Business appraisers and securities valuation experts are frequently called upon to determine the fair market yield of private fixed income securities. Such engagements can include determining the preference rate in recapitalizations involving preferred units, such as freezes; structuring the terms of private notes in transactions; or determining the Fair Market Value of existing promissory notes or preferred stock.
Financial theory and literature has well-established methodologies for determining the marketable values of fixed income securities. In practice, valuation experts generally start by determining the applicable credit rating of the fixed income security by performing a ratio and coverage analysis of the underlying debtor. The analysis continues by screening publicly traded comparable fixed income securities with a similar credit rating and terms (e.g., time to maturity, amortization, call/put features, floating vs. fixed rates, etc.); and then selecting the applicable yield for the fixed income security at hand. For private fixed income securities, further adjustments are often warranted due to differences with their publicly traded comparables, including the private note’s lack of a debenture, lack of regulation and oversight, lack of credit rating, and lack of marketability. We refer to the applicable yield of a private fixed income security as the “fair market yield.”
When valuing private fixed income securities, appraisers will often subjectively increase the yield to account for certain of these factors, as limited empirical data exists for measuring their economic impact. Although subjective adjustment is necessary for some differences between publicly traded and private notes, we believe that the widely accepted restricted stock studies, which have been used in the past primarily when appraising equity securities, may be helpful in determining the applicable adjustment to the yield of private notes for their lack of marketability.
Overview of Restricted Stock Studies
Since 1971, there have been over a dozen studies that have compared the quoted price of freely traded public stock to the price at which restricted stock of the same company was purchased in a private placement. Restricted stock is identical to freely traded stock except for temporary restrictions that preclude it from trading on the open market for a certain period of time. Such restrictions are contained in SEC Rule 144 (“Rule 144”), which governs the purchase and resale of restricted securities. Since restricted stock studies compare the prices that investors are willing to pay, at the exact same point in time, for two otherwise identical securities, with one being fully liquid and the other having liquidity-related restrictions, the results of these studies serve as a useful starting point in assessing an appropriate discount for lack of marketability.
Although the restricted stock studies are primarily utilized for measuring the lack of marketability of privately held stock, we believe they may also be useful in determining the fair market yield of a private fixed income security. In fact, many of the differences between private notes and the securities underlying the restricted stock studies are already being considered by appraisers when valuing private stock, including risk, cash flows, and the time until liquidity can be achieved.
As presented in the table Summary of Restricted Stock Studies, average discounts attributable to restricted stock have ranged from 10.9% to 45.0%. As can be seen in the table, the marketability discounts implied from the restricted stock studies have generally trended downward over time. The decline in average discounts reflected in more recent restricted stock studies may be largely attributable to changes in securities laws that had the effect of enhancing the liquidity of restricted stock. Prior to 1990, institutional investors that purchased restricted stock and did not register the stock had a minimum holding period of two years before the stock could be sold in the public market. Average restricted stock discounts reflected in pre-1990 studies generally ranged from 25% to 35%.
In 1990, the SEC adopted Rule 144A. Rule 144A enhanced the liquidity of restricted stock by permitting qualified institutional investors to trade unregistered securities among themselves. This increased liquidity (which resulted in potentially shorter holding periods for institutions due to the elimination of the minimum two-year holding period for unregistered stock) resulted in lower negotiated restricted stock discounts. Average restricted stock discounts reflected in studies prepared subsequent to Rule 144A, but prior to the 1997 amendment, generally ranged from 20% to 27%.
In 1997, the SEC reduced the required holding period imposed by Rule 144 from two years to one year. Although there are few post-1997 empirical studies of restricted stock, the limited data available indicates that average restricted stock discounts were lower still relative to previous studies. In particular, the Columbia Financial Advisors studies referenced in the Summary of Restricted Stock Studies table determined average restricted stock discounts of 13.0% and 21.0%. In addition, Business Valuation Resources analyzed 187 post-1997 transactions included in the FMV Opinions Restricted Stock Database and found average and median discounts of 23.8% and 21.0%, respectively.
In 2007, the SEC further reduced the required holding period for the resale of restricted securities for both affiliates and non-affiliates of a reporting issuer from one year to six months, effective February 15, 2008. This amendment to Rule 144 was enacted with the stated objectives of increasing the liquidity of privately sold securities of public issuers and decreasing the cost of capital for all issuers without compromising investor protection.
Following the SEC’s most recent reduction to the required holding period, Stout conducted a study (the “Stout Study”) of restricted stocks that analyzed the time period incorporating transactions in the few years both before and after the most recent changes to Rule 144. In this manner, the Stout Study provides updated data and analysis to measure the impact of a shorter holding period on restricted stock discounts. The Stout Study found transactions with average and median discounts of 10.9% and 9.3%, respectively.1 The overall indicated discounts reported in the Stout Study are lower relative to the previous market studies due to the presence of registration rights in a majority of the restricted stock transactions, which effectively reduced the holding period to even less than that mandated by the Rule 144 minimum holding period.2
Factors that Impact Marketability
As evidenced by the declining discounts from the restricted stock studies, an investment’s expected “holding period,” or the period of time before liquidity can be achieved, is a major driver of its marketability (or lack thereof). All else being equal, the longer the expected holding period of an investment, the greater the discount for lack of marketability. Thus, as the Rule 144 holding period restrictions have shortened, the implied discounts have declined.
In addition to holding period, appraisers generally consider other factors that impact a security’s level of marketability. Based on our review of the restricted stock studies, we have identified several additional factors that demonstrate a strong relationship to the size of restricted stock discounts, mainly the security’s risk and volatility and its level of distributions. In general, as the risk profile of a security increases, its discount for lack of marketability should also increase. On the other hand, as the level of distributions increases, the discount for lack of marketability should decline.
Quantifying the Yield Adjustment Due to Lack of Marketability
As discussed earlier, when determining the fair market yield of a private note, appraisers should first determine what the yield would be if the note were publicly traded on a regulated exchange (the “publicly traded yield”). In such a case, the note would have an indenture, which is a legal and binding contract between a bond issuer and the bondholders that specifies all of the important features of a bond, such as its maturity date, timing of interest payments, method of interest calculation, callable/convertible features if applicable, and so on. In addition, the indenture may include covenants, which are designed to protect the investor by forbidding the issuer from undertaking certain potentially risky activities such as incurring additional indebtedness or selling assets. If the private note being valued lacks any of these protections, then an upward adjustment to the publicly traded yield may be necessary. We call this adjusted yield the note’s “marketable yield,” as it represents the yield of the private note as if it were freely tradable. This would represent the coupon payment on a fully marketable note if issued at face value (the “hypothetical marketable coupon”). However, private notes often are not marketable. Thus, the final step in determining the fair market yield of the private note is to consider its lack of marketability.
Similar to accounting for other differences between publicly traded and private notes, in determining a private note’s fair market yield, the marketable yield should be incrementally adjusted upward to account for lack of marketability. Given that fixed income prices decrease as yields increase, the resulting diminution in value captures the lack of marketability of the private note. By calculating the present value of the “hypothetical cash flows” of the note (its future hypothetical marketable coupon payments and face value at maturity), discounted at the fair market yield, we can measure the implied “discount for lack of marketability” from that value by comparing it to the value of the fixed income security based on the marketable yield (the “marketable value”).
The adjustment to the marketable yield when seeking to capture the impact of lack of marketability can be thought of as a scale. As percentage points are added to the marketable yield to account for the note’s lack of marketability, the present value of the hypothetical marketable cash flows declines. It is the appraiser’s job to determine exactly how much of an adjustment should be made. If too great of an adjustment is made to the marketable yield, the fair market yield will be too high and the present value will be too low. If too little of an adjustment is made, the fair market yield will be too low and the present value will be too great. We believe that the restricted stock studies can help appraisers determine how much to adjust the marketable yield by analyzing the discount between the market value of the note and the present value of the hypothetical marketable cash flows as marketability adjustments are made to the marketable rate.
In determining the necessary discount for lack of marketability from the present value of the note’s hypothetical marketable cash flows (and the required adjustment to the market yield to result in such a discount), the appraiser should consider the differences between the restricted stocks and the private fixed income security.
In general, the discounts for restricted stocks should be greater than private fixed income securities, all else being equal. This is because fixed income securities generally receive regular coupon or preference payments, which should increase marketability. This factor should also reduce volatility. Additionally, notes and preferred equity are senior to common equity, reducing their risk profiles, especially if the fixed income security has high seniority compared to other financing sources. This factor should also reduce volatility. Appraisers should also consider the risk profile of the company issuing the private note as well as those from the restricted stock studies. Consideration of the underlying company’s size, revenue, earnings, and volatility may all have an impact on the discount for lack of marketability. Finally, a comparison of the holding period of the private note should be made to the restricted stocks. The duration of private fixed income securities may be significantly longer than the effective holding periods of the restricted stock studies, which should increase the discount for lack of marketability.
In the following example, we assume an appraiser is asked to determine the coupon of a to-be-issued private note so that the note’s face value equals its Fair Market Value. The note will be issued by a private manufacturing company. The note agreement has the following provisions:
Based on the risk profile of the private note, the appraiser determines that on a publicly traded equivalent basis it would have a credit rating between BBB- and BBB+. The appraiser then searches for publicly traded bonds having a similar credit rating with similar terms, and locates a universe of bonds that are deemed to be comparable. In many instances, an appraiser will eliminate bonds classified as structured repackaged asset-backed securities, convertible preferred securities, putable or callable bonds, sinkable issues, government agency bonds, or U.S. taxable municipal bonds, as these securities may not be comparable to the terms and characteristics of most private notes. On a publicly traded equivalent basis, the appraiser estimates the yield on the private note to be 4.0%. Given, however, that the note has additional risk factors relative to publicly traded bonds, including the lack of an offering prospectus, an indenture, regulatory oversight, and access to audited financial statements, the appraiser selects a marketable yield of 5.0%. Based on a face value of $10,000,000, this results in a “hypothetical marketable coupon” of $500,000 per annum. Given that the marketable yield and the coupon rate are the same in this case, the face value should equal the value of the note on a fully marketable basis (the marketable value).
To determine the lack of marketability adjustment to the marketable yield, the appraiser compares the risk profile of the private note to the stocks in the restricted stock studies. He considers the volatility of the guideline bonds compared to the volatilities published in certain of the restricted stock studies (the Stout Study notes a strong correlation between the volatilities and marketability discounts of its analyzed restricted stock transactions). The appraiser also makes a comparison of the risk factors of the company issuing the private note to the restricted stock companies, and considers the risk differences in the equity of these companies to the debt of the subject company. The appraiser also considers the difference in the estimated holding periods of the restricted stock and the duration of the private note (although this will be an iterative calculation based on the selected fair market yield).
Based on a thorough analysis of the factors, the appraiser determines that the discount from the note’s marketable value should be approximately 20% to account for lack of marketability. To determine what the fair market yield must be, the appraiser models out the note’s hypothetical marketable cash flows and discounts such cash flows at a Fair Market Value yield (the variable he is solving for). The appraiser then adjusts the Fair Market Value yield until the present value of the hypothetical marketable cash flows of the note, when discounted at the fair market yield, reflect the appraiser’s sought out discount relative to the market value. Ultimately, in this case, the yield must be increased to 6.5% to result in an approximate 20% “discount for lack of marketability” between the present value of the hypothetical marketable cash flows at the fair market yield and the marketable value of the note. Accordingly, the appraiser determines that the coupon of the note should be $650,000, based on a fair market yield of 6.5%. At this coupon (and based on the fair market yield of 6.5%), the Fair Market Value of the private note equals its face value of $10,000,000.
Although the restricted stock studies are widely used for determining the applicable discount for lack of marketability of privately held stocks, appraisers may consider them useful in determining the applicable adjustment to the yield of private notes for lack of marketability. These studies may help to remove some of the inherent subjectivity that is present in an appraiser’s determination of the Fair Market Value of private fixed income securities.
1 Aaron M. Stumpf, Robert L. Martinez, and Christopher T. Stallman, “The Stout Risius Ross Restricted Stock Study: A Recent Examination of Private Placement Transactions from September 2005 through May 2010,” Business Valuation Review, Spring 2011, pp. 7-19.
2 The Stout Study considered the amount of time elapsed since the completion of the transaction and the date the shares were ultimately registered, noting the average amount of time elapsed was approximately four months.