Common Valuation Issues with Illiquid Securities
IMGCAP(1)]Private and otherwise illiquid securities have increased in number and complexity in recent years, leading to increased scrutiny from auditors and regulators regarding their valuation.
Such instruments may be rich in economic features and closely linked to an equity security, a debt security, or more of a hybrid instrument with elements of each. These nuanced securities typically contain options and market conditions (such as return multiples or thresholds, and specific internal rate of return and price performance targets) that alter cash flows over the life of the security and raise valuation challenges. Valuation of these securities often arises in connection with corporate transactions, external financings and the implementation of an incentive compensation plan or award.
Management is responsible for the fair value measurement of these securities for audit and general reporting purposes, as well as potential tax considerations connected with changes in financial position and income. Such valuation estimates, and financial model selection in particular, currently are receiving increased attention.
Financial Model Selection
Selecting an appropriate valuation approach and financial model is critical to the analysis. These instruments generally require a cash flow model that captures the unique features specific to the security’s appropriate valuation. Such models may be statistical in nature, employ a numerical method versus a closed-form solution, and dynamically capture feature interactions in the context of the total instrument. These components are modeled with simulation and lattice approaches to arrive at an expected value, capturing security-specific and market inputs.
In many instances, time-volatility-based models are required to capture properly the inputs relevant to the security’s value, particularly when a security has an option value element. Models constructed using lattice and Monte Carlo frameworks are the most common. Such models generally are expected by regulators and auditors in arriving at a fair value estimate for securities, while the selection of a particular approach often will be dictated by the features of the instrument. Securities exhibiting price path dependency generally are analyzed using a Monte Carlo model, while securities with features that provide for “early exercise” are well suited to a lattice model.
Common Security Types Suited to Financial Modeling
Restricted stock awards are granted in a variety of forms as incentive compensation to management and other investors or interested parties. One such example is restricted stock that vests according to a market condition defined as Total Shareholder Return, or TSR, which is measured over a defined period and compared to a selected peer group. The relative performance of the stock defines the portion of the award that is vested. Such a restricted stock award is modeled using a Monte Carlo simulation to project the subject company’s TSR, as well as the TSR for all of the peers. The vesting features are incorporated into the model and the simulation creates the stock’s payoff diagram based on the features of the award. Since the payoff diagram is like that of a call option, financial theory underlying option-pricing models is applied to the analysis.
Convertible debt securities can have a number of economic features that shape the future cash flows and impact the fair value measurement. These may include issuer and holder redemptions that alter the maturity of the debt, a make-whole feature triggered by an early debt retirement or other result, and/or contingent conversion prices, to name a few. A lattice model, typically in the form of a binomial, commonly is used to capture the features of the debt instrument in a manner that considers the interaction of the various features, including the possibility of an early settlement of the debt at a time when the economic value of the option would indicate.
Private company preferred stock can have economic rights that are important to capture in a fair value measurement. The stock generally will have a liquidation preference, may have a cumulative dividend yield, and is likely to be either participating or convertible. If more than one series of preferred stock has been issued, then an equity allocation analysis likely will be done. Recently, the option pricing method has become a predominant methodology accepted for valuing these securities in a complex equity structure. Such an analysis requires an understanding of the capital structure, distribution rights and option-pricing theory.
A feature-rich security not readily priced in the market, and requiring a fair value measurement, brings modeling challenges that need to be clear in concept and approach. Incorporating the appropriate inputs that are determinants of value and modeling the cash flows in a manner consistent with the terms of the security and financial-economic theory goes a long way toward developing a supportable fair value estimate.
Rob Barnett is senior vice president of Valuation Research Corporation.