The Hertzel/Smith Study

Certain appraisers rely upon academic research in their determination of the magnitude of the marketability discount to a marketable minority interest of value.  We thought it appropriate to review one such piece of academic research to determine its content and applicability to the ongoing debate.

In 1993 a paper was published entitled “Market Discounts and Shareholder Gains for Placing Private Equity” by Michael Hertzel and Richard L. Smith.¹  It has drawn attention (and been quoted) for its observations about discounts observed in private placements.

Overview of the Study

The objective of the Hertzel/Smith study was to determine the underlying reasons for discounts observed in the pricing of securities in private placements and the positive abnormal returns associated with the announcement.  While illiquidity associated with unregistered stock seemed to provide a partial explanation, “it is not clear why investors require, and firms are willing to accept, such sizable discounts.”²

The authors used a sample of private placement announcements from January 1, 1980 through May 31, 1987 .  The information was derived from a variety of public sources.  The study identified 106 transactions (of which 18 were for unregistered shares) with some two-thirds of the observations occurring in the second half of the study.  Mean and median discounts were 20.14% and 13.25%, respectively.  The authors also found an additional discount of 13.5% for placements of restricted shares.³  The range of discounts for the 106 observations is not explicitly stated.  However, the data seems to suggest lower discounts (less than 10%) for the larger companies in the study (market value greater than $75 million) to the higher levels (approximately 35%) for companies with less than $25 million in market value.

In summary, the total discounts observed seem consistent with a number of other private placement/restricted stock studies.  Hertzel and Smith attempt to analyze private placement discounts to determine what factors may influence the size of the discount, rather than simply saying it was a marketability discount due to illiquidity.

Hertzel and Smith concluded that the private placement discounts were influenced by:

• The costs incurred by private investors in the resolution of informational asymmetry about the firm.  Stated alternatively, when value is more difficult to ascertain, investors will expend more resources to determine value and thus require larger discounts.
• lliquidity of the unregistered stock.
• Compensation for expert advice or related monitoring services provided by the private investor.
• Changes in the ownership structure of the firm.

The size of the private placement discount tended to increase as the:

• The opportunity for resale decreased.  To quote the paper “the information hypothesis implies that discounts will be larger for placements where opportunistic resale of the shares is precluded.  A longer required holding period provides an incentive for private placement investors to incur additional costs to assess firm prospects.”⁴
• Size of the placement decreased (measured by dollar size).
• Firm size decreased (as measured by the market value of equity 30 days prior to the announcement).
• Difficulty in assessing the underlying value of the firm increased (as proxied by financial distress, speculative products and book to market equity).
• Placements where the value of intangible assets is an important component of firm value.

Mercer Capital’s Observations of the Study

The authors further concluded that a private placement was evidence that management believed that the subject company was undervalued in the marketplace.  In essence, the private placement was cheaper in that management believed that the existing shareholders would retain a higher proportion of ownership with a private placement than with a new public issue of stock.

Hertzel and Smith concluded the additional discount of 13.5% for private placement of restricted shares was consistent with the belief that restricting resale of the shares was costly for the selling firm (and presumably more risky for the purchasing shareholder).  Nevertheless, the authors expressed some skepticism that the restrictions on resale would result in a discount so high. They note that restrictions on resale would not be important to many investors in private placements, as they are long term investors.  The following comment is found in a footnote of the paper: “…given the substantial resources of institutions that do not value liquidity such as life insurance companies and pension funds, it is not obvious that investors would require substantial liquidity discounts just for committing not to resell quickly.”⁵

The authors do not explain why they believe that insurance companies or pension funds do not value liquidity.  However, that is not important to the essential point.   The fact that the reason for the discount is not obvious does not render the existence of the illiquidity discount untrue.  The reality seems to be that their study isolates a substantial discount for the inability to dispose of a stock quickly (illiquidity).  Secondly, the investment attitudes of long-term investors do not serve to reduce the aggregate discounts in their sample.   The total discount exists whether they value liquidity in its purest sense or not.

The authors believe that informational effects are critical in understanding the magnitude of the discounts.  In essence, a private placement resolves the informational asymmetry in the marketplace.  As the difficulty in measuring and assessing value rises, the discount was also observed to rise thus compensating the investor for the costs associated with assessing the firm value.  Given that small firms were more likely to be the most difficult to assess, it is not surprising that the higher discounts were associated with this group.  To the extent that the investment appeared to be in an “opportunity” as compared to a more developed business, the discount would be higher, once there is a linkage to smaller size as a proxy for higher risk.

Another example of higher risk requiring a discount was the observed increase in the discount of 9% when the firm was evidencing financial distress.  Once again, higher risk translated into a higher discount.  Does this mean that higher financial risk means that an additional 9% is automatically added to the computation of the discount?  Of course not.  It only proves that the discount is likely higher (with this one factor isolated from the others) and that a higher return for risk must be explicitly considered.  The impact of risk on the final conclusion of the discount must be taken in context with all of the other factors.

The authors also consider a broader definition of the “costs” of a public offering as compared to a private placement as a further means of understanding the discount.  They suggest that a private placement “avoids the negative public issues announcement effect, the underwriter spread, residual underpricing, and other costs not reflected in the spread.”⁶  The authors immediately caution the reader that “simple cost comparisons can be misleading.”⁷  For example, Hertzel and Smith suggest that the shares of companies which used a public offering to raise funds exhibited adverse share price movements, effectively raising the cost of the offering.  Nevertheless, the differentials in cost do not appear to fully explain the discount according to the authors.  This concept of cost can be very meaningful given the propensity of some appraisers and the courts to consider only the direct underwriting as a cost of raising funds in the public market.

The study also examines the impact of the ownership changes on the observed discount.  Seventy of the 106 transactions reported sufficient data to be analyzed.  Lower discounts were often observed when there was a change of control or an infusion of cash by investors who previously owned a significant portion of the outstanding stock.  Changes of control were described as events, which could influence corporate governance.  Single buyers were more likely to cause a visible change in influence than passive investors were.  The authors ultimately concluded; however, that change of ownership concentration was not a variable with a high potential for explaining discounts in their sample.

Conclusions for Business Appraisers

What can business appraisers draw from this paper?

• The discounts observed in the private placement of securities to the freely traded price are real and observable over time.
• The reasons for the discount are subject to debate, particularly the degree to which the discount is derived purely from illiquidity features.
• Hertzel and Smith argue that informational asymmetry is a substantial portion of the discount, not illiquidity.  Others might simply reply that informational asymmetry is a cause of illiquidity.  (This topic will be the subject of a future issue of this newsletter.)
• Business appraisers’ use of the term “Discount for Lack of Marketability” may lack specificity from the perspective of academic writers in that it includes all of the reasons for the discount to the freely traded price.  Those who rely on Hertzel and Smith to prove that the marketability discount is only 13.5% are guilty of omitting other essential factors in determining the total discount to the freely traded price.  The collective ability of appraisers and academics to agree as to how the discount should be “sliced and diced” may be limited; however, no one should selectively take portions of this paper without considering the work as a whole.
• Risk, however measured, is extremely important in assessing the discount.  Since the market had already priced the shares in the sample at the marketable minority level of value, some additional risks are being borne by the private placement investors.  As the risk rises, so does the private placement discount.
• Hertzel and Smith isolated a discount for illiquidity, but were unable to explain it to their own satisfaction.

The work of Hertzel and Smith and other academics studies noted in the paper should likely prompt us, as business appraisers, to look more carefully at our vocabulary.  The existence of discounts in private placements is undeniable, yet only a portion is likely due to pure illiquidity.  The key factors of (1) risk, (2) expected growth in value, and (3) the holding period are all clearly present.  It is incumbent on any business appraiser to identify these key factors and measure them as best as possible given the situation.

It is also important to recognize that the existence of uncertainty in the analysis does not render it invalid.  Investors in privately placed securities accept key elements of uncertainty as an inherent part of the transaction.  The business appraiser simulates these factors in a careful and detailed analysis of the entity being valued in order to determine the discount to the marketable minority value.  The current appraisal vernacular may call it a marketability discount, but it really encompasses all of the elements which reduce value from the freely traded minority interest.

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Endnotes

¹ Hertzel, Michael and Smith, Richard L., “Market Discounts and Shareholder Gains for Placing Private Equity,” The Journal of Finance, Volume 48, Issue 2 (June 1993), pp. 459-485.

² Ibid, p. 459.

³ Ibid, p. 480.

⁴ Ibid, p. 465.

⁵ Ibid, p. 480.

⁶ Ibid, p. 469.

⁷ Ibid, p. 469.

Reprinted from Mercer Capital’s E-Law Newsletter 2003-02, June 5, 2003.

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