The Price of Illiquidity
Lack of transaction data lowers the value of an asset. Fair Market Value of a financial asset (a private promissory note is an example) is based on observing and comparing actual transactions under current marketplace conditions. But, if no transaction data exists that demonstrates the prices and the discounts being applied by the market, assumptions must be made to arrive at Fair Market Value. The lack of actual market transaction data, and the lack of an active market to transact in, automatically lowers the value of an asset. Discounts must be applied that represent the additional risks and costs related to illiquid assets.
Illiquid assets (difficult to sell assets) are worth less than those that can be rapidly and cheaply converted to cash, at a reasonable price. Investors are willing to pay a premium for assets that are more liquid. For illiquid assets like promissory notes, where a market may not exist, the appraiser must develop a Fair Market Value approach based upon a hypothetical market, which incorporates the assumptions potential market participants would use in purchasing the asset. These assumptions invariably include discounting the note to reflect its illiquidity.
Illiquidity is a major negative factor for appraisers who value assets that do not have readily available market quotations. The absence of liquidity lowers the value of the asset by the illiquidity discount. All other things being equal, the more illiquid the asset is, the less value it has. Determining the appropriate discount and applying it in the valuation of illiquid financial assets is now, and has always been a challenge.
When an illiquid asset is valued, its level of illiquidity is related to other financial assets of similar nature, and to the economic conditions, as of the appraisal date. A discount amount is derived from this analysis based on mature, reasonable and experienced judgment.
Valuing and Appraising Promissory Note Illiquidity
There is no exact formula or rule-of-thumb for arriving at the Fair Market Value of a private promissory note. It is a “Judgment process” that requires a sound method and an experienced expert to arrive at a reasonable, defensible conclusion of value. It should be based on what investors are willing to pay for similar assets having similar risk characteristics as of the valuation date.
Any method selected to be used will have its shortcomings. Like many other specialty skills, estimating an appropriate discount for an illiquid note requires judgment. The court cases have recognized the value of an appraiser’s judgment over mechanical applications of rules of thumb and theoretical formulas.
What is Fair Market Value?
Fair Market Value is the price at which the note would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. It is the price received for selling an asset in an orderly transaction between anonymous market participants, not adjusted for transaction costs.
Factors considered relating to the borrower and to the promissory note transaction are: financial statements, credit ratings, employment and earnings, payment history, amount and nature of collateral security, repayment terms and conditions of the loan, economic outlook, amount of control of the asset, restrictions on transferability, and costs associated with collecting if default occurs, plus additional items dictated by the specific asset.
All of these factors must be considered when selecting the appropriate discount for lack of liquidity. These factors are used as a guide, but the judgment of the appraiser remains the key.
Experienced judgment, specialized training and education, and common sense are all keys to arriving at a reasonable and defendable discount for illiquidity.