Solving the valuation puzzle that illiquidity creates
What is the lack of liquidity?
A note or other investment asset that cannot be quickly converted to cash is an “illiquid asset.” In addition to notes, other investments of this type include limited partnerships, real estate, or investments in the securities or debt of a company that is low-priced, or not listed on a major stock exchange.
What is Marketing?
Marketability is a measure of an asset’s ability to be bought and sold. If there is an active market for a note or other financial asset, it has good marketability. Marketability is similar to liquidity, except that liquidity implies that the value of the asset is preserved, while marketability indicates that the security can be easily bought and sold – it is salable.
What is the challenge of illiquid assets?
The combination of credit turmoil, dysfunctional business conditions, and insufficient capital create significant valuation challenges for non-marketable assets. There is a lack of transparency, even in good times. The inability to collect information is a major handicap. The lack of liquidity reduces the value of the asset by the amount of a “discount for illiquidity”. Other things being equal, the less liquid the asset is, the less value it has. Measuring this discount and applying it in valuations of illiquid assets is always a challenge that requires experienced judgment.
What is fair market value?
“Fair market value” is the price at which the property would change hands between a willing buyer and a willing seller, with no obligation to buy or sell and both with reasonable knowledge of the relevant facts. For the trading of liquid assets in active secondary markets, valuations should reflect observable price quotes, recent transactions, or primary issue prices for identical assets.
For illiquid assets, if actual prices cannot be established due to illiquidity and lack of trading activity, an alternative approach is needed. The approach should reflect values that approximate the sales values in a hypothetical and orderly transaction.
Although it may not reflect an actual observable offer or transaction, “Fair Market Value” must be a market-based measure; its calculation should use assumptions that informed market participants would use.
How is an illiquid financial asset valued?
Experienced judgment is the key to valuing private and illiquid investments. It is not a mathematical calculation or a textbook process; it is a “judgment process.” Requires a solid understanding of the promissory note or financial asset. The goal is to reach a value conclusion that is 1) reasonably established and defensible; 2) uses methods accepted by investors who trade similar assets; 3) uses market information that is reliable and adequate.
Experienced judgment can be used, based on an understanding of the public markets that relate to the asset in question. This type of market experience is necessary to interpret the results within the context of industry conventions and dynamics. The assumptions underlying the illiquid asset valuation estimates should be based on the market, whenever possible, and obtained from reliable and independent sources.
It is necessary to decide the appropriate discount rate applicable to the note being appraised; your individual and unique risk/return profile should be integrated into the valuation process. Benchmark yields used for interpolation must bear some relationship to current and/or historical yields of comparable assets. This means that valuation experts must have experience in various disciplines, including trading, quantitative research, credit analysis, and structured finance.
Conclusion: Fair Market Value When a Market Is “Down” and “Unordered”
Fair market value is based on observation of transactions under current market conditions. But, if no buy/sell data exists to demonstrate the discounts that market participants apply to fully illiquid financial assets, assumptions must be made to arrive at fair market values. For illiquid notes and other financial assets, where a market may not exist, the appraiser must develop a fair market value approach based on a hypothetical market, incorporating the assumptions that potential market participants would use to purchase the security.
