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Pluris FAS 157 Handbook November 2008
- 1. Fair Value of Illiquid Securities
Fair Value of Illiquid Securities
‐ Restricted Securities
‐ Auction Rate Securities
Auction‐Rate Securities
H A N D B O O K O N FA S 1 5 7 A N D FA I R VA LU E – H O W D O
WE GET FROM HERE TO THERE?
NOVEMBER 2008
E S P E N R O B A K , C FA
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- 2. The TEN Questions
2
What are the implications of the “exit price” concept?
1.
2. How does FAS 157 change valuation?
3. Why are investors unlikely to respect Level III measurements?
4. What additional disclosures will be required for “Level III
What additional disclosures will be required for Level III
4
securities”?
5. How can we get from Level III to Level II?
6. Wh is mark to model a dirt
Why is mark‐to‐model a dirty word in the FAS 157 context.
ord in the FAS 157 conte t
6
7. What are illiquidity discounts and how do we measure them?
8. Why does Black‐Scholes always overvalue warrants?
9. What are the key valuation metrics for Auction‐Rate securities?
10. Are blockage discounts really eliminated?
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- 3. Contents
3
Basic Concepts
Level II and Level III Measurements
Level III Disclosures
Mark‐to‐Model
Models and Illiquidity
q y
Examples: Auction‐Rate Securities, Restricted Stock,
Warrants and Convertibles
Blockage Discounts
Summary
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- 4. Basic Concepts
p
4
F A S 1 5 7 W I L L L I K E LY R E Q U I R E S I G N I F I C A N T
A D D I T I O N A L W O R K T O E S TA B L I S H F A I R V A L U E S F O R
H E D G E F U N D S , P R I V AT E E Q U I T Y F U N D S , A N D P U B L I C
R E P O R T I N G E N T I T I E S A N D M AY M A K E T H E Y E A R ‐ E N D
AUDIT PROCESS MORE BURDENSOME, BUT WHY?
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- 5. FAS 157 – What’s new?
5
Funds have to mark securities at “fair value” – not new…
“Fair value” is a market‐based concept – also not new…
On the other hand:
FAS 157 demands greater disclosures – red flags will be
more visible.
The market is defined better, giving less valuation leeway.
The exit price concept is new.
The measurement hierarchy is new.
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- 6. FAS 157 – What’s new? (cont.)
6
The upshot:
The upshot:
Auditors will be more reluctant to sign off on fair value
measurements.
New questions come up regularly about “what FAS 157
really means.”
We’re in a state of flux regarding fair value
measurements.
The huge volume of additional required disclosures may
The huge volume of additional required disclosures may
be burdensome for reporting entities.
The next two audit seasons could be interesting.
g
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- 7. Definitions
7
Fair value: the price that would be received to sell an
asset or transfer a liability in an orderly transaction
between market participants on the measurement date.
Orderly transaction: assumes market exposure to allow
for usual and customary marketing activities prior to the
measurement date; is not a forced transaction.
measurement date; is not a forced transaction
Exit price: for assets held, this is the price received upon
sale in a hypothetical transaction.
sale in a hypothetical transaction
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- 8. Definitions (cont.)
8
Exit market*: the principal (best volume) or most
advantageous (highest price) market for the asset.
Market participants: knowledgeable, able to transact,
willing to transact, and independent of the reporting
entity.
Key inputs in valuation analysis: assumptions of market
Ki ti l ti li ti f kt
participants.
* Considered from the perspective of the reporting entity – market must be
available to the entity.
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- 9. Exit v. Entry Prices
9
Purchase price is not necessarily fair value – not even on
the purchase date!
Was the transaction between related parties?
Was it a forced or “fire sale” transaction?
f d “f l”
Is the “unit of account” of the purchase transaction different from
what it would be in an exit?
Did the purchase price include transaction costs?
Were additional securities, or separate rights, issued with the securities?
Were the securities purchased in a market different from the
Were the securities purchased in a market different from the
principal exit market?
Example: PIPE market vs. secondary market for PIPE securities.
Example: secondary market sales of ARS
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- 10. Valuation Inputs (the “levels”)
10
Valuation techniques used to measure fair value shall
maximize the use of observable inputs and minimize the use
of unobservable inputs – FAS 157
Fair Value Hierarchy – focus on inputs, not techniques:
Level I – Observable Inputs: unadjusted market prices for identical
assets.
assets
Level II – Observable Inputs: quoted prices for similar assets in active
markets, quoted prices for identical or similar securities in inactive
markets, other observable market inputs, and inputs derived from
markets other observable market inputs and inputs derived from
or corroborated by the market.
Level III – Unobservable Inputs: everything else.
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- 11. Fair Value Hierarchy
11
Level I securities – not a major concern (except for
blockage issues).
The big concern is Level II and especially Level III
measurements – can they be trusted?
FAS 157 – if a valuation relies on a mix of inputs, the level
of hierarchy within which the measurement is classified is
f hi h ithi hi h th t i l ifi d i
based on the lowest level input that is significant.
Significant additional disclosures for Level III
Significant additional disclosures for Level III
measurements may be expensive.
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- 12. Can We Trust Level III Measures?
12
“(…) Goldman reaped huge gains within the level 3 pot in the
third quarter. For example, it made a net gain of $2.94 billion
from level 3 derivatives, financial instruments whose value is
based on the value of underlying securities. And get this:
based on the value of underlying securities And get this:
$2.62 billion of that gain was unrealized.
“Goldman spokesman (…) responded that the level 3
derivative gains ‘did not come from level three inputs,’ but
from ‘observable’ data taken from more liquid markets.
“Why not classify the derivatives in the theoretically more
“Wh t l if th d i ti i th th ti ll
liquid level 2 and level 1 pools, then? ‘The rules preclude us
from doing so’.” – Fortune, October 15, 2007.
g , ,
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- 13. What else is new?
13
FAS 157 removes cost‐benefit analysis.
It notes that the best valuation method may also be the
most costly.
The reporting entity need not “undertake all possible
efforts to obtain info about market assumptions,” but it
cannot i
t ignore reasonably available information.
bl il bl i f ti
Must consider information about risk & restrictions.
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- 14. Auction‐Rate securities
14
Securities initially sold with the expectation of active
auction markets to provide liquidity frequently.
Valuation must reflect the extent to which this
expectation is no longer applicable.
Current valuations a function of how long auctions are
expected to keep failing, the riskiness of the securities,
t dt k f ili th i ki f th iti
the applicable maximum rate, and returns on similar
illiquid securities.
illiquid securities
Secondary markets are available and provide valuation
data for securities for which auctions are failing.
g
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- 15. Restricted Securities
15
The effect of a restriction on resale must be considered –
if that restriction would be considered by market
participants.
Example – Rule 144 restrictions. (Repeals exception in FAS
115 for restrictions shorter than one year).
“The adjustment would reflect the amount market
“Th dj t t ld fl t th t kt
participants would demand because of the risk relating to
the inability to access a public market…
the inability to access a public market ”
For quantifying the discount, ASR 113 is referenced.
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- 16. Restricted Securities
16
ASR 113 – old SEC rule for investment companies.
Incorporated in FAS 157 by reference.
Methods held to be inappropriate by the rule:
pp p y
Valuing restricted securities at market price, without discounts.
Valuing restricted securities at cost.
Applying a constant, or rule‐of‐thumb, discount.
l l f h bd
Determining discounts without reflecting changes in restrictions
(such as reductions in the remaining holding period).
Amortizing the “purchase discount” at some set rate.
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- 17. LP Interests (funds)
17
Consider another “restriction”: hedge fund lock‐ups and
closed‐end funds.
f
Funds‐of‐funds, pension funds and other investors invest at
NAV: entry price.
NAV: entry price.
Exit price?
If an LP investor wanted to (and was able to) sell its interest,
wouldn’t most buyers demand a haircut for a one‐year
ld ’ b d d hi f
lockup?
Alternatively, when the lock‐up is over, we value at NAV.
y, p ,
If no discount taken at beginning of lock‐up, are we saying
length of holding period doesn’t matter?
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- 18. Level II and III Securities
18
W H AT A R E L E V E L 3 A S S E T S A N D H O W A R E T H E Y
V A L U E D ? G I V E N T H AT L E V E L I I I M E A S U R E M E N T S W I L L
B E M E T W I T H G R E AT S K E P T I C I S M F R O M I N V E S T O R S ,
HOW CAN FUNDS MINIMIZE THE SIZE OF THIS
“BUCKET”?
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- 19. Level III Securities
19
(we use the term loosely…)
( th t l l)
“Level 3 is not that useful,” confesses a risk controller at a
big European bank. Banks have tended to use it as a
bucket into which they throw any securities they find hard
to value and then make an educated guess at the price.
to value and then make an educated guess at the price.
Among Wall Street firms, the soaring amounts of Level 3
securities now exceed their shareholder equity. – The
Economist, November 8, 2007.
Economist November 8 2007
There is no such thing as Level III securities ‐‐ only Level III
measurements.
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- 20. Internally Developed Valuation Inputs
20
Level III – meant for securities where there is little market
activity.
Reporting entity may use its own data in valuation –
however, inputs should reflect assumptions market
participants would apply.
Reporting entity “shall not ignore information about the
R ti tit “ h ll t i if ti b t th
assumptions of market participants that is available
without undue cost and effort.
without undue cost and effort ”
Level III inputs must be adjusted if information indicates
market participants would use different assumptions.
p p p
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- 21. Level II Securities
21
Level II measurements:
More objective, since they do not rely on manager‐driven “models”
or other unobservable assumptions that cannot be tested.
More accurate, since the market provides a check on the value
More accurate since the market provides a “check” on the value
otherwise not available.
More precise, if market indications tend to cluster closely around a
certain level of pricing.
Investors are more likely to consider Level II
measurements credible.
measurements credible
So, how do we get to Level II?
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- 22. Level II Measurements
22
Quoted prices for similar assets or liabilities in active
markets.
Example: PIPE securities, other restricted securities.
Quoted prices for identical or similar assets in inactive
markets.
Markets with few transactions.
Markets with few transactions
Markets where prices are not current, or where quotes vary over
time or among market makers.
Principal‐to‐principal markets or other markets where little
information is publicly available.
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- 23. Level II Measurements (cont.)
23
Observable data other than quoted market prices.
Interest rates and yield curves.
Volatilities.
Credit risks and default rates.
di i k dd f l
Inputs derived primarily from observable market data
through correlation or regression analysis.
through correlation or regression analysis
The key distinguishing characteristic (relative to Level III
inputs) is that the fair value problem is solved by market
inputs) is that the fair value problem is solved by market
participants.
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- 24. Level III Disclosures
24
WHY ARE THE NEW DISCLOSURES REGARDING LEVEL 3
A S S E T S S O O N E R O U S ? W I L L S E N S I T I V E I N F O R M AT I O N
BE REQUIRED TO BE DISCLOSED?
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- 25. Level III – More Disclosures
25
New financial statement disclosures:
The fair value measurements on the reporting date.
Magnitude of fair value measurements, by hierarchy.
For all Level 3 measured securities, a reconciliation:
For all Level 3 measured securities a reconciliation:
Total gains or losses for the period, and a description of where they are
reported in the income statement.
Purchases, sales, issuances and settlements.
Purchases, sales, issuances and settlements.
Transfers in and/or out of Level 3.
For Level 3 securities, the amount of total gains or losses
attributable to a change in unrealized gains or losses.
attributable to a change in unrealized gains or losses.
The valuation techniques used and any changes to those
techniques.
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- 26. Purpose of Additional Disclosures
26
The goal of the additional disclosures is to provide
statement users with a sense of the measurement error
risk implicit in each financial statement.
Level I Level II Level III Total
$120.5m $20.5m $59.0m $200.0m
60% 10% 30% 100%
If a financial statement user assumes that Level I, II and III
measurements are ±1%, ±5%, and ±40%, respectively,
1% 5% d 40% il
that would imply the entire fund’s measurement is ±13%.
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- 27. Disclosure Concerns
27
Will the disclosures provide too much information about
management’s dispositions throughout the year?
Note that any change in valuation methods for Level III
must be disclosed and discussed – such changes may be
significant from year to year and may be hard to explain
to investors.
to investors
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- 28. Mark‐to‐Model
28
V A L U AT I O N M O D E L S R E S U LT I N L E V E L 3
MEASUREMENTS, FOR MOST SECURITIES. THIS IS
B E C A U S E , W H I L E B E G U I L I N G I N T H E I R S I M P L I C I T Y, S U C H
M O D E L S A R E A L M O S T N E V E R P R O P E R LY T E S T E D W I T H
E M P I R I C A L M A R K E T D ATA .
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- 29. Valuation Models
29
Separate empirical valuation models from theoretical
models.
Separate theoretical models that have been tested those
that have not.
Example: Black‐Scholes model.
Theoretical model.
Yet, in widespread use in options markets, tested by participants and
research.
But, what about illiquid options?
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- 30. Valuation Models (cont.)
30
Black‐Scholes model example continued:
Model assumes both underlying security AND option are continuously
dl b h d li i i i l
tradable.
Market participants know that the model works only for the most‐liquid
issues.
These factors limit its usefulness under FAS 157.
If measuring the value of actively traded options, can use the
market prices to value securities (Level I).
p ( )
If not actively traded, have to rely on market data on similar,
not actively traded options (Level II) or an internally‐
developed “haircut” from Black‐Scholes (Level III).
p ( )
For illiquid options (or warrants) – using Black‐Scholes alone,
without adjustment, would always be inappropriate, because
it ignores known evidence on market participant assumptions.
g p p p
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- 31. Other Models
31
Exotic non‐traded derivatives are almost always valued
with mathematical models.
Model‐makers and users have a burden to show that
investors actually buy and sell at the prices indicated.
In cases where the market is very thin, market prices may
fluctuate wildly. At what point do we disregard the
fl t t ildl At h t i t d di d th
market?
Answer, under FAS 157: never (?!)
Answer under FAS 157: never (?!)
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- 32. Mark‐to‐Model v. Mark‐to‐Market
32
REPORTING ENTITIES “SHALL NOT IGNORE
I N F O R M AT I O N A B O U T M A R K E T PA R T I C I PA N T S T H AT I S
R E A S O N A B LY A V A I L A B L E W I T H O U T U N D U E C O S T A N D
E F F O R T.” – F A S 1 5 7
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- 33. Models and Illiquidity
33
Illiquid securities are always worth less than fully liquid
securities, c. p.
The impact of illiquidity on securities prices is hard to
model and has not been successfully modeled in testable,
peer‐reviewed research.
Most valuation models from the literature – even widely
M t l ti dlf th lit t id l
used models, such as CAPM or Black‐Scholes – take full
liquidity as one of their simplifying assumptions.
liquidity as one of their “simplifying assumptions ”
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- 34. Models and Illiquidity (cont.)
34
• “Continuous‐Time” Finance
Continuous Time Finance
• Basis for many of the advances in modern finance:
breaking trading activity down to infinitesimally small
g g y y
steps.
• Example: Black‐Scholes formula
• Problem: illiquid assets do not move in this fashion as
they do not trade continuously.
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- 35. Illiquidity Discounts
35
Illiquidity discounts describe the difference between the
as‐if‐fully‐liquid price and “fair value”.
Illiquidity discounts are a function of:
Length or severity of liquidity restrictions.
Length or severity of liquidity restrictions
Risk of illiquid securities.
Is volatility the best measure of risk? Is beta?
y
Example: “off‐the‐run” Treasuries
The 29‐year (off‐the‐run) Treasury bond always trades at a discount
from the 30‐year bond, because it s less liquid.
from the 30 year bond because it’s less liquid
Discount is typically small (low risk compared with equities), but the
spread can widen when there is market stress.
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- 36. Illiquidity Discounts (cont.)
36
Illiquidity discounts apply to all restricted, or otherwise
illiquid, securities, except for pure “blockage” illiquidity.
Transaction data from arm’s‐length secondary market
sales (investor to investor) of restricted securities are the
best available “exit price” indications.
Transaction data from private placement studies is also
T ti d t f it l t t di i l
widely used to determine illiquidity discounts.
Theoretical models, such as the Longstaff, Finnerty and
Theoretical models such as the Longstaff Finnerty and
Tabak models, are occasionally used, but empirical testing
on these models has been very limited.
y
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- 37. What if the Market Dries Up?
37
Example: 2007 credit crunch.
“the Center for Audit Quality (made it clear) that despite
the severity of the current market crunch, they intend to
apply the fair value standard consistently” – Accounting
Web, November 20, 2007.
“In the white paper the Center refused to consider
“I th hit th C t f dt id
transaction volume as an indicator of a ‘distressed’ sale” –
Financial Week, November 15, 2007.
Financial Week November 15 2007
“The auditors have to do this as a matter of self‐interest
and survival” – Ed Ketz (quoted in Accounting Web).
(q g )
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- 38. Center for Audit Quality
38
White paper on “Measurements of Fair Value in Illiquid
(Or Less Liquid) Markets.”
“Questions have arisen about (…) whether current market
prices are more indicative of distressed sales”.
In 2004 release, the SEC held that the registrant violated
GAAP by using a definition of fair value that assumed
GAAP b i d fi iti f f i l th t d
supply and demand were in reasonable balance.
Specifically, the SEC objected to the practice of ignoring
Specifically the SEC objected to the practice of ignoring
quoted prices and “taking the longer view”.
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- 39. Center for Audit Quality (cont.)
39
If transactions are occurring in a usual and customary
manner, those deals are not “forced” sales.
The fact that transaction volume is low does not indicate
the sales are forced or distressed sales.
Decreased volumes in a market do not necessarily mean
the market has become inactive.
th k th b i ti
“Markets with a reduced transaction volume under
current conditions are still considered active if
current conditions are still considered active if
transactions are occurring frequently enough on an
ongoing basis to obtain reliable pricing information.”
gg p g
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- 40. Center for Audit Quality (cont.)
40
The final word on available market data:
FAS 157 requires that quoted prices from active markets
be considered whenever available – Level I inputs.
If the market is not active, observable transactions in that
If th k ti t ti b bl t ti i th t
market are Level II inputs – and must be considered.
Conclusion: market data cannot be ignored when
Conclusion: market data cannot be ignored when
measuring fair value.
“In most cases, the use of a valuation model is acceptable
only when quoted prices in active markets are not
available.”
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- 41. SEC Comment Letter
41
March 2008 letters
Specifies disclosures for MD&A, especially for any model‐
driven valuations
Notes that FAS 157 does not require mark to market if
“market” consists of forced or distressed sales
“Supporters of using fair value believe that investors and other users of
financial statements are better served by knowing, where possible, what
something is currently worth rather than relying on management
assumptions – which many experts deride as a rose‐tinted “yes, but it is going
assumptions which many experts deride as a rose tinted “yes but it is going
to go up again” approach. ‐ Financial Times, April 1, 2008
Lynne Turner: […] the notion that if you have a distressed asset, you can avoid
market prices, which is not the spirit or intention of this rule
market prices which is not the spirit or intention of this rule”. – FT April 1 08
FT, April 1, 08.
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- 42. SEC Comment Letter
42
March 2008 letters
Specifies disclosures for MD&A, especially for any model‐
driven valuations
Notes that FAS 157 does not require mark to market if
“market” consists of forced or distressed sales
“Supporters of using fair value believe that investors and other users of
financial statements are better served by knowing, where possible, what
something is currently worth rather than relying on management
assumptions – which many experts deride as a rose‐tinted “yes, but it is going
assumptions which many experts deride as a rose tinted “yes but it is going
to go up again” approach. ‐ Financial Times, April 1, 2008
Lynne Turner: […] the notion that if you have a distressed asset, you can avoid
market prices, which is not the spirit or intention of this rule
market prices which is not the spirit or intention of this rule”. – FT April 1 08
FT, April 1, 08.
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- 43. FSP 157‐3
43
FASB Staff Position: Fair Value in Inactive Markets
Warns against broker quotes, in particular.
Provides amendment to FAS 157 – new Example. p
Invested in AA tranche of CDO
Market increasingly inactive, widening bid‐ask spreads, volume
down
Few observable transactions, no current quotes, widely varying
quotes
Approach chosen: increase discount rate from when markets were
active, supplement with data from indicative quotes.
Supported by SEC September 30 release.
Supported by SEC September 30 release
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- 44. DOL Letter (June 2008)
44
To pension plan investors in hedge funds.
“A process which merely uses the general partner’s
established value for all funds without additional analysis
may not insure … fair market value”
Plan administrators “must have a thorough knowledge of
the general partner’s valuation methodology”
th l t ’ l ti th d l ”
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- 45. Example: ACAS
45
“The most surprising piece of the company’s earnings
release (was the) valuation of its investment in European
Capital, a publicly traded (…) stock that fell 18%” –
TheStreet.com, “American Capital avoids loss with fishy
Th St t “A i C it l id l ith fi h
math,” November 2, 2007.
Drop resulted in $140m loss, instead took $2m gain.
Drop resulted in $140m loss instead took $2m gain
A control premium was added to the valuation, because
the company owns a 65% stake.
the company owns a 65% stake
However, the large stake is also illiquid.
ACAS is down 9% since the release.
ACAS is down 9% since the release
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- 46. Example: Freddie Mac
46
“A change in the way the Company values some assets
that aren’t traded reduced credit losses by $1.3 billion,
while a separate rule that let’s the company pick and
choose which assets to measure contributed an equal
h hi h tt t ib t d l
amount, Freddie Mac said.” ‐ Bloomberg, May 14, 2008.
“Freddie Mac used FAS 157 to list $156 7 billion in so
Freddie Mac used FAS 157 to list $156.7 billion in so‐
called Level 3 assets”
Josh Rosner: They put a lot of lipstick on this pig
Josh Rosner: “They put a lot of lipstick on this pig”
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
- 47. A few more words of wisdom…
47
“Some people on Wall Street think that nearly every sale today is
a forced sale. … What the SEC should require is a disclosure
when a company concludes athat a market price should be
ignored because it came from forced liquidation or distress sale
ignored because it came from ‘forced liquidation or distress sale’
Then there should be a disclosure of how much lower that
distress price was from the value the company is using…” – If
Market Prices are Too Low, Ignore Them, Floyd Norris, New York
Market Prices are Too Low Ignore Them Floyd Norris New York
Times, March 28, 2008.
“The [SEC] letter provides guidance only for MD&A disclosures. It
[] p g y
does NOT modify FAS 157, nor does it provide any guidance or
interpretation on the application of FAS 157” – PwC memo, April
29, 2008.
29 2008
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- 48. Example: Auction‐Rate Securities
p
48
A U C T I O N ‐ R AT E S E C U R I T I E S W E R E I S S U E D W I T H T H E
C L E A R E X P E C TAT I O N ( A M O N G A L L O R M O S T
P U R C H A S E R S ) T H AT T H E S E C U R I T I E S W O U L D B E L I Q U I D
AT R E G U L A R I N T E R V A L S ( E . G . , 7 D AY S ) . W H E R E T H AT
A S S U M P T I O N N O L O N G E R A P P L I E S , S E C U R I T I E S M AY N O
L O N G E R B E W O R T H PA R .
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
- 49. Exit Market Example: SecondMarket
49
SecondMarket trading network. Trade ARS and Restricted
securities.
Approximately 1,000 members; primarily hedge funds
and other institutions.
Members manage over $300 billion in assets.
More than 1,200 transactions over 4 years.
Competitive bidding, negotiated transactions.
Standard documents, shorter closing times.
More information: www.SecondMarket.com
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
- 50. LiquiStat Database
50
More than 800 transactions (Auction‐rate securities,
restricted stock, warrants, convertibles, hybrids, units).
Discounts from 5% to 85%.
Discounts a function of block size, days left of holding
period, “borrowability” of shares, volatility, market
capitalization, revenues, total assets, market‐to‐book
it li ti ttl t k tt b k
ratio, trading volume, etc.
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
- 51. Basics of Auction‐Rate Securities
51
Types of ARS: MARS, SLARS, and ARPS, etc.
Auctions at set intervals, usually 7 days (but up to 60)
The yield reset at each auction, at market‐clearing level
y g
Maximum Applicable Rate, or “penalty” rate, applies if
failed auction
Auction failure if not enough buyers to purchase shares or
notes of all sellers
Until this February, the banks would step in as buyer of
last resort, whenever an auction looked like it might fail
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
- 52. Basics of ARSs (cont.)
52
Typical issuers and ARS issues:
Municipalities, student loan writers, and others issuing debt with
long‐term maturity. High penalty rates if auctions fail.
Closed‐end mutual fund issuing preferred shares with no maturity.
Closed end mutual fund issuing preferred shares with no maturity
Low (floating) penalty rates if auctions fail.
Secondary market emerging as auctions fail:
y gg
Significant number of buyers, including distressed debt funds
Bid and ask prices dependent on market view of how long auctions
are likely to keep failing
are likely to keep failing
Valuation metrics considered include penalty rate relative level, type
of issuer, volatility and liquidity of (fund) investors.
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
- 53. ARS Valuation Metrics
53
Risk of issuer (fund or other)
Kind of issuer (funds, munis, CDOs)
Volatility of revenues/earnings or asset values
Illiquidity of assets in fund
lli idi f if d
Type of assets (fund strategy, assets classes, industry sector)
Leverage and interest/dividend coverage
Leverage and interest/dividend coverage
Liquidity (auctions or secondary market)
When did auctions begin failing?
Auction failure‐rate
Issuer attitude towards refinancing
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- 54. ARS Valuation Metrics (cont.)
54
Yield
Maximum applicable yield (“penalty” rate)
Taxable‐equivalent yield
Yields on comparable instruments (AAA corporate preferreds, traded
i ld bl i ( f d dd
v non‐traded muni bonds, etc)
Other Terms/Characteristics
Other Terms/Characteristics
Perpetual? Maturity date?
Size of interest. Size relative to market
Ease or difficulty of transferring “bidding rights”
Other terms in prospectus
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
- 55. Example: Restricted Stock
p
55
RESTRICTED COMMON STOCK REPRESENTS SHARES
I S S U E D W I T H O U T R E G I S T R AT I O N , A N D S U B J E C T T O T H E
VERY SIGNIFICANT ILLIQUIDITY CONSTRAINTS OF RULE
144, INCLUDING A HOLDING PERIOD, VOLUME LIMITS,
MANNER OF SALE, AND OTHER RULES.
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
- 56. Basics of Restricted Stock
56
Typically issued without registration.
In PIPE (private investment in public equity) transactions.
As compensation.
As part of bankruptcy/workout process.
fb k / k
In mergers and acquisitions.
Also, control or affiliate stock.
Also, control or affiliate stock.
Can be sold to the public via a prospectus sale.
Can be sold to the public relying on Rule 144.
a be so d o e pub c e y g o u e
Can be sold in private transactions using the 4 (1‐1/2)
exemption .
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
- 57. Private Sale Process (SecondMarket)
57
Section 4 (1‐1/2) exemption.
Hybrid of 4(1) and 4(2) exemptions in the ‘33 Act.
No general solicitation.
Buyers should be accredited investors.
Securities keep restrictive legend.
Buyers should have investment intent.
“Rule of thumb”.
Registration rights, if any, transfer.
Private sales price at a discount from market.
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
- 58. Discount Varies with Holding Period
58
70.0%
60.0%
50.0%
Discount
40.0%
30.0%
30 0%
D
20.0%
10.0%
10 0%
0.0%
0
0
0
0
0
0
0
0
0
0
0
0
0
10
30
50
70
90
11
13
15
17
19
21
23
25
27
29
31
33
35
Days of Illiquidity Remaining
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- 59. Rule 144 Holding Period – to 6 mths
59
SEC just approved change in Rule 144 – holding period cut in
half. Also, changes to volume limits and other changes.
Longer holding periods – greater discounts. However:
Not a linear relationship (quadratic).
N t li l ti hi ( d ti )
Factors other than the holding period also important.
LiquiStat: discounts better correlated with log of days remaining
q g y g
or square‐root of days remaining.
Halving the holding period will NOT halve the discount.
Most PIPEs are registered well before 180 days after the
M t PIPE i t d ll b f 180 d ft th
placement.
Reducing the holding period will likely not have a significant impact on
the valuation of the average PIPE.
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
- 60. Restricted Stock Discounts
60
Market Block Size Revenues Holding Market Volatility Discount
Cap ($ )
C ($m) ($m)
($ ) Period
P id Price
Pi
(Days)
Average 335 283% 35 133 $8.67 82% 31.2%
Median 217 97 1 114 3.69 73 33.4
1st Quintile 431 77 80 89 14.67 72 19.5
2nd Quintile 416 93 79 158 13.54 74 20.9
3rd Quintile 192 305 1 122 3.84 76 32.3
4th Q i til
Quintile 207
20 484 2 98 4.38
4 38 78
8 38.5
38
5th Quintile 140 470 1 176 3.81 108 51.5
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
- 61. Pluris Restricted Stock Models
61
Linear regression models: designed to produce discounts
that reflect market participant preferences.
Conforms with FAS 157 – Level II inputs (see page 22*).
12
10
8
6
4
2
0
0 0.2 0.4 0.6 0.8 1
* Inputs derived primarily from observable market data through correlation or regression analysis.
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
- 62. Why not just use the purchase discount?
62
ASR 113 (and FAS 157, by extension) prohibits a simple
application of the purchase discount, amortized as the
holding period is “earned away”.
But why?
Lack of information on how the discount is amortized,
i.e., it should not be reduced proportionally.
i it h ld t b dd ti ll
Many factors other than just the holding period are
important to the size of the discount.
important to the size of the discount
The purchase price (for the PIPE) is not an exit price, as
the PIPE market is not the exit market.
the PIPE market is not the exit market
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
- 63. Example: Warrants
p
63
W A R R A N T S A R E F R E Q U E N T LY I S S U E D T O I N S I D E R S ,
SERVICE PROVIDERS, PIPE INVESTORS AND OTHERS AS
“ S W E E T E N E R S .” B L A C K ‐ S C H O L E S A L W AY S O V E R V A L U E S
WA R R A N T S B E C AU S E T H E Y A R E I L L I Q U I D.
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- 64. Basics of Warrants
64
Typically not tradable; illiquid even if the underlying stock
is registered and freely tradable – Black‐Scholes
inapplicable, in either case.
“Ratchets” can reset the strike price, partially, fully or
more than fully, if the issuer sells stock for prices that are
below certain thresholds.
below certain thresholds
In addition, standard anti‐dilution protections always apply.
Cashless exercise provisions are becoming more and
Cashless exercise provisions are becoming more and
more common.
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- 65. Warrant Transactions
65
Restricted Securities Trading Network – more than 400
“trades” in warrants.
Average closing time shortening; around 12 business days
(versus 7 for restricted stock) now.
Warrants always trade at discount from Black‐Scholes.
Warrants most often trade at a premium over intrinsic
value; sometimes at a discount.
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
- 66. Warrant Discounts (SecondMarket)
66
Market Stock Intrinsic Delta Money- Volatility Discount
Cap ($m) Price Value ness
Average 185 $5.26 $1.04 0.787 0.065 76% 42.8%
Median 136 3.95 0.22 0.799 0.045 75 44.8
1st Quintile 207 4.96 1.55 0.841 0.325 57 18.5
2nd Quintile 126 4.12 0.23 0.796 0.148 65 34.2
3rd Quintile 126 3.46 0.49 0.788 0.128 77 44.8
4th Quintile 150 3.47 0.25 0.811 0.136 83 54.4
5th Quintile 97 2.47 0.00 0.736 -0.281 86 62.7
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
- 67. Warrant Discounts
67
The “moneyness” of the warrant is a key driver of the
discount.
Moneyness or ln(s/k): measure of how far into or out of the money
the warrant is.
the warrant is
Measure of the riskiness of the instrument: warrants that have
significant intrinsic values are less “leveraged” than right at‐the‐
money warrants.
Warrants on high‐volatility stocks tend to have higher
discounts.
discounts
Contradictory effects: higher volatility drives the Black‐Scholes
values up, but also drives up the discount.
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
- 68. Example: Convertible Debentures
p
68
M O S T C O R P O R AT E D E B T S E C U R I T I E S A R E L E S S ‐ T H A N ‐
F U L LY L I Q U I D , W H I C H S H O U L D A F F E C T T H E I R F A I R
VA LU E . W I T H C O N V E R T I B L E S , B E C A U S E T H E Y A R E
EQUITY‐LIKE, THE HIGHER RISK WILL ALSO LEAD TO
HIGHER ILLIQUIDITY DISCOUNTS.
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- 69. Basics of Convertibles
69
Can be convertible debentures or preferred shares.
With mandatory redemption after a certain number of
years, preferred share issues can be modeled in a way
that’s similar for debentures (set time to “maturity”).
Can have fixed conversion prices, floating conversion
prices or both (the lesser of).
i b th (th l f)
Can be subject to “resets” under certain circumstances.
May have face value and conversion price denominated
Mh f l d i id i d
in different currencies.
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- 70. Basics of Convertibles (cont.)
70
Hybrid instruments with both debt and equity
characteristics.
More equity‐like instruments:
Smaller, riskier issuers: nano‐cap and micro‐cap segments.
Floating conversion prices, exploding ratchets, resets, etc.
Pay‐in‐kind (PIK) instruments or interest payable in common.
Pay in kind (PIK) instruments or interest payable in common
Zeroes or heavily discounted bonds.
More debt like instruments:
More debt‐like instruments:
Conversion prices issued at significant premium to market.
Low or no warrant coverage/not a significant discount (OID).
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- 71. Basics of Convertible Valuations
71
Distinguish between convertible value and “kicker” value
at issuance – warrants often have substantial value.
Distinguish between fixed income portion of convertible
and “optionality” portion at issuance. May use models of
varying degrees of complexity.
Models can yield “pure” fixed income yield spread
Mdl i ld “ ” fi d i i ld d
(absolute or relative), once the optionality (and
“sweetener” value) has been removed from the equation.
sweetener value) has been removed from the equation
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- 72. Basics of Convertible Valuations (ct.)
72
Can use three methods for determining yields and yield
spreads:
Yield at issuance, adjusted for “kicker” and optionality.
Comparable yields from secondary market transactions (LiquiStat).
bl ld f d k ( )
Comparable yields from PIPE market transactions.
Yields vary significantly, from below‐average for corporate
Yields vary significantly from below‐average for corporate
bond yields to 20%+ range for high‐volatility nano‐caps.
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- 73. Basics of Convertible Valuations (ct.)
73
Convertible valuations can be at a premium to “intrinsic”
or as‐if‐converted value.
Reflects the value of the “floor” downside protection to the equity
value of the instrument.
value of the instrument
Implies little or no illiquidity discount for the underlying shares –
effective registration statements and no “implied” blockage.
Valuations can be at a discount from face value.
Risky, highly illiquid positions in nano‐cap issuers.
Significant deterioration in the stock price.
Significant deterioration in the stock price
Usually “fallen angels” with or without floating conversion prices.
Severe illiquidity for the underlying convertible.
Most convertibles: value somewhere in‐between.
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- 74. Blockage Discounts
g
74
H A S F A S 1 5 7 E L I M I N AT E D B L O C K A G E D I S C O U N T S ? W H AT
ARE THE EXCEPTIONS FROM THE RULE AND WHY
SHOULD WE BE MORE CONCERNED ABOUT THE
EXCEPTIONS THAN THE RULE?
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- 75. Radical Change for Hedge Funds
75
FAS 157 mandates undiscounted valuations (P x Q) for
unrestricted shares.
Exception: shares that trade in markets that are “not
active
active”.
What is an “inactive” market?
Low trading value and zero‐volume days.
g y
So inactive it casts doubt on the market’s ability to value the issuer
properly.
If the latter, shouldn t we reject market indications
If the latter shouldn’t we reject market indications
altogether and value the stock like private equity?
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
- 76. Blockage Discounts
76
Current (pre FAS 157) practice has been to discount large
positions up to 20% or more for blockage.
Reflects the fact that any holder of a very large position
would face severe illiquidity constraints if selling (exit!).
But the FASB found:
Significant differences in practices between investors in large blocks:
some would sell in block, some would sell in smaller pieces.
Goal was to generate measure of fair value that was independent of
g p
the internal policies of funds.
Blockage discounts are highly arbitrary because little empirical data
is available.
is available
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- 77. Exceptions
77
Very little guidance on what constitutes an “active”
market.
Even if market is “inactive,” must consider transaction
data as Level II inputs – but should also consider other
data as Level II inputs but should also consider other
data, such as P/Es, values of comparable firms, etc.
Also, consider convertibles or warrants for large
, g
positions:
Distinguish between different securities that are valued. P x Q
mandated only for freely tradable securities (not converts or
mandated only for freely tradable securities (not converts or
warrants) and only for Level I measurements.
A buyer of such securities would consider ease of getting out of the
position, which includes consideration of trading volume.
position, which includes consideration of trading volume.
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
- 78. Summary
y
78
SUMMARY AND CONCLUSIONS
FUNDS AND FUNDS‐OF‐FUNDS ARE WISE TO BEGIN
E X P L O R I N G T H E R A M I F I C AT I O N S O F F A S 1 5 7 A S S O O N
AS POSSIBLE AND WELL BEFORE THE NEXT AUDIT
SEASON
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- 79. Summary and Conclusions
79
There is significant potential for disagreement among
auditors, the FASB, the SEC, and reporting entities over
the meaning(s) of FAS 157.
The new rules imply significant diversions from past
The new rules imply significant diversions from past
practices and a greatly heightened scrutiny of fair value
estimates, along with new disclosures.
FAS 157 changes the game even for reporting entities that
have not adopted the rules yet, because the principles
put forth illustrate proper calculation of fair value – and
put forth illustrate proper calculation of “fair value” – and
would apply, to some extent, also under prior‐period
GAAP.
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- 80. Summary and Conclusions (cont.)
80
Illiquid securities and illiquidity discounts are a focal point
of dissension over the new rules.
There will be significant pressure to avoid classifying
measurements as Level III measures, because of:
New disclosure requirements that apply only for Level III.
Less credibility lent by investors to Level III measures.
Less credibility lent by investors to Level III measures
Illiquidity discounts can be very high, depending on
security characteristics.
security characteristics.
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
- 81. Summary and Conclusions (cont.)
81
Most valuation models do not properly adjust for
differences in liquidity.
Most theoretical models overvalue illiquid securities.
Very significant “bias” in FAS 157 toward empirical market
data – implicit in hierarchy of inputs, and in focus on exit
markets and exit prices.
kt d it i
Reporting entities cannot ignore reasonably available
market data – evidence regarding the assumptions
market data evidence regarding the assumptions
commonly held by actors in the market for similar or like
securities.
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
- 82. About Pluris
82
ABOUT ESPEN ROBAK
A B O U T P L U R I S V A L U AT I O N A D V I S O R S L L C
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
- 83. Espen Robak, CFA
83
Espen Robak, President of Pluris Valuation Advisors LLC, is a nationally
recognized expert on restricted securities, securities d i
id t titd iti iti design, l l of
levels f
value, and discounts for lack of liquidity, and a prolific writer on business,
valuation and taxation topics. Recent article topics include PIPE (private
investment in public equity) valuations, proposed new Rule 144,
illiquidity discounts, valuation of stock options M&A arbitrage data
discounts options, data,
restricted stock and marketability, and the valuation of trademarks. Mr.
Robak has been quoted in the Financial Times, Forbes, CFO Magazine,
PIPEs Reporter, Compliance Week, Inside Market Data, Opalesque,
Hedge Fund Manager Week, HedgeWorld and Absolute Return.
g g , g
Over more than a decade, Mr. Robak has been responsible for research on restricted stock, illiquid
(unregistered) warrants, convertible debentures, convertible preferred shares, SPAC securities, and
equity swap transactions.
Mr. Robak has provided valuation services for portfolio valuation, stock-based compensation and
other financial reporting purposes, transaction fairness, estate and gift tax, corporate and personal
income tax, employee stock ownership plans, litigation support and other purposes.
Mr. Robak has Master’s in Business Administration and Bachelor’s of Science degrees from the
g
University of Oregon. He has also earned the Chartered Financial Analyst designation.
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
- 84. Pluris Valuation Advisors LLC
84
Pluris Valuation Advisors LLC is a full‐service valuation firm specializing in valuing restricted securities and other
assets that lack liquidity. Valuing illiquid securities is endlessly challenging. The positions of the FASB and the SEC
q y gq y gg p
are ever‐shifting. The market is evolving, presenting a “moving target” for the valuation expert, administrator,
compliance officer, auditor, and SEC examiner tasked with making sense of the process. Pluris was founded
specifically for the purpose of bringing clarity and consistency to the valuation of restricted securities, including
restricted stock, convertible securities, warrants, and other derivatives. Our particular strengths include:
Established Reputation. Our research on PIPE securities valuations is well‐known and has been published in
Valuation Strategies, the PIPEs Reporter, Compliance Week, Inside Market Data, BV Resources, Opalesque,
Hedge Fund Manager Week, HedgeWorld and Absolute Return. Our LiquiStat database is featured in the most
widely‐used textbook for the American Society of Appraisers. Through our parent company, Pluris has funding
from Pequot Ventures.
Specialized Expertise in Portfolio Valuations. The majority of our work is for portfolio valuation purposes. Our
professionals know and understand the positions of the SEC and your auditors; and our valuation reports have
been designed to be auditable. In fact, our valuation reports have been accepted, and relied upon, by virtually
all major hedge fund accounting firms.
Focused Knowledge in PIPE Securities. Valuing the restricted securities of public companies is subject to
unique challenges. PIPE market participants know that illiquid securities are inherently less valuable than fully
liquid ones. But how much less? Pluris is the only valuation firm that specializes in valuing PIPE securities. You
liquid ones. But how much less? Pluris is the only valuation firm that specializes in valuing PIPE securities. You
can count on us to have research answering every valuation challenge.
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- 85. Pluris Valuation Advisors LLC (cont.)
85
LiquiStat™. The discount for illiquidity is both the most challenging and the most controversial valuation
adjustment made. The LiquiStat study of transactions on the RSTN is proprietary to Pluris and provides us with
real‐world data on investor preferences with respect to restricted securities and illiquidity discounts. To the
best of our knowledge, LiquiStat is unique in the valuation industry and provides unrivalled support for our
valuations.
Capital Market Expertise. Pluris is affiliated with Restricted Stock Partners, which manages the largest trading
market for restricted securities in the United States, the Restricted Securities Trading Network (RSTN). Our
other affiliate, Aspenwood Capital, has experience placing equity, debt and derivative securities in PIPE
transactions.
Transaction Experience. Because of the capital markets knowledge we can access through our affiliation with
RSP, we can often provide insights not easily gleaned from “academic” research alone. For example, if the cost‐
of‐borrow is an important factor for a particular security, our extensive network of contacts provides a source
of information unavailable to most other valuation firms.
Controversy Support. Valuation is an inherently subjective effort, which is why valuation opinions are often
also a source of controversy, whether between a hedge fund and its auditor, a taxpayer and the IRS, or a public
company and the SEC. With Pluris as your valuation advisor, you can be certain that our senior professionals
are experienced with audits and litigation. Most importantly, we know how to resolve controversies before
they become the subject of litigation or worse.
hb h bj f li i i
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- 86. Contact Information
86
Pluris Valuation Advisors LLC
26 Broadway, Suite 1202
New York, NY 10004
www.PlurisValuation.com
Pl i V l ti
Espen Robak, President
Voice: (212) 248‐4500
Fax: (212) 248‐4599
Fax: (212) 248 4599
ERobak@PlurisValuation.com
© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500