Estimating the fair value of a nonmarketable financial instrument, or one that is restricted from sale, is conceptually challenging. Even though it could take significant time and effort to transact the instrument—in some cases, it can mean waiting years for a restriction to expire—the accounting standards require the owner contemplate its immediate value in a fair value transaction.
The valuation industry’s response has been to first estimate the fair value of the financial instrument, assuming it is marketable, and then to adjust this value by a discount for lack of marketability (DLOM). Valuation professionals generally justify the application of a DLOM by stating that an investor would require a higher return based on the additional time and risk associated with disposing of a nonmarketable instrument. This argument, however, only considers the buyer’s requirement for a higher return; the seller’s willingness to accept a DLOM is forgotten.
Since immediately disposing of a nonmarketable financial instrument can be challenging, its forced sale or liquidation value would likely differ from that of an otherwise identical marketable counterpart. Would the same be true, however, in a transaction in which the seller is not forced or compelled to accept a significant discount?
This article will show that it would be suboptimal for a seller to accept a DLOM under the fair value conditions set out in Accounting Standards Codification (ASC) Topic 820, “Fair Value Measurement.” Under fair value conditions, applying a DLOM creates an opportunity to make risk-free profits (or arbitrage) between the marketable and non-marketable security, which can lead to significant distortions from a financial reporting perspective.
What Is Fair Value?
Fair value is a principles-based valuation and financial reporting framework that contemplates the value of financial instruments under specific conditions. Perhaps the most distinguishing characteristic of a fair value framework is the need to consider both the buyer’s and the seller’s perspectives. In a fair value framework, the buyer’s requirement for higher returns is tempered by what sellers are willing to accept.
ASC Topic 820 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” The market participants to a fair value transaction are defined as—
- independent of each other (i.e., not related parties);
- knowledgeable, that is, having a reasonable understanding about the asset or liability and the transaction using all available information, including information that might be obtained through due diligence efforts that are usual and customary;
- able to enter into a transaction for the asset or liability (i.e., free of any restrictions or constraints);
- willing to enter into a transaction for the asset or liability (i.e., motivated but not forced or otherwise compelled to do so); and
- assumed to act in their own economic best interest.
ASC Topic 820 also makes it clear that a fair value measurement does not include transaction costs.
To the extent that a transaction reasonably fits these fair value conditions, the price is the most credible estimate of fair value. If a transaction does not conform to fair value conditions, however, this price can not be relied upon to estimate fair value. Therefore, determining fair value is not as simple as writing down the transaction price.
Liquidation versus Fair Value
Combining the accounting definition of fair value and the stated characteristics of market participants, it can be seen that fair value arises from an orderly transaction between independent, willing, able, and knowledgeable parties acting in their own economic best interests, having had reasonable time to perform due diligence, considering all the available information, assessing the perceived risk and expected return of the instrument, and agreeing on a fair price.
Under fair value conditions, it would be suboptimal to take a discount to the fair value of a marketable security instead of waiting for it to eventually become marketable.
Prior to the current comprehensive accounting guidance, one may have inadvertently estimated the immediate liquidation value of a financial instrument. Immediate or forced liquidation value is a one-sided transaction in which the holder is assumed to dispose of (or settle) a financial instrument even if it is economically detrimental to do so. Liquidation value is buyer-side biased and answers the question of what the seller would receive in disposing of an instrument immediately. Discounts to fair value arise naturally in an immediate liquidation value framework, reflecting either the penalty for suboptimally disposing of a financial instrument, the buyer-side bias of a forced-sale transaction, or the mispricing due to insufficient time for one party to perform reasonable due diligence (i.e., information asymmetry).
Standards setters have helpfully clarified that immediate liquidation value is not necessarily fair value. In a fair value framework, it is necessary to ask not only whether a buyer would pay less for a non-marketable instrument, but also whether a seller would accept a lower price.
What Is the Value of Marketability?
Simply stated, when faced with the decision to sell at a significant discount or to hold onto a financial instrument, a willing, able, and knowledgeable market participant would choose to hold it. Under fair value conditions, it would be suboptimal to take a discount to the fair value of a marketable security instead of waiting for it to eventually become marketable. Therefore, the only price agreeable to both buyer and seller in a fair value transaction is the fair value of the marketable security without any DLOM. One can demonstrate this result more formally by considering the nonmarketable security to be a derivative of the underlying marketable security.
Pricing financial derivatives relies on the ability to hedge (or replicate) the payoff of the derivative using the underlying security. Therefore, the assumption of marketability is only a requirement for the underlying security, and not the derivative itself.
The valuation of any derivative begins with defining its payoff. The payoff of the nonmarketable security occurs at the end of the nonmarketable period and is equal to the fair value of the marketable security. Because the cost of hedging the marketable security is its current price, the cost of hedging the nonmarketable security is therefore the current price of the marketable security (i.e., zero DLOM).
Intuitively, this result makes sense, as the fair value of a financial instrument must capture the perceived risk and expected return characteristics of the instrument over any future time horizon (including any restricted or nonmarketable period).
DLOMs and the No-Arbitrage Argument
Because the cost of hedging the non-marketable security is the current price of the marketable security, it follows that applying a DLOM creates an opportunity to make risk-free profits, or arbitrage. Noarbitrage arguments have two underlying principles: 1) economically identical financial instruments must have the same value, and 2) any mispricing of economically identical instruments will lead to market participants exploiting this mispricing through an arbitrage strategy (i.e., making risk-free profits) until it is resolved. It would be difficult to argue that a valuation which allows for significant arbitrage opportunities represents fair value in an orderly market.
Assume an investor holds a nonmarketable security valued at $80, and that the security’s otherwise identical marketable counterpart is valued at $100 (i.e., there is a 20% DLOM). Because of this price differential, an arbitrage opportunity exists; the investor holding the nonmarketable security can sell (short) the marketable security, receiving $100 in proceeds. Since after the nonmarketable period the marketable and nonmarketable securities are identical, the nonmarketable security offsets exactly the short marketable position under all future scenarios. This strategy results in a $20 risk-free profit.
Despite the simplicity and rigor of the no-arbitrage argument, proponents of DLOMs argue that short selling a security is not always possible and can incur significant transaction costs. In addition, the nonmarketable security may be contractually precluded from being used as collateral, or the holders prohibited from hedging their position. In fact, some have argued that because of frictions or inability to practically hedge, no-arbitrage arguments should not necessarily apply, or the no-arbitrage condition should not be required in a fair value framework.
What these critics are missing is that fair value is performed under specific, idealized conditions for financial reporting. The reporting standard of fair value dictates that participants are knowledgeable, the market is orderly, and frictions are minimal. Therefore, any arbitrage opportunities under fair value conditions will translate into distortions to financial reporting, regardless of whether one can actually implement the arbitrage strategy or practically hedge. This is best demonstrated with the following example.
Illiquidity premiums observed in the market allow for the illiquidity risk characteristics of financial instruments.
Company A holds a marketable security with a fair value of $100, and Company B holds the same security, except that it is nonmarketable or restricted from sale for two years. Company B has taken a 20% DLOM (i.e., the fair value recorded is $80). After two years, the fair value of the non-marketable security will equal that of the marketable security. If performance is measured as the difference in fair value between subsequent periods, then Company B has a much higher propensity to outperform Company A; in particular, when both companies simply hold their respective securities, Company B will always outperform Company A by $20. This arbitrage occurs regardless of how the security performs or the ability to practically hedge.
Unfair Circumstances that Give Rise to DLOMs
The circumstances under which a market participant would accept a significant discount are simply not fair value conditions. A market participant may be willing to accept a significant discount if—
- the seller is distressed or has an immediate need for cash that cannot be sourced elsewhere;
- the seller is compelled to sell as a result of legal, regulatory, or other requirements;
- the seller is not able or does not have sufficient time to perform reasonable due diligence (i.e., the seller is not as knowledgeable as the buyer);
- the seller wants to give away value to the buyer (perhaps to a charitable organization, relative, or other related party);
- the seller is being financially compensated for the discount through other mechanisms; or
- the buyer has undue influence over the seller.
It follows that transactions with significant discounts to fair value are unlikely to conform to fair value conditions and therefore cannot be used to justify DLOMs in a fair value framework.
Market-Based Illiquidity Premiums
Illiquidity premiums observed in the market allow for the illiquidity risk characteristics of financial instruments. These premiums can be a significant factor when estimating fair value, reflecting both the characteristics of the instrument and market conditions at the time of the transaction, and are already included in the fair value of the marketable instrument. For example, low-grade bonds are generally considered less liquid than investment-grade bonds; as such, the yields observed in the market for low-grade bonds will generally reflect a higher illiquidity premium than investment-grade bonds. When estimating the fair value of a bond issued by a private company similar to the issuers of low-grade bonds, using the market yields in the low-grade bond market already incorporates a market-based illiquidity premium.
Another example is small-versus large-cap stocks. Transactions for smaller companies tend to reflect higher rates of returns, which would include market-based illiquidity premiums. Therefore, when estimating the fair value of a small private company, the use of market-based required rates of return for similar companies already includes market-based illiquidity premiums.
It is therefore important to distinguish DLOMs from market-based illiquidity premiums. Illiquidity premiums are already reflected in the required rates of returns observed from fair value transactions. The no-arbitrage arguments that negate the application of a DLOM in a fair value framework do not imply that market-based illiquidity premiums do not exist, or that they should not be considered in a fair value framework.
Temporary versus Permanent Nonmarketability
In most cases, nonmarketability is temporary, in that there is an expectation that the holder will realize a return in the future. As shown above, temporary nonmarketability has no impact on fair value; however, there may be rare cases where an instrument is never expected to be marketable, and there is thus no mechanism for the holder to realize any investment proceeds. No rational investor will make a financial investment without any hope of realizing a return; therefore, in a fair value framework, a financial instrument that is permanently non-marketable is worthless, not because it is nonmarketable, but because it has no expected future cash flows.
Common Arguments and Approaches to DLOMs
The application of DLOMs within a fair value framework is becoming increasingly widespread. Furthermore, the discounts applied in practice are significant, ranging from 20% to 40%. Why are optimal behavior and no-arbitrage arguments not resonating with valuation professionals?
The concepts underlying DLOMs predate comprehensive fair value accounting guidance, and have been widely used in valuations for tax, litigation, and other purposes. Proponents of DLOMs have compiled so many approaches and arguments that, despite their self-proclaimed flaws and lack of adherence to fair value conditions, they seem to have led to justification by sheer magnitude. While objective optimal behavior and no-arbitrage arguments should have the last word in a fair value framework, it is worth delving into some of the main misconceptions and flaws in the current approaches used to justify and measure DLOMs for financial reporting.
Why are optimal behavior and no-arbitrage arguments not resonating with valuation professionals?
Market participants will always prefer a marketable security.
The majority of discussions relating to DLOMs justify their application by saying that investors will always prefer a marketable instrument to an otherwise identical nonmarketable instrument. Therefore, the value of the non-marketable instrument must be less than the value of an otherwise identical marketable instrument. This argument’s conclusion is not only subtly flawed, it is also biased toward buyer-side investors, reflecting a liquidation value. A more accurate statement would be that buyers will always prefer a marketable instrument to an otherwise identical nonmarketable instrument. As a result, the value of the nonmarketable instrument must be less than or equal to the value of an otherwise identical marketable instrument.
For fair value, however, one must consider the seller’s perspective. No seller would accept a penalty or additional discount for perceived risk and expected return already incorporated into the fair value of a marketable instrument; therefore, from the seller’s perspective, the value of the nonmarketable instrument must be greater than or equal to the value of an otherwise identical marketable instrument. Combining both perspectives, it becomes clear that a fair value transaction for a nonmarketable instrument will only occur if its value equals the value of the marketable instrument.
Access to information and minority interests.
Some have argued that a lack of access to information or holding a minority interest justifies the application of a DLOM in a fair value framework. Information can be a valuable commodity, and minority holders may not be privy to all pertinent information. Does access to information really matter, however, in a fair value framework, in which one presumes knowledgeable investors, reasonable due diligence, and an orderly market?
Controlling investors have full access to information and the ability to use that information to influence the future cash flows, risk, and return of the underlying investment. Minority investors may or may not be privy to information relating to the underlying investment; however, given they do not have the ability to use the information to garner any influence, such access to information (or lack thereof) has no impact on the fair value of their minority interest. Minority investors usually just passively share value with the controlling investor. Therefore, the fair value of the minority interest proportionately follows that of the controlling investors, and it would be suboptimal for an independent, willing, able, and knowledgeable seller to accept a discount to this value in an orderly transaction.
Blockage factors are adjustments to the quoted price of an asset or liability because the market’s normal trading volume is insufficient to absorb the quantity held by an investor. Examples of blockage adjustments range from premiums needed to entice investors to sell a strategic block of tightly held shares to discounts needed to entice buyers into the market to dispose of a relatively large block of shares. The latter is often used to justify a DLOM to the market price of a share when estimating the fair value of a block of shares that is larger than the size of the normal trading volume.
When justifying a DLOM to fair value, however, the question is not whether one would expect a discount as a result of immediately liquidating a large block of shares, but rather, whether one would expect such a discount under fair value conditions. Distinguishing value by size may be appropriate in a liquidation framework in which the valuation basis requires one to contemplate market disruptions or other significant frictions caused by the immediate sale of a large block of shares. A discount caused by market disruptions, however, is unlikely to conform to an orderly transaction and therefore cannot justify a DLOM to fair value. If a company holding a large block of shares decides to liquidate all of its shares immediately despite an expected adverse market disruption, then the resulting market disruption should result in a loss relative to the value of the shares under fair value conditions.
Stated differently, if the immediate sale of a large block of shares were expected to result in a significant discount, then it would not be optimal to immediately liquidate all the shares and cause such a market disruption. In these circumstances, contemplating the immediate sale and allowing for the expected discount would constitute a forced sale or immediate liquidation value as opposed to fair value. A more optimal strategy might be to dispose of the shares in smaller volumes over a longer period. In practice, investors will often employ such strategies to dispose of large holdings.
Even though the primary reason for investors to spread the sale of large blocks of shares over time is to avoid significant discounts, valuation professionals will often measure the expected time needed to dispose of a large block and use this period as a basis for measuring and justifying a significant discount. This practice of using market participants’ optimal behavior to avoid discounts as the basis for estimating and justifying discounts is nonsensical. Indeed, blockage factors are specifically disallowed under accounting standards when estimating fair value for financial reporting purposes.
A discount caused by market disruptions, however, is unlikely to conform to an orderly transaction and therefore cannot justify a DLOM to fair value.
Put option models.
A nonmarketable security is equivalent to a marketable security less the ability to sell the security over the nonmarketable period. Since a put option gives the holder the right to sell the underlying instrument at a certain date for a specified price, many valuation professionals estimate a DLOM based on the value of a put option.
One could construct a number of equivalence relationships between otherwise identical marketable and nonmarketable securities over a nonmarketable period using puts, calls, and forwards as follows:
- Marketability equivalence put option, where the nonmarketable security is equivalent to the marketable security less a put option with the length of the nonmarketable period and an exercise price equal to the fair value of the marketable security at the end of the nonmarketable period.
- Marketability equivalence forward purchase agreement, where the nonmarketable security is equivalent to a forward contract to purchase the marketable security at a price of zero at the end of the nonmarketable period.
- Marketability equivalence collar, where the nonmarketable security is equivalent to the marketable security less a put option with the length of the nonmarketable period, plus a call option of equal length, with exercise prices equal to the fair value of the marketable security at the end of the nonmarketable period.
Since puts, calls, and forwards are typically priced under no-arbitrage conditions, it is not surprising that all the above equivalence relationships result in the fair value of the nonmarketable and marketable security being equal. To avoid this zero-DLOM result, valuation specialists have adjusted the marketability equivalence put option by setting the exercise price to the current or average future fair value of the marketable security. In making this adjustment, the marketability equivalence put option becomes a protective put option (David Chafee, “Option Pricing as a Proxy for Discount for Lack of Marketability in Private Company Valuations,” Business Valuation Review, December 1993, http://bit.ly/2DrbLeP; John D. Finnerty, “An Average-Strike Put Option Model of the Marketability Discount,” Journal of Derivatives, Summer 2012, http://bit.ly/2rnSGVW). A protective put helps ensure that the marketable security will not devalue. Under fair value conditions, it is illogical to argue that a marketable security has downside protection, or insurance, just because it is marketable.
More recently, Lester Barenbaum, Walter Schubert, and Kyle Garcia have suggested using an equity collar to estimate DLOMs (“Determining Lack of Marketability Discounts: Employing an Equity Collar,” Journal of Entrepreneurial Finance, Spring 2015, http://bit.ly/2FWVso8). They correctly acknowledge that disposing of a financial instrument not only removes potential downside exposure (represented as buying a put option), it also removes potential upside exposure to the financial instrument (represented as selling a call option). As with the protective put, the marketability equivalence collar that gives a zero DLOM is adjusted by setting the exercise prices of the put and call options equal to the current fair value of the marketable security, yielding a nonzero but much smaller DLOM.
Ultimately, any use of option pricing techniques to estimate a nonzero DLOM implies arbitrage in a fair value framework. Using option pricing models that assume no arbitrage to estimate discounts that create arbitrage opportunities is contradictory.
Empirical studies used to support DLOMs have focused on initial public offerings (IPO) and the issuance of restricted shares. IPO studies estimate the DLOM as the percentage change of the price of shares pre-IPO (i.e., when they are nonmarketable) versus post-IPO (i.e., when they are marketable). Restricted share studies analyze the price differential between private investments in public equities (PIPE)—which are restricted from sale until registered—relative to their freely traded counterparts.
Because pre-IPO shares are typically issued to related parties and PIPE transactions are characterized by the compulsion to raise urgent funding, neither reflects transactions under fair value conditions. Furthermore, the majority of studies fail to isolate the impact of lack of marketability from the observed discounts. For example, John D. Emory Sr., F.R. Dengell III, and John D. Emory Jr. attribute the entire discount observed between pre- and post-IPO to lack of marketability (“Discounts for Lack of Marketability, Emory Pre-IPO Studies 1980-2000 as Adjusted October 10, 2002,” Business Valuation Review, December 2002, http://bit.ly/2BdEC0J). Anyone who has been involved in an IPO can attest to the plethora of risks and hurdles that need to be overcome for success. It is thus unreasonable to ascribe the price differential between pre- and post-IPO fully to a lack of marketability. Indeed, IPO studies have not been widely accepted because it is so difficult to eliminate the other factors that may account for the observed price differential.
The notion that a market participant would prefer a marketable instrument to one that is nonmarketable may be true, but this preference does not translate into a difference in value under fair value conditions.
Similarly, for PIPE transactions, issuance discounts cannot be fully attributable to post-issuance restrictions. In particular, secondary equity offerings issued to the public are also issued at discounts, and yet are not restricted from immediate sale. More recently, Robert Comment conducted a comprehensive study using over 1,100 PIPE transactions where he carefully isolated the impact of lack of marketability, as well as remedying other flaws in prior studies, and concluded that the DLOMs observed are no larger than 6% [“Revisiting the Illiquidity Discount for Private Companies: A New (and Skeptical) Restricted Stock Study,” Journal of Applied Corporate Finance, Winter 2012, http://bit.ly/2Bfxr8z]. Thus, even under unfair conditions such as PIPE transactions, the support for significant marketability discounts under fair value conditions is tenuous at best.
An Untenable Position
The notion that a market participant would prefer a marketable instrument to one that is nonmarketable may be true, but this preference does not translate into a difference in value under fair value conditions. When an instrument is temporarily nonmarketable, it is suboptimal to sell at a discount, and the application of a DLOM presents arbitrage opportunities in a fair value framework, which can lead to significant distortions for financial reporting purposes. While there may be transactions that exhibit marketability discounts, they do not conform to fair value conditions and therefore cannot be used to justify DLOMs in a fair value framework. Therefore, the application of DLOMs in a fair value framework should be rare and perhaps even limited to cases in which financial instruments are permanently nonmarketable.