Presenters. Topics Covered

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1 Day 2, Session 13, Discounts for Lack of Marketability and Liquidity What the Heck is Going On? A Practical Response to New Attacks and New Support (presented at the AICPA s 2011 National Business Valuation Conference, held on November 6 8, 2011 at the Aria Resort & Casino, Las Vegas, NV) Presenters James Hitchner, CPA/ABV/CFF, ASA, Managing Director, Financial Valuation Advisors, Inc., Ventnor City, NJ Shannon Pratt, CFA, ARM, ABAR, FASA, MCBA, CM&AA, Shannon Pratt Valuations, Inc., Portland, OR Topics Covered As newer databases and models emerge, new attacks on the validity and magnitude of DLOM have also emerged. The speakers will tackle these issues head on. Highlights include: Review of a new book by Peter C. Dawson criticizing both traditional DLOM data as well as the validity of a DLOM, including potential double discounting Review of a new paper by Robert Comment that also challenges the magnitude of a DLOM and potential double discounting Review of other new DLOM critiques A new look at Ashok Abbott s research on liquidity A review of the new Pluris DLOM database Beginning of Session on Dawson s Book [ 00:03:08 through 00:03:30 ] Hitchner: and then I also received, and several of us in the industry received, a book by Peter Dawson that s a whole book, self published, but about an inch thick book that deals with discounts for lack of marketability and a lot of very, very new ideas and concepts that we are going to cover. The end of Shannon Pratt s Summary of Robert Comment s Paper [ 1:04:35 through 1:05:24 ]: As I have said many times, [real world] investors cherish marketability. Conversely, they extract a much higher cost of equity capital for lack of marketability compared to public companies. Most investors will not invest in equity where their capital is locked in, and those who do expect a much higher 1

2 return on their money. Unfortunately, Robert Comment s working paper is based on several flawed impressions, and I hope that after reading this he has a greater appreciation of the investors inclinations toward discount for lack of marketability. Jim Hitchner and Shannon Pratt on Dawson s Book [ 1:05:25 through 1:15:23]: And now we go over to a Hitchner: So, is it fair to say that you are not in any way shape or form in agreement with Mr. Comment s paper? Hitchner: Hitchner: Hitchner: I m in vehement disagreement. Is that the bottom line? [laughing] and now we will go over to another piece that a [laughing] You ain t seen nothing yet, right Shannon? [both laughing] Yeah. Jim Hitchner is gonna present the Dawson book. Yeah, I was, uh, Peter had sent it to me, and I think you may have gotten a copy, Yeah, I have. Hitchner: several people got it. We were asked to review it. And, so his book is The Economics of Business Valuation Discounts and Competitive Risk Return Paradigm, came out in August It is selfpublished. And here s the information on it. And this is a quote from his, the beginning of his book. This is him quoting himself: Peter is not, nor does he represent himself to be, an accredited business appraiser or an expert on generally accepted business valuation theory and practice. Although the content of this text appears to the present author at the time of publication to be sound and straightforward, it is essentially has not been peer reviewed. So, when I see those two comments in a book that criticizes DLOMs and traditional valuation methodology and severely criticizes professional appraisers that s this thick, okay, these two comments trouble me, alright, right off the bat. So, I m not going to say any more about that. It is the present author s opinion that the business valuation literature is somewhat scattered and perhaps in the early stages of its development. Shannon, how long you been doing this? 2

3 Hitchner: Um, over 40 years 40 years was my first testimony. Before that, I was at Portland State University, some refugee from the academic world. [both laughing] Hitchner: But, I mean, some things we do are in its infancy, some things we do are pretty far along. I mean, DLOMs have been around for a long time. They continue to evolve. But, I m not so sure we are in the early stage of development. Um, he says that there is compelling and convincing arguments that lead one to seriously question the validity of valuation discounts under the FMVS that [is] fair market value standard. Okay, and here s something that is pretty important: Since the Hypothetical Investor has a sufficient cushion of liquid investments to meet most unexpected events and he tends to have a long term investment horizon, he likely places a fairly low value on the short term liquidity of his longterm assets. In other words, he s saying that it doesn t matter. People that invest in long term investments, such as private companies, could care less about liquidity. Alright, that, in my experience and I ve been doing this since, I ve been doing valuations since 1980 um, is not the case. Does anyone in this room agree with that comment? I didn t think so. Shannon, I doubt that you agree with the comment [Pratt laughs]. Okay. the Hypothetical Investor is short term oriented. Where s that coming from? I thought the hypothetical investor was hypothetical. Alright, now it s a hypothetical investor that is being niched into a certain area. That s not in my experience. he places a non negligible value on control and liquidity the DLOC and DLOM are inversely related other desirable asset characteristics that may offset the negative impact of the DLOC and DLOM. He s also saying there s double discounting in terms of, if you do your traditional discount rate, that embedded in there is already a lack of marketability, lack of control and then you are discounting it again would be, in his opinion, double discounting. Shannon s going to do a piece after this that shows you otherwise. Um, The present author believes that subjective adjustments to [a] benchmark discount[s] are inherently unreliable. This quote ticked me off. Alright, so, 3

4 In addition, an appraiser s livelihood may depend on his ability to provide value to his clients, which in turn can depend (in part) on his ability to advocate for his clients. [Pratt laughs] See I m, J. Fishman, you re the only person in the room going like this, no, I m just kidding, [Pratt and Hitchner laugh] he s going like this, he s shaking his head. Alright. Is this something that happens? Of course it does. Does some of that kind of stuff happen in any kind of profession? Of course it does, but that s a pretty broad statement. The degree to which an appraiser is able to advocate for his clients may depend on his ability to to get the conclusions that the client wants. Alright. I, I don t do that. Most of the people I know don t do that. Do some people do it? Yeah, but those people that are advocates, we tend to know who they are, don t we? In your community, in your city, don t you know who the advocates are? And are they a majority, or a minority? Depends on where you re at, okay. In my experience, the majority are not. But there s always a small minority that are, but you can t do a blanket statement like that. He talks about I m going to run through these quick, I m not going to go through them all, but because I want to get to the questions... But, he talks about the flaws in the restricted stock studies, and one of the, he mentions the Bajaj 7 percent. He believes that that s a ceiling on the discount, that it should not be any higher than 7 percent. That, according to Bajaj analysis, that would be, it would have to be, that or lower in terms of application for discounts for lack of marketability. I think the 7 percent is crazy. Does anybody in here not think the 7 percent is crazy? You know, you can t go by feel, but it sure doesn t feel right. 7 percent, you know. Maybe it s not 50 or 60, but it s sure not 7, generally speaking, generally speaking. There are instances where a 50 to 70 percent discount is justified. In fact, I had one case where 90 percent discount was justified. Um, the [real world] person couldn t even get communication with the company, and even get financial statements. Hitchner: Okay, so the theme again is segmenting or niching the hypothetical buyer and seller, the hypothetical investor what he calls, in a short term and long term types of investors, and that, you know, longer term investors don t care about liquidity and so on. I m going to jump ahead in the slides because that s a repeating theme that, what I believe he is doing is violating the hypothetical buyer and seller and niching that into a specific area, and I think it is just wrong, Shannon would you agree? Oh Yeah. Hitchner: Typical minority investor accepts 7 percent maximum DLOM. He goes on to talk about the IPO and restricted stock studies but, again, I m going to go through the slides, he talks about the hypothetical investor, and what their needs are, and Shannon and I both disagree vehemently, I would say, with the concept that he s presented here in terms of niching who the hypothetical, the thing that you don t do with the hypothetical buyer and seller is niching. Its inclusive of what? All buyers and sellers. So, 4

5 Well, Hitchner: He also says the size premium, size and specific company risk capture these discounts and, if that s so, additional discounts will be double discounting. No, well, I should throw in one caveat here. It s okay to identify the potential buyer and seller as a category. In other words, maybe all family members, or all people with such and such characteristics, that s acceptable. Hitchner: Okay. No DLOMs, This leads the present author to conclude that a discount for a lack of market may not be applicable at all under the FMVS. In other words, no discount. Size premium, he says, is not generally accepted. Who in here uses a size premium for doing a discount rate? [laughs] Does that look generally accepted to you? Yeah [laughing]. Hitchner: Alright, do I need to talk anymore about that? So, this is getting pulled out of the air; that s a kind way to put it. Umm, appraiser integrity: the present author explains why, even when appraisers are as objective as they can be when making subjective adjustments, subjective adjustments are inherently unreliable. There s pressure on us to get the numbers. So, he does say that not all of these comments apply to all appraisers, but these are pretty severe attacks on the industry at large, and there just falsely, they re just wrong, and, and, and false. Alright, so he continues to talk about all these areas and he calls for some body or some group that should now be vetting peoples reports to make sure that they are not biased. Who s going to do that? I think the courts do that, don t they? So, in many cases. Questions at the End of Session 13 on Dawson s Book [ 1:35:49 through 1:36:14 ] Hitchner: Are you concerned that Dawson or Comment s articles will gain, or have they already, enough traction to be cited by the IRS or others? No. Hitchner: Trying to cut that off right now. I m not saying the IRS necessarily focused on it, but cut it off right there. Alright. 5

6 [ 1:37:26 through 1:38:02 ] Hitchner: Do you think Peter Dawson (I guess you could say Comment too) would be able to withstand a Daubert Challenge? [laughing] No. Hitchner: [continues to laugh] We are going to get through a lot of questions this way. [laughing] Can you expand on that answer? [laughing] No. I, I think Dawson has so many outrageously false premises in his book that [laughing] there is no way that he would withstand a Daubert Challenge. Slide 1: Peter C. Dawson Session 13 s Slides on Dawson s Book The Economics of Business valuation Discounts and the Competitive Risk return Paradigm First edition, August, 2010 Self published Peter C. Dawson o PhD, MA and BA in economics at the University of Connecticut o Taught 27 college economics courses in various economic subjects at several universities o Worked as an economist with the IRS for eight years petercdawson@yahoo.com Slide 2 Peter C. Dawson Peter is not, nor does he represent himself to be, an accredited business appraiser, or an expert on generally accepted business valuation theory and practice. (Preface, p. iii) Although the content of this text appears to the present author, at the time of publication, to be sound and straightforward, it has not been subject to an independent peer review process over a sufficient period of time to say that all the kinks and/or errors have been found and remedied. (Preface, p. iii) Slide 3 BV Profession Criticisms 6

7 It is the present author s opinion that the business valuation literature is somewhat scattered and perhaps in the early stages of its development. (p. 1) The author attempts to redirect business valuation theory away from a somewhat ad hoc approach, which includes some disconnected valuation steps and valuation adjustments, toward a more cohesive and consistent conceptual and theoretical framework. (p. 1) Slide 4 Discount Validity compelling and convincing arguments that lead one to seriously question the validity of valuation discounts under the FMVS. (p. 2) For a DLOC (DLOM) to be valid, at a minimum it should be applied to a base value that is a controlling (marketable) value. (p. 3) Since the Hypothetical Investor has a sufficient cushion of liquid investments to meet most unexpected events and he tends to have a long term investment horizon, he likely places a fairly low value on the short term liquidity of his long term assets. (p. 7) Slide 5 Hypothetical Investor In essence, the present author believes that valid DLOCs and DLOMs rest upon a minimum of the following assumptions: (1) the Hypothetical Investor is short term oriented, (2) he places a non negligible value on control and liquidity, (3) the DLOC and DLOM are inversely related to the degree of control and liquidity conveyed by, or associated with, ownership of an asset, respectively, and (4) other desirable asset characteristics that may offset the assumed negative impact that lack of control and lack of marketability have on Fair Market Value are assumed to be relatively small or non existent. (pp. 7 8) Slide 6 Alleged Appraiser Bias The present author believes that subjective adjustments to a benchmark discount are inherently unreliable. * (p. 10) In addition, an appraiser s livelihood may depend on his ability to provide value to his clients, which in turn can depend (in part) on his ability to advocate for his clients. (p. 10) The degree to which an appraiser is able to advocate for his clients may depend on his ability to provide a more favorable Fair Market Value conclusion, which in turn could depend on his ability to make subjective adjustments. (p. 10) 7

8 *This is in addition to the issue of using unreliable benchmark discounts to which subjective adjustments are applied. Slide 7 Restricted Stock Studies Flaws in Restricted Stock Studies? (p. 23) The primary reason why the restricted stock discounts that are typically cited by business appraisers are not reliable is the fact that they do not correct for or remove the influence of non marketability factors. (p. 23) Bajaj, et al. (2001) conclude that, after controlling for all other factors influencing private placement discounts, an issuer would have to concede an additional discount of 7.23% simply to compensate the buyer for lack of marketability (p. 114). (p. 26) Slide 8 Typical Long Term Investor The typical long term investor has a weaker preference for liquidity than the typical short term investor, which, in turn, means he does not value liquidity as much as the typical short term investor. (p. 27) Accordingly, the typical long term investor requires a smaller DLOM than the typical short term investor in order to be persuaded to purchase and hold a relatively illiquid long term asset. (p. 27) Slide 9 Typical Minority Investor Would Accept 7% Maximum DLOM Under the FMVS, the Hypothetical Investor is the typical investor in closely held interests. (p. 27) The typical investor in closely held business interests is a long term investor, or else he would not be willing to invest in closely held interests, which typically are long term assets (partly because they typically don t pay an annual dividend to third party owners, including the Hypothetical Investor). (p.27) That is, Bajaj et al. s (2001) 7.23% restricted stock DLOM likely represents the upper bound of a range of possible DLOMS applicable to a minority closely held business interest under the FMVS. (p. 27) Slide 10 IPO and Restricted Stock Discounts 8

9 IPO and Restricted Stock discounts are not reliable measures of the DLOM for closely held interests because they are determined in markets that predominantly are comprised of short term investors who directly own the IPO and restricted stock shares. (p. 31) The Hypothetical Investor is a well diversified investor, or else he has not behaved rationally and, therefore, he is not the Hypothetical Investor under the FMVS. (p. 51) This fact does not appear to be generally accepted among business valuation practitioners, however. (p. 51) Slide 11 Size and Specific Company Risk The present author believes that a small company size premium and a company specific risk adjustment to the present value discount rate are forms of a marketability discount because, in effect, they reduce the estimated market value of a subject company to account for the perceived fact that the subject company is less marketable, and therefore less desirable and valuable, relative to the average publicly traded company (based on size and other company specific differences between the subject company and the average publicly traded company). (p. 54) Slide 12 No DLOM Applicable This leads the present author to conclude that a discount for a lack of market, DLOM, may not be applicable at all under the FMVS. (p. 106) In other words, no form of discount for lack of marketability would be applicable under the FMVS. (p. 106) Slide 13 Size Premium Not Generally Accepted The application of a size premium to the present value discount rate (and thus to the capitalization rate) is not generally accepted in appraisal practice. (p. 170) An unsettled issue is, by definition, not generally accepted. (p. 171) Nevertheless, many appraisers appear to continue to apply a size premium in their calculation of the present discount rate. (p. 171) The present author believes that the application of a size premium is a combination of doublecounting of systematic risk (i.e., beta) risk factors and a nonsystematic risk adjustment. (p. 171) Slide 14 9

10 Appraiser Integrity Attacked In Chapter 11, the present author explains why, even when appraisers are as objective as they can be when making subjective adjustments, subjective adjustments are inherently unreliable. (p. 221) In this chapter he explains the incentives and pressures that may lead an appraiser to perform his subjective appraisal steps with less than full integrity, which would increase the unreliability of subjective valuation steps. (p. 221) Slide 15 Appraiser Integrity Attacked Perhaps it stands to reason that one should not rely solely on USPAP as a check on appraiser conduct. (p. 222) The motivation to pursue profit, along with the incentives and constraints faced by the typical appraiser, can impact an appraisal report s objectivity. (p. 222) The combination of relaxed external constraints and client pressures allows, and can promote, biased asset value conclusions. (This is not to suggest all, or even many, appraisers succumb to such pressures.) (p. 223) 10