Think like an investor, not an accountant!
If fair market value is to determine investor expectations and equity risk; then why do these factors receive limited or no consideration when opining on the level of impairments (investor concessions) ubiquitously referred to ask discounts? This article addresses the business risks associated with asset-holding companies' equity that should be considered and reported when preparing a valuation report.
Let's begin with the basics. If we agree with the use of fair market value as the governing standard of value, we will consider the notional investor ("buyer" and "seller") and return expectations; then we're starting off on the right foot. We also understand that return reflects both yield/income and growth/appreciation (hopefully this is the case!) So, as a simplistic example, we have a widely traded small cap public stock that we purchase at $100 and sell a year later for $125 and receive a $2 yield; we can agree the total return (pre-tax) is 27 percent. Since that is a concentrated position, we recognize that over time, and assuming we're endeavoring to mitigate this risk in our equity position, we may wish to diversify the portfolio. Let's assume that adequate diversification takes just over five years and has a total return of 17 percent, of which 2 percent is yield and the balance is growth, and such a performance is an approximation to U.S. small cap public equities' returns over 30 years. One may agree on several things. First, that diversification may be wise. Second, that there is likely a reasonable holding period to achieve adequate returns, and third, that a benchmark proxy ought to exist as to what "reasonable" would be.
Then why does all of this go out the window when valuing equity in real estate-holding companies? It seems unreasonable that more time is expended on what type of studies are used that best support the application of the discount for lack of control (DLOC) and discount for lack of marketability (DLOM) than returning back to the notional investor and the assessment of risks. I would argue there is a "round-peg, square-hole" syndrome here because what commonly occurs is that the valuation analyst with limited experience or knowledge will (a) obtain the market value of the real property; (b) replace the book value with the market value; (c) add other assets and deduct liabilities; (d) apply the pro rata percent of equity to be valued and then apply the DLOC and DLOM. Nonsense!
The above process would do little to eliminate the period in which the date of value would occur. With all due respect to Judge Laro and his precedent-setting case Estate of Mandelbaum, the notion of starting with a median somewhere between 30 to 35 percent combined discount is simply incorrect as markets are dynamic. Shannon P. Pratt and Roger J. Grabowski point this out in their most recent edition of Cost of Capital. Markets and values/discounts are influenced by interest and inflation rates as well as entity and equity specific risks. Therefore, analysis goes well beyond the influence of the entity's bylaws or shareholder agreement provisions. It goes to the equity risks tied to the entity and asset held. As an example, we must ask, "What is the influence of using debt at a certain interest rate and terms to influence returns? Is the level of debt optimal, or is any debt somehow a 'bad' thing?"
Few sage investors would consider putting "cheap" debt to work in order to lever their return, especially at inordinately low interest rates, where after taxes, the shared risk may be comparable to "free" cost of capital when compared to the inflation rate. Many accountants and appraisers miss this element in their analysis. They also miss what is the "typical" holding period for the different real property asset classes. They somehow miss the typical asset class yield and appreciation to derive total return expectations of the investor considering a direct investment in real estate. This needs to be contrasted with an equity interest in an entity holding real estate. These oversights suggest the valuator analysis falls far short of the fair market value standard of considering the notional investor's return expectation. This is proven again because the accountant has not considered whether the aggregate DLOC/DLOM application creates an adequate post-return adjustment to incentivize the notional investor, or one that is a gross overstatement of discount because the return is so ridiculously high that no seller would ever agree to making such an incentive concession to the buyer unless under duress to do so.
"With all due respect to Judge Laro and his precedent-setting case Estate of Mandelbaum, the notion of starting with a median somewhere between 30 to 35 percent combined discount is simply incorrect as markets are dynamic. Shannon P. Pratt and Roger J. Grabowski point this out in their most recent edition of Cost of Capital."
If this was all, we'd say it is an important lesson and nothing more would need to be said. Sadly, many a designated real estate appraiser, business appraiser, accountant, and economist continue to do the above steps "a" through "d" without the rigor required. Further, this mechanical approach has created a commoditization of the valuation report work product; it has caused a downward drag on the fees charged, because those professionals (mostly attorneys) who request them know not what is still lacking in these work products.
Assuming the entities have a legitimate business purpose, then operational risks should be considered and documented, so should the holding period and likely pool of buyers. Let's start with the last two items, as they are relatively simple to address. If the entity has been operating for say 15 years, one familiar with real estate investment would say it has been held for at least one full cycle; a cycle is typically a period of time where high and low values are exhibited; the "typical" cycle entails a holding period of seven to 10 years. So, what does that mean to the equity holder-that the controlling interest has not considered leverage (applied debt) or sale of the asset at or near its market peak? Would this potentially imply an extended holding period? If so, would a legitimate argument be made for a higher DLOM due to this indication?
What about the post discounted equity interest? Let's say for argument's sake the 20 percent equity interest was valued at $5 million. Who is the notional investor in this pool of buyers? Clearly, it would be an accredited investor; however, more than that, it would have to be a notional individual or entity, which presumably would be unwilling to concentrate risk. Therefore, wealth would have to far exceed $5 million. Among the 132,000 U.S. households with wealth at or above $25 million, I believe that few of these households might invest in real property or, more specifically, a non-controlling interest in a private-entity holding real property. Therefore, the pool of buyers is actually smaller-much smaller. Those familiar with investment would say that to mitigate risk, the wealth would have to be nearer to no more than 10 percent in any one investment bucket. This means having $50 million and the ability to write a check or a check with partial debt to acquire this interest with most traditional banks seldom loaning on private entity minority interests.
Here's where the true lamenting occurs: real estate or business appraisal associations, accounting societies, state bar associations (or their national headquarters), the courts, and he IRS do not sufficiently mitigate for this thinly traded market. The average report contains limited to no company specific risk analysis or discussion despite what is being valued is equity in an entity. Below are examples of items often not addressed, but which clearly have a bearing on entity and/or equity risk:
- Age, health, education, experience of management and successors
- Tax-assessed versus market value
- Benefit-derived by cost segregation
- Property titled correctly
- Annual growth rate/embedded gain
- Appraiser's market exposure duration
- Provision for environmental hazard
- Poor yield and/or month-to-month leases
This article's point is that a valuation engagement is far more than an Excel® modeling or a mark-the check-off-the list exercise. Much more needs to be conveyed and considered. Further, as valuation experts, we should be well compensated for intellectual rigor, and clients should expect to pay for the value we provide. Until we expect nothing less, we get next to nothing for less.
