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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  


   © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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?



           © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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

        © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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? 



 © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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.

         © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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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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



         © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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.


             © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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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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. 


          © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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.


         © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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                ,            ,

         © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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. 




        © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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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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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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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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? 


          © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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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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. 

         © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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

         © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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?


          © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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.


          © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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. 


          © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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? 




  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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.


          © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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%. 


         © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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




        © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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 .  



    © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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? 



         © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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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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 (?!)



        © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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




     © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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 ” 



         © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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. 




          © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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.


          © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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

         © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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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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”.


        © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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

        © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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.” 


         © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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.

            © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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.

            © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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
         © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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 ”




         © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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
        © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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
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

         © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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
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
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
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
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
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


          © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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
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
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
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
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

                  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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
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
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
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
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.  




  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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. 


          © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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
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
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
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.



    © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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. 


        © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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).


          © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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



        © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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. 




         © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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.
          © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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?




    © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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
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

          © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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
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

  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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. 

         © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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
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
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
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
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. 

                   © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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


                © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
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

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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   © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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? © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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?  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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. © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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. © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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.  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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. © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 , , © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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.  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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.  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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.   © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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?  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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”?  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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.  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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? © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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. © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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.  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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?  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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. © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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%.  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 .   © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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?  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 (?!) © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 ”  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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.  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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. © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 ) © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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”. © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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.”  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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. © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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. © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 ” © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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.   © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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.  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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. © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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.  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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). © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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.  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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. © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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? © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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.  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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.  © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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 © Pluris Valuation Advisors LLC  ● www.PlurisValuation.com  ● 212.248.4500
  • 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