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By Scot A. Torkelson, Vice President
INTRODUCTION
The relationship between risk and the applicable lack of control and lack of marketability discounts is a crucial part of the valuation of partial interests in holding entities. A common error among practitioners is the misapplication of lack of control discounts from one asset class to another. For example, lack of control discounts developed from data for operating companies may be erroneously applied to the asset class of marketable securities or the asset class of real estate holdings. Accurate risk assessment depends on using an asset-class-appropriate discount rate. Following is a discussion of various discounts based upon asset class with comparison charts to illustrate the differences.
LACK OF CONTROL DISCOUNTS
According to the Business Valuation Committee of the American Society of Appraisers, the term "minority discount" or "lack of control discount" is defined as "the reduction, from the pro rata share of the value of the entire business to reflect the absence of the power of control." The reverse of a lack of control discount is a control premium, as witnessed when a controlling interest in a company is purchased. Control premiums have been further studied as a basis for determining and justifying lack of control discounts for the various asset classes: operating companies, real estate holdings, and marketable securities.
Asset Class: Operating Companies
The studies for lack of control discounts most commonly look to the public markets. One study, published by W. T. Grimm and Partnership in Mergerstat Review, has been conducted for each year from 1990 to 1999. All public partnership control acquisitions of another partnership reported in each year were analyzed. Some years recorded up to 1,700 such transactions which supplies a strong database for their analysis. Over this ten-year period, according to the Grimm Study, the average premium paid over market ranged from 35.1% to 44.7%, implying lack of control discounts of 26% to 30.9%. Following is a representation of discounts from the Mergerstat Study, 1990 to 1999. Another study, published by Houlihan, Lokey, Howard, & Zukin, Inc. (HLHZ), analyzed 218 transactions in 1986 and 1987 and found average implied discounts of 29% to 33%, respectively.
Asset Class: Real Estate Holdings
In studies developing the applicable lack of control discounts for real estate holdings, the data is frequently developed from Real Estate Investment Trusts (REITs).
In one such study, conducted by Lance Hall and published May 1993, discounts for REIT properties averaged from four points to twenty-four points lower than lack of control discount rates for operating businesses (averaging 12 points lower over the entity's period) over the same period 1982 to 1991 meaning that the average discount for REITs over this period has been proximate to 22%. Thus there has been tremendous variability in market-derived discounts for REIT properties over the period, from a low of -5% lack of control discount in 1985 to a high of -40% lack of control discount in 1991. However, throughout this period, the discount for lack of control for REITs has been consistently lower than for operating companies (fig. 1).
Asset Class: Marketable Securities
The source of comparison for the development of lack of control discounts applicable to marketable securities can be found in closed-end funds and is provided by Morningstar, Inc. Morningstar is among the leading sources of data for such closed-end investment companies and is considered to be similar to what Standard & Poor's provides for the public stock and bond markets. We consider the data derived by Morning-star to be as reliable as Standard & Poor's. The difference between NAV (Net Asset Value) and market price for closed-end funds has trended in a narrow range from -2% to -13% over the past fifteen- years, averaging approximately 7.5%, or trending at approximately one-half the long term lack of control discounts indicated for REITs (fig. 2).
LACK OF CONTROL DISCOUNTS FOR MARKETABLE SECURITIES
Based upon these studies, the overall lack of control discounts for operating companies ranged from 26% to 33%. REITs, which relate to the real estate portions of a partnership, have ranged from 15% to 22%. For the closed-end investment funds, the data range from 6% to 12% for domestic equities at this time.
RISK & RETURN
The relationship between risk and the applicable lack of control discount is a crucial part of the valuation of partial interests in holding entities. As mentioned earlier, a common error among practitioners is the inappropriate application of lack of control discounts from one asset class to another. For example, the lack of control discounts from operating companies may be incorrectly applied to the asset class of marketable securities. The relationship of risk and lack of control discounts is demonstrated in the following chart. Expected returns were developed from Ibbotson Associates data available at this time.
As can be readily seen, the anticipation of higher returns is associated with higher risk in the marketplace, and the impact upon perceived risks on the absence of control reflects a higher discount as well. Simply stated, as an asset class becomes riskier the perceived need to control the assets becomes greater, and the disinclination for a partial interest leads to the higher applicable discounts. If an asset is perceived to be lower risk, then the danger of owning a partial interest is also lower as control becomes less of an issue. Thus, the disinclination of owning a partial interest in such an asset class is also less. Conversely, the ownership of a start-up company with high risks results in more dependence upon the management and its ability to control or direct the company. This inability by a partial owner to effect control in such higher risk enterprises results in the highest lack of control discounts.
INFERENTIAL APPLICATION TO LACK OF MARKETABILITY
The most common method of establishing lack of marketability discounts for non-controlling interests in stocks is to look at the discounts for a publicly-traded stock which has had blocks of its stock restricted
The most common method of establishing lack of marketability discounts for non-controlling interests in stocks is to look at the discounts for a publicly-traded stock which has had blocks of its stock restricted from open market sales. §144 Restricted Securities are also called letter stock. Letter stock is, therefore, identical to freely-traded public stock except that it is restricted from trading publicly for a specified period. Letter stock is typically issued when companies issue new stock or when (as in corporate acquisitions) registration of such stock with the SEC is not practical because of costs at the time or timing in the market.
Again, it must be noted that such a discount cannot be randomly applied to any given investment, due to the fact that all equities, from the lowest to highest risk stocks, were examined in this study. Further, data from the letter stock focuses upon operating companies. The same misapplication cautions must apply for lack of marketability discounts as for lack of control discounts; identify the asset class, then apply the appropriate asset class discount.
The most noted original lack of marketability discount study was conducted in the 1970s by investment banker Robert E. Moroney, "Most Courts riskier the perceived Overvalue Closely Held Securities," published in Taxes-The Tax Magazine, March 1973. His study examined 146 individual blocks of restricted equities. These blocks were discounted from 10% to 90% from their counterpart unrestricted securities. The average discount was 35.6%. Additional studies since this landmark study have essentially supported the conclusions of the Moroney study. Among these, Mr. Michael J. Maher published a study in September 1976, with the mean marketability discount for restricted stock at 35.4%. In yet another study, conducted in 1991 by Mr. Silber, the mean marketability discount for restricted stock was 33.8%. The most recent study, completed by Management Planning, indicated a mean discount of 27.7% and a median discount of 28.9%. Thus, the results of numerous §144 Restricted Securities analyses, show that the average for lack of marketability discounts has remained in a fairly narrow range from 28% to 36% for operating companies. All of the studies previously discussed were for operating companies exclusively, a class of assets with a considerable goodwill component and considerably higher risk than other asset classes. While the data considered can be useful it must be appropriately adjusted to the asset class being valued. With respect to quality and risk factors, real estate rates of return typically range from 10% to 14% annually (average of 12%) as of the current date, whereas return rates for operating companies, for example, range from a low of 18% for highly secured small capitalization companies to in excess of 35% (average of 25% shown on chart below -dark blue bar) for operating companies with extensive levels of goodwill. The publicly available information pertaining to marketability discounts is based upon these types of operating companies with much higher risk and therefore the expected higher yield levels required to attract investors. We estimate the lack of market ability discount for the asset class of real estate holdings at approximately a 15.0% lack of marketability discount, rather than the range of from 27.5% to 36% indicated for operating companies (dark gray and light blue bars). Data for marketability discounts is only available for operating companies, thus we must adjust these for the lower risk asset classes. We have estimated a reasonable lack of marketability discount from the available data for each asset class (light gray bar).
CONCLUSION
The application of discounts relative to the differing risk levels of asset classes is well-supported in the lack of control discount analyses where more precise data is available. We are of the opinion that the same relationship exists within the area of lack of marketability where such precise measures among the asset classes is unavailable. As can be seen in the previous chart, the lower risks of the marketable securities asset classes (cash equivalents) and the real estate asset classes result in a downward adjustment in the lack of marketability discounts indicated for operating companies.
The data provided in this article draws from a variety sources applicable to the various asset classes. In each instance, the specific partial interest holdings must be considered along with the current value date. The figures presented here should not be construed as the numbers to be used for these various asset classes in all cases. Rather, in this article, we are attempting to show the significance of the differences in discounts among the various asset classes. When asset-class-appropriate discounts are applied, the assessment of risk is supportable. The common error of misapplication of discount data from one asset class to another must be avoided.
