emerging market finance

1

Yale School of Management

Emerging Market Finance

Lecture 11: Valuation of Illiquid Securities

Challenge: shares and other securities are

often illiquid in emerging markets! How

much should you value them?

2


Evidence on Illiquidity DiscountsSilber (1991): Rule 144 letter stocks: average

discount of 34% (based on 69 private transactions, from 1981-88)

3


Discount Size and Firm Characteristics: the U.S. Sample

4


Discounts on Illiquid Bonds

Amihud and Mendelson (1991) and Kamara (1994): yield spread between illiquid notes and liquid Treasury bills = 35 basis points.

Boudoukh and Whitelaw (1991), the yield spread = 50 basis points between designated benchmark bond and less liquid government bonds in Japan.

5


China’s Experience with Illiquid Stocks

State Shares: owned by the state and not publicly tradable

Restricted Institutional Shares (RIS): held only by institutions (financial and otherwise), and never publicly tradable

Floating common shares: A-shares and B-

shares

6


The RulesState shares can only be transferred to other

institutions privately

RIS shares are officially only transferable via private search and negotiations. But, since Dec. 1998, auction houses have been selling RIS shares in semi-public auctions

Regardless of share type, no short-selling is allowed.

7


Typical Ownership Pie

State37%

RIS28%

A-shares30%

B-shares5%

8


To first examine price discounts, we use two sets of data: the auction data

2,577 RIS auction transactions from August 2000 to June 2001, on 18 auction houses mostly in Shanghai. Total stocks auctioned: 258

Auctions take place on weekends and eveningsParticipants have to be “institutions” (mostly,

private-fund management firms)Auction houses advertise in advance

9


Private-Placement Sample

242 transactions

Aug. 2000 to July 2001

Much larger blocks

10


Summary Statistics for AuctionsRIS Auction Transactions

Price Discount

Trans. Value ( in 1,000

yuan)

Trans. Size ( in 1,000

shares)

Auction B/P

Auction E/P

Avg. 77.93% 622 204 0.76 0.04

(Std. Dev.)

(6.65%) (674) (242) (0.42) (0.08)

Med 78.90% 424 136 0.67 0.05

Max 97.22% 28,800 12,000 3.60 0.34

Min 36.98% 13 5 0.00 -0.39

11


What Does the Discount Mean?

Suppose you have two firms with identical future cashflow and operating under identical environments

But, firm A is publicly traded, while firm B is privately owned.

Then, firm B’s worth is only 21% of firm A’s, simply because firm B is private!

12


Summary Statistics for Private Placements

Price Discount

Trans. Value ( in 1,000

yuan)

Trans. Size ( in 1,000 shares)

B/P E/P

Avg. 85.59% 76,340 31,800 1.16 0.04

(Std. Dev.)

(8.32%) (72,940) (26,870) (1.74) (0.02)

Med 87.03% 52,570 24,570 0.97 0.05

Max 99.40% 494,810 326,830 20.39 0.46

Min 56.28% 270 510 0.00 -0.62

13


Discounts across B/M Groups

80.74%

91.74%

78.58%

89.63%

77.56%

86.57%

75.43%

83.92%

72.57%

78.74%

70%

75%

80%

85%

90%

95%

Avg

Dis

coun

t

Low MediumB/M Ratio

High

RIS Discounts by B/M Ratio

Blue: auctions

Red: private-trans.

14


Discounts by Auction Quantity

74.47%

89.03%

74.99%

88.19%

77.00%

83.49%

78.06%

85.79%

80.14%82.62%

70%

75%

80%

85%

90%

Avg

Dis

cou

nt

Low MidAuction-Quant

High

Average Discounts Across Transaction Quantity Groups

Blue: auctions

Red: private-trans.

15


Discounts by Fraction of RIS Shares in Ownership Structure

75.04%

84.43%

74.58%

85.68%

77.99%81.92%

79.06%

87.83%

78.18%

87.84%

70%

75%

80%

85%

90%

Avg

Dis

cou

nt

SmallShare

Mid-Level LargeShare

RIS as Fraction of All Shares Outstanding vs Discounts

Blue: auctions

Red: private-trans.

16


Discounts by Age (since IPO)

79.72

75.86

73.09

86.2685.42

88.25

70

72

7476

78

80

82

8486

88

90

< 2 Years Between 2 & 7 Yrs 7 Yrs & Older

Avg

Dis

cou

nt

(%)

Blue: auctions & Red: private transfers

17


Future Investment Returns in RISAssume the trading restriction is lifted in T years

(uncertainty). Share price at time of lifting is unknown. Adopt “buy & hold”

Annual returns from holding RIS until the restriction is lifted inShare Price at Time of Lifting T=1 Yr T=2 Yrs T=3 Yrs T=5 Yrs T=10 Yrs

50% of Today's Price 127.27% 50.76% 31.48% 22.78% 17.84%

75% of Today's Price 240.91% 84.64% 50.50% 35.88% 27.80%

100% of Today's Price 354.55% 113.20% 65.65% 46.01% 35.37%

125% of Today's Price 468.18% 138.37% 78.44% 54.39% 41.55%

150% of Today's Price 581.82% 161.12% 89.62% 61.59% 46.80%

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Are the RIS Auction Prices Reasonable?

The answer lies in the rules.

Three rules are binding, each causing a distortion:

RIS shares not tradable, but transferable No short-selling allowed (binding for floating shares) RIS shares only for institutions, not for the public.

Let’s look at two types of models.

19


Longstaff’s (1995) Model

Assumption: the illiquid stock is locked up for some T years (not tradable at all).

Then, the upper bound on the price discount:

20


Longstaff’s (1995) Model

1)exp()()2(/1)( 8222

2222 TTTT NPpTD

21


Upper Bounds on Illiquidity Discounts: Longstaff (1995) Model

20%

30%

40%

50%

60%

70%

80%

90%

100%

110%

1 2 3 4 5 6 7 8 9 10

Years before the trading restriction is lifted

Illi

qu

idit

y D

isco

un

t U

pp

erB

ou

nd

Sigma=30%

Sigma=40%

Sigma=43.5%

Sigma=50%

22


Amihud and Mendelson (1986) Model

Liquid stock: no trading costsRIS transferable “privately”, but not tradable publicly,

means it is MORE costly to exchange ownership Let c be the % search/transaction cost for RIS (whenever there is a

buy or sell). Put aside the no-short-selling aspect for now.

Then, relative to the fair value of a floating share, the discount for RIS is

d = PV(all future transaction costs)

23


Table for Fair Non-Marketability Discount (without short-selling constraint)

Assume c = 5%. T = # of yrs before lifting, t = # of yrs in a typical RIS holding period.Cost of capital = 10% per year

T = 1 year T = 2 years T = 3 years T = 5 years T = 10 yearsAvg holding periodt = 1/2 year -14.52% -32.23% -48.29% -76.08% -100.00%

t = 1 year -5.00% -14.09% -22.36% -36.70% -62.59%

t = 2 years -5.00% -5.00% -13.26% -20.09% -30.40%

Years before lifting restriction

24


Discount due to No-Short-Selling

With No-Short-Selling, stock prices can be far above fundamentals, yet no one can do anything about it.

Due to its emerging-market status, suppose the right P/E for China is 30.

Relative to the floating-share price, a reasonable discount should be

No-Short-Selling discount + Non-Marketability discount

25


Illiquidity Discounts based on Amihud & Mendelson (1985)

70%

75%

80%

85%

90%

95%

Years before RIS Trading Restriction is Lifted

Illiq

uid

ity D

isco

un

t

Avg. holding period = 1 yr.

Avg. holding period = 1.5 yrs.

Avg. holding period = 2 yrs.

26


Restricted vs Floating Shares:

a cause for other things Everyone wants to go IPO! No one wants to

stay private, even if it means they have to take risk and make up the numbers!

With relatively few shares floating, easy to manipulate common share prices!

leading to “pyramid corporate family empire”.

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With such discounts, every public corp. will be run like a “hedge fund”

With the RIS shares priced so low, takes only little capital to acquire a “controlling shareholder” position

The price discount for RIS shares relative to floating A-shares is so high (84% avg.) that every firm wants to be a “hedge fund”:

Long RIS (or, state shares) and get the right to short floating A-shares.

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“Hedge Fund” Strategy

Public Company ABC

Pay $0.16 to acquire an RIS or state share, to become “controlling shareholder”

Sell floating A-shares to public at $1 per share.

Transfer cash through “related-party” transactions

29


Sample for the Control Premium

154 private transfers of state-owned shares (SOS) to other state-owned enterprises (SOE) (with 91 transfers involving controlling blocks and the other 63 transfers non-controlling blocks)

17 transfers of controlling SOS share blocks to private firms, and 3 non-controlling SOS share blocks to private firms.

30


Control Premium Size

4.45%

7.93%

0.82%

21.63%

0%

5%

10%

15%

20%

25%

国营非控股国营控股民营非控股民营控股

% SOS price premium relative to book value of equity per share

Control Blocks to private firms

Non-Control Blocks to

private firms

Control Blocks to SOEs

Non-Control Blocks to SOEs

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Control Premium Relative to Floating A-Share Prices

18.05%

16.09%

20.10%18.65%

0%

5%

10%

15%

20%

25%

国营非控股国营控股民营非控股民营控股Control Blocks to private firms


private firms



32


Control Premium Relative to Revenue Per Share

1.2

1.5

3.75

1.66

0

1

1

2

2

3

3

4

4



private firms



33


ROE Across Groups

8.75%

6.83%

0.56%

8.67%

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%



private firms



34


ROA across Groups

3.53%3.37%

0.44%

3.17%

0%

1%

1%

2%

2%

3%

3%

4%

4%



private firms



emerging market finance

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