Liquidity on value – part one
If we imagine two identical investments A and B, both returning 6% a year and with the yield increasing at a rate of 3% a year, with everything else being equal, we would anticipate, that they would have the same price and the same value.
We now interpose one difference. Investment A can be realised rapidly for a known price in a large market and for modest transaction charges, and in addition to this the bid-offer spread is relatively small. Investment B is not listed on such a market so there is no ready and obvious means of realisation. One of the riddles perplexing business valuers is to try and determine the price difference between A and B. The holder of a liquid investment can realise the investment:
- rapidly;
- for a publicly available price;
- with a relatively small bid-offer spread,
- with the sale not having an effect on that price; and,
- with modest transaction costs.
An illiquid investment lacks one or more of these qualities.
It is demonstrable that a liquid investment should be more valuable than one which is illiquid: we are not obliged to fall back on empirical evidence, anecdote or speculation. The liquid investment A, can be considered to be identical to the illiquid investment B, which is bundled with a put option, enabling it to be realised by reference to the market price of A. As the put option in this circumstance would have value, the value of the illiquid investment B must be less than the liquid investment A and the challenge is to identify a reasonable range for that discount.
We can look at these attributes of liquidity and see if they give us clues as to the discount which should be applied when they are not present and it will probably come as no surprise that several of the above qualities have been put under the forensic knife, to try and identify a measurement for illiquidity. However before doing this, we need to explore some of the terminology and the difficulties that can arise from imprecision in the language employed.Words and meanings
In North America some valuers have held anguished discussions because of the loose description of illiquidity. It is very commonly known as DLOM, or Discount for Lack of Marketability. With such a description, the question then arises as to whether or not a controlling interest in a private company should have such a discount. A majority shareholder does normally have the ability to offer the shares for sale to the market. However this does not mean that the shares are liquid in any conventional sense of that word. Some say that the acronym DLOL is more appropriate in such circumstances. (Clearly minority holdings in private companies are normally both unmarketable and illiquid).Imaginary transaction process
The next point to address is the stage of the imaginary transaction process which is deemed to have been reached when the investment is being realised and therefore valued. The transaction must be deemed to be on the cusp: the marketing has been done and the costs and time so incurred have been spent. They are therefore of no direct account when considering the value at the point of exchange and completion. The buyer has been identified and both parties are poised to sign, and if this is the case, we need to explore what the illiquidity discount is designed to address.In considering the market value of an investment we need to consider it from the viewpoint of the buyer: she will know that it takes longer and costs more to realise the illiquid investment which she is about to buy. She also knows that the next buyer will also recognise this simple fact, as will the next.
The discount for illiquidity is therefore not based on time delays and costs for the seller as these have to be ignored in determining market value: it is similar costs and delays and uncertainties in the future which have to be estimated and baked into the market price from the viewpoint of the buyer. This factor will vary according to the anticipated holding period of the buyers in question.
Conventional sources
The long established means of studying illiquidity discounts have been various restricted stock studies and also analysis of pre-IPO transactions in private company shares. The restricted stock studies compare the pricing of stocks in listed companies in the USA, some of which cannot be traded for periods of one year or more. These are often known as letter stocks. The pre-IPO studies analyse transactions in the shares of private companies in the 6 months or more prior to an initial public offering.The frailties of these studies are being recognised more and more:
- there are often contractual terms with such transactions which are not disclosed;
- for restricted stock studies the samples are small;
- several of the restricted stock studies which appear to reinforce one another are actually covering the same small number of transactions;
- for many of these letter stocks the period of restriction has fallen since the main studies were undertaken and is now only 12 months in any event;
- it tends to be shares in smaller and thinly traded entities which have a restricted stock issue.
Speed of realisation is not present
As already identified, the first attribute of liquidity is the rapid potential sale of the investment. An investment which can be realised at market price today is more liquid, and has a higher value, than one which can only be realised at the then market price in 180 days time.What does this mean for the investor?
- The opportunity cost of selling at an opportune moment is lost.
- Therefore investments with inherently greater volatility should be more materially affected than those which are in more stable sectors.
- The cost of the replacement investment may have increased in the interval.
- Price movements in the investment itself is a virtually neutral factor as there must be nearly equal probabilities of a gain as a loss.
- The investor may have her own personal reasons for wishing to realise her wealth and this cannot be achieved.
Andrew Strickland, Consultant, Scrutton Bland Group
Valuation Group, June 2015