Family Limited Partnerships: Supporting Valuation Adjustments

Usually when there is talk of a limited partnership structure in an estate plan, the individual or family is seeking to simplify an otherwise cumbersome process of gifting hard-to-value or hard-to-divide assets such as real estate, marketable securities, closely held businesses, or perhaps, even assets of a more peculiar nature. Of course, another benefit of this “simplification” can be a reduced estate and/or gift tax.

The typical valuation begins with a top-down analysis of the inventory of assets and liabilities inside the partnership. Underlying asset values are individually appraised by qualified experts or asset values are observed in the markets in which they trade. This part of the analysis establishes the aggregate net asset value of the limited partnership. Moving from this point to the conclusion requires a careful processing of what can be a large amount of additional information:

• What are the economic circumstances surrounding the assets?
• What are the cash flow characteristics inside the partnership?
• What are the terms of the partnership agreement?
• Are there any peculiar downside exposures or upside potentials?

Answers to these and similar questions help us to interpret the economics of the limited partnership interest and can help lead to a reasonable quantification of what are commonly referred to as minority and marketability “discounts”. The most important part of the limited partnership valuation analysis is quantifying appropriate discount adjustments. Discounts deserve careful support, which can be obtained from a variety of sources:

• Public Secondary Markets for Limited Partnership Interests. Units of previously syndicated real estate, oil and gas, and other investment partnerships have secondary markets in which a limited amount of trading takes place. Where pricing is reported by market makers, deep discounts to underlying net asset value are typical.
• Precedent Valuation Cases. It would be rare for the facts of a precedent court case to support a specific discount directly. However, it is clear from a reading of cases in general that courts do recognize that willing buyers and sellers adjust for the lack of control and marketability. More importantly, cases highlight the nature of credible evidence from valuation experts.
• Restricted Stock Studies. These studies compare the prices of shares in publicly traded companies that have issued both freely tradable stock and “restricted” stock. The studies assist in measuring marketability discounts.
• IPO Studies. These studies compare pre-offering private transaction prices to initial public offering prices across samples of companies that have gone public. The differentials can be quite large and tend to support marketability discounts for closely held securities.
• Closed-End Investment Companies. There is a tendency for the public markets to discount share prices of closed-end funds relative to their net asset values. Although their asset structures, organizational form, distribution policies, investment policies and other attributes can differ markedly from a closely held limited partnership, the valuation of closed-end funds corresponds, in a generic sense, to almost any fractional interest in assets.
• Real Estate Investment Trusts. REITs can be observed trading at discounts to their net asset values. Like closed-end funds, there are peculiarities of REITs that diminish their direct comparability to a closely held limited partnership. In spite of these limitations, REITs can give both an indication of the direction and magnitude of discounts to net asset value in a given market and they can provide an indication of long-term return expectations of minority interest investors in real estate portfolios.

Valuing a limited partnership interest can be complicated and time consuming. Whatever the level of complexity, careful documentation of the valuation process will benefit users of limited partnerships. There is a sound and reasonable framework for valuation, but there is no standard formula. Please call for more information or to discuss a valuation issue in confidence.

Reprinted from Mercer Capital’s Value Added^TM – Vol. 7, No. 4, 1995.