When it comes to valuing companies, the experts love nothing more than precision. Applicable cash flows will be adjusted for each extraordinary or non-recurring dollar, while the discount rate may be triangulated through different methods, resulting in a precise fraction. However, when it comes to determining the appropriate discounts for lack of control and lack of marketability, a sledgehammer is often used instead of a scalpel.
The sledgehammer approach typically results in the same discount conclusion for most valuations, regardless of the fact pattern. Why the discrepancy in diligence? From experience, we would say that many valuation experts don’t have good data for determining the appropriate discounts and don’t invest the time to understand the data they have. Herein, we seek to analyze a popular data source used in determining discounts for asset-holding entities. Along the way, we will not only learn how to interpret the data, but also how an advanced understanding of the data can help experts determine a spectrum of discounts for different scenarios. Most importantly, we will show that experts who do not know the data are most likely overvaluing your client’s investments by understating the discounts.
Data for determining discounts come in many different forms. Depending on the valuation question at hand, an expert may be using closed-end fund data, restricted stock data, pre-IPO data, secondary market partnership/real estate investment trust (REIT) data, or various other available sources. In this article, we will be focusing on limited liability company (LLC), REIT, and secondary market partnership data that are generally used for determining the discounts applicable to investments in private asset-holding entities (most commonly, companies that hold real estate assets). The most popular data used throughout the appraisal industry is collected and published annually by Partnership Profiles Inc. (PPI), and is referred to as the Survey of Re-Sale Discounts (PPI Study). The annual studies PPI prepares have included more than 400 publicly held real estate programs. While these programs are publicly registered with the Securities and Exchange Commission, they are not publicly traded. However, these interests trade in the secondary market, which consists of several independent firms that operate as the primary intermediaries between buyers and sellers of publicly registered but non-publicly traded real estate entities (including partnerships, limited liability companies, and real estate investment trusts). PPI uses the results of these trades as the basis of its studies. The primary indicator many experts look at is the discount (or premium) on their net asset values (NAV) at which the shares in these programs trade. The NAV is defined as the market value of the assets (primarily the real estate) less liabilities. The programs usually reported the NAV based on internal valuations and/ or appraisals prepared by third-party appraisers hired by the programs. In summary, by comparing the NAV per unit of each real estate entity with the actual price at which the general public purchased an interest, price-to-value discounts can be determined.
If having access to the PPI Study has put the expert in a position to analyze the discounts, then the next question is whether the expert understands the data relative to the discount. Is the discount for a lack of control? Is the discount for a lack of marketability? Or is it a combination of both? Perhaps most importantly, how do the characteristics of the PPI entities compare to the characteristics of a private entity?
With regard to the first question, we believe the discounts the transactions in the PPI Study exhibited are essentially combined discounts for lack of control and lack of marketability. The control element is relatively clear-cut, with the minority investor having no control over such considerations as:
The lack of marketability issue is a little more complex. The entities included in the PPI Study trade in the secondary market, which is supported by several intermediary firms that match up buyers and sellers. However, the market is not very efficient because there is a limited number of buyers and it can take several months to complete a transaction. The process is certainly nothing akin to a publicly traded security, for which you can call your broker and immediately attain liquidity. On the other hand, the market created by having several intermediary firms is significantly more liquid than that available to most of the private real estate holding entities that have no established intermediaries or seasoned buyers whatsoever to offer liquidity to their investors. To muddy the waters a little more, the liquidity of the market for the programs PPI examined has improved over the years. During the late 1990s, there was an influx of buyers to the market when the financial reports and other public filings became easy to obtain online via the Security and Exchange Commission’s Electronic Data Gathering, Analysis, and Retrieval (EDGAR) filing program. Finding knowledgeable buyers became easy. As expected, along with a shortening of the holding period, we have seen a drop in the average discounts published in the annual PPI Study. So where does that leave us with regard to the discount for a lack of marketability? All else being equal, the discount the PPI Study reflected is a combined discount for lack of control and “limited” marketability. It therefore stands to reason that any discount determined for a private real estate investment should include the addition of some incremental discount for the higher degree of illiquidity associated with a private entity in comparison with the programs in the PPI Study. All of this takes place under the heading of “all else being equal,” as this portion of the analysis does not consider differences in performance, use of leverage, property type, or the terms of the governing documents. Clearly, the ability to sell your interest and create liquidity for your investment plays a significant role in determining the appropriate discount.
So what else do we know about how the PPI Study impacts the discounts? We know that the publishers of the data go to great lengths to only include entities and transactions with consistent fact patterns when it comes to factors impacting control and marketability. To be eligible for the PPI Study, the program must:
The publishers of the PPI Study present the above factors. They also disclosed that the majority of programs in the most recently published studies are REITs. There are numerous differences between the unlisted REITs and a private partnership that PPI identifies in its annual study. However, something that may not be well known by the appraisal industry and is not highlighted in the PPI Study is that nearly all the REITs included in the study offer share redemption programs (SRPs) to their investors. Through the SRPs, the REITs provide their investors liquidity by periodically redeeming outstanding units from the investors upon request at prices the REITs set. The REITs typically set a budget for the redemption program every year and redeem units throughout the year as they are requested and until the budget is exhausted. The redemption programs and budgeted amounts can differ from one REIT to another and from one year to the next. Budgets for the SRPs are often tied to funds available from the dividend reinvestment programs the REITs offer. Typically, the SRPs have the following characteristics:
While PPI aims to exclude from its annual study any program entity that has definitively stated plans to liquidate, the publication has not excluded any of the REITs that offer investors liquidity through an SRP. Given that the REITs readily purchase outstanding units at prices set at a high percentage of NAV and not based on secondary market pricing, the inclusion of these transactions in the PPI Study limits comparability to private entities that have no such programs.
For instance, consider Corporate Property Associates 18 (CPA:18) – Global Inc., a publicly owned, non-traded REIT included in PPI’s 2018 study. CPA:18 maintains a quarterly redemption program that offers to purchase the shares of any shareholder at a price equal to 95% of the latest reported NAV (the same NAV used in the PPI Study). The only limitations or restrictions stated in their annual reports are that sufficient funds must be available to redeem the shares and the shares redeemed during the year cannot exceed 5% of the total outstanding shares. CPA:18 fulfilled all redemption requests made last year. Also consider Black Creek Diversified Property Fund Inc. (Black Creek), another publicly owned, non-traded REIT included in PPI’s 2018 study. Black Creek maintains a monthly redemption program that offers to purchase the shares of any shareholder at a price equal to 100% of the latest reported NAV. The only limitations or restrictions stated in its annual reports are that shareholders must have held the shares for one year (or receive a price equal to 95% of the NAV) and the shares redeemed during the quarter must not exceed 5% of the total NAV. Black Creek fulfilled all redemption requests made in the latest year. Transactions included in the 2018 PPI Study for CPA:18 and Black Creek reflected discounts of 1% and 6%, respectively. The liquidity the redeeming programs offered to investors has clearly influenced the secondary market pricing. Based on the terms of the SRPs, these REITs offer investors better liquidity options and shorter investment horizons than what is available in the liquidating partnerships that PPI excludes from the study.
After going through the terms of the SRPs in the public filings of all the REIT programs, Stout has separated the data in the 2018 PPI Study into two groups: (i) REIT programs with active unrestricted SRPs; and (ii) REIT/partnership programs with no SRPs or heavily restricted or suspended SRPs. The REIT programs in the 2018 PPI Study that have active SRPs reflected an overall mean discount for lack of control and limited marketability of approximately 14.7%, while the programs with no SRPs (or suspended or heavily restricted SRPs) have an overall mean discount of approximately 26.5%. The correlation of the lower discounts associated with the programs that offer active redemptions is so strong that a bifurcation of the transactions reported in the PPI Study between redeeming and non-redeeming programs is critical for a meaningful comparison with a private entity. Comparing a private entity to the entire database of transactions in the PPI Study without accounting for this liquidity is a good example of how the applicable discount can be understated because your expert doesn’t know the data.
One of the exciting benefits of knowing your data is that you begin to understand the spectrum of discounts for lack of control and lack of marketability that may be reflected in the data. For example, most practitioners would agree that a true minority interest in a private family partnership does not have control or marketability and should be able to avail itself of the full discount upon analyzing the data and drawing the appropriate comparisons. How would this conclusion change if the interest in question were a majority interest with significant rights, including the ability to begin a dissolution of the entity? Would some reduced discount be appropriate? How about if the interest in question were the general partner of the partnership? How about if the interest were a general partner, but only one of many? The relevant observation here is that the discount is not an on-off switch but rather a continuum of potential rights, preferences, and privileges that will impact the overall discount conclusion. This continuum has given rise to such concepts as lack of full control, limited control, or control premium and its marketability counterparts of lack of marketability, limited marketability, or full liquidity. And, while your expert may understand the concepts behind the various levels of control and marketability, how you quantify the incremental steps and properly support the conclusion may not be as clear. Analyzing the non-redeeming programs of the PPI Study separately from the redeeming programs is one way to further this understanding.
But wait – there may be more. Enter for our consideration an excluded data set of the PPI Study that analyzes programs that have announced imminent liquidation. As detailed in the 5th edition of the Comprehensive Guide for the Valuation of Family Limited Partnerships, the nice folks at PPI have provided an updated study of those entities that have announced near-term liquidations. To be included in the study, the requirements are:
The program must have reported a near- term (within nine months) plan to liquidate, whereby virtually all the program’s assets were contracted for sale through a sale or merger agreement at the time of the announcement:
Based on the data PPI compiled, investors in the secondary market are buying interests in liquidating programs at an average price-to-value discount of 14%. It is not surprising that the average discount of 14% is comparable to the average discount of the redeeming programs. Some level of risk and uncertainty to attain full liquidity (cash) exists for investors in either program, and, yet, the time frame to get there is very similar. The prior liquidating partnership study PPI conducted in 2000 resulted in a similar discount indication of 16%. In other words, minority investors demand a significantly reduced discount to NAV once a liquidation has been announced. This makes conceptual sense, as the illiquidity component has been virtually eliminated by the proposed liquidation and, along with it, the lack of a control component, as control will be attained upon distribution of the proceeds. On the other hand, it also makes sense that some discount is still applicable for the uncertainty of the liquidation proceeding (a typical dissolution will require investor approval and a filed proxy statement with the Securities and Exchange Commission) and the uncertainty of the period (generally several months after the announcement).
With this additional information, the valuation expert is now in a better position to fill in more of the spectrum of potential valuation discounts. For example, the valuation of a minority interest in a family limited partnership that holds real estate might start with the PPI Study and subsequently adjust for the increased illiquidity of the interest in the private entity relative to comparable programs in the PPI Study. Further, this discount would be best determined by a comparative analysis with the non-redeeming programs only, as they are the most comparable to a private entity in terms of illiquidity. Valuing an interest in an entity that provides some future opportunity to put your interest back into the entity or contains very opportunistic buy-sell provisions is not a problem if you lean on the PPI data with active redemption programs. How about a majority limited partner interest that can initiate a dissolution of the partnership but cannot remove the general partner? Look no further than the PPI Liquidating Program Study.
Understanding the data and the correlating discounts of the various programs is the first step of a sound analysis. Once the appropriate programs have been identified, a specific analysis based on performance characteristics should follow. Based on the findings of the PPI Study and verified by appraisal experts, some of the strongest correlators to the size of the discount are the level of distributions, the level of debt the entity used, and the property type. Assuming that your expert’s initial selection of the appropriate program left enough data points for further specificity, sorting the remaining data by the factors outlined above will bear the best comparative analysis. To provide one example of the potential impact of specificity, over the years, the studies PPI published have provided an average discount of approximately 42% for real estate-holding entities that hold undeveloped land and have no distributions, while the average discount for entities holding triple-net-lease income-producing properties is approximately 17%. This is clear support for the theory that giving up control and liquidity is not nearly as painful when you have a long-term lease in place and are receiving an immediate return on your investment. Risk matters – and the riskier the entity, the higher the discounts tend to be.
When preparing a comparative analysis of a private entity with the programs in the PPI Study based on financial characteristics, it is important to understand another key difference between REITs and other pass-through entities, such as a limited liability company, a partnership, or a subchapter S corporation. This is especially important now that the vast majority of the programs contained in the PPI Study are unlisted REITs, which are subject to different taxation than the partnerships in the study and other pass-through entities. For all practical purposes, REITs are generally exempt from taxation at the trust level as long as they distribute at least 90% of their taxable net income to their shareholders. The dividend payments the REITs make may be taxed to the shareholder as ordinary income or capital gains or treated as a return of capital. In contrast, investors in the pass-through entities are taxed based on their share of the taxable income the entity generated. The pass-through entities are not required (unless stated in their governing documents) to distribute all or any of their taxable income. Therefore, minority investors in the pass-through entities may be exposed to taxable income from which they receive no money (phantom income). Imagine a partner- ship that only pays out enough to cover the tax liabilities of the partners associated with the pass-through income of the partnership (a relatively common policy of private partnerships). The investor in the partnership receives distributions that must then be used to pay taxes. In essence, the investor is left with no cash return. Since investors in the REITs are only taxed on the income they receive, the investors will always have cash remaining after they pay their taxes. Since the investors in such pass-through entities will be subject to greater tax per dollar distributed than the unitholders in the REITs, the distribution yields are not directly comparable. The distribution yields of the pass-through entities are often less attractive than indicated in a direct comparative analysis with the REITs. Further, the requirement that REITs distribute at least 90% of their taxable earnings reduces the possibility of minority investors receiving an after-tax cash yield on their investment. Lack of consideration of this key difference between a REIT and a typical private real estate-holding entity could further result in an understatement of the discount.
What you don’t know won’t kill you. But when it comes to being an expert appraiser, what you don’t know about the data might very well cause the client or the planner to want to kill you when the IRS comes auditing or you leave valuable planning dollars on the table. This article addressed one of the many data sets appraisers use, and yet a similar approach based on understanding the nuances of the data is equally pivotal with other data. If you know your data, not only can you be a better resource to your clients, you can also put yourself on firmer ground in the defense of your work.
This article originally appeared in Business Valuation Resources, LLC.