interpreta*onofregressioncoefficients:“thesta*s*calsignificanceofacoefficientdoesnothingtosupporttheaccuracyofthenumericalvalueofthecoefficient”

-  Cannotextrapolatetheresultsofaregression-  Variousdegreesofregistra*on

§ Problemsstatedabovedonotjus*fytouseaveragediscountasameasureofDLOM.

Concluding Remarks-Firm Specific Discount

§ Anothercri*cismfromprac**oner’sliteraturewhichisinlinewiththesugges*onsinIRSDLOMJobAidorDamodaran2005:DLOMshouldvaryacrossfirmssoavaluatorshouldnotusetheresultsfromanyoftheanaly*calstudieswithoutgelngbehindthedata.§ Damodaran2005:-  Liquidityofassetsownedbythefirm-  Financialhealthofthefirm-  Possibilityofgoingpublicinthefuture-  Sizeofthefirm-  Controlcomponent

§ ButthevariablesthataffectDLOMisopentodisputeaswellandmodelsthates*matefirmspecificDLOMhaveseriousweaknesses,too.

Conclusion

§ Restrictedstockstudiesaresupportedbyprac**oner’sliteratureandcitedinreports.§ Academicliteraturestudiesprivateplacementsbutnotmuchinterestedines*ma*ngdiscountinrestrictedstocks.So,thereislimitedevidenceintheacademicliterature.

§ Thereisnotaconsensusaboutthepropermodeltoes*mateDLOMbutthereissolidempiricalevidencerepor*ngdiscountsinallprivateplacementsandthefollowingstockpriceincrease.

§ PrivateplacementtheoriesneedtobeconsideredifDLOMises*matedusingrestrictedstocks.