Analysing Liquidity: When the State of Matter matters to Expert Valuers in Damages Assessments

Quantifying damages often requires an independent assessment of the market value of an asset. When this asset is a direct or indirect interest in a business, valuers may consider the price per share at which publicly listed shares have been exchanged. They may do so to:

• assess the market value of parcels of those shares on the same or different date;
• estimate multiples that apply to comparable companies, to value the subject matter on the basis of a relative valuation; or
• derive a beta factor to use in the estimation of a discount rate, to apply in a discounted cash flow valuation.

When performing such analyses, valuers often consider whether the shares under review are ‘sufficiently liquid’. Insufficient liquidity may render the relevant data unreliable for the intended purpose. However, in the authors’ experience, there is no consensus as to when a share should be deemed ‘sufficiently liquid’ or the weight a valuer should place on the prices of shares that do not meet that threshold.

In this chapter, we explain the concept of liquidity and explore the above issues in the context of shares in public companies. We consider how liquidity is measured, what causes it and the implications of illiquidity for valuation analyses. Simply put, is it correct to dismiss valuation evidence from a stock that is thinly traded?

We find that context is crucial. Faced with evidence of insufficient liquidity, a valuer should examine the causes of illiquidity and assess whether trades in the asset in question satisfy the relevant conditions of market value. For example, a lack of buyers may simply reflect current market conditions as opposed to ‘illiquidity’. It may well be wrong to ignore data in these circumstances. Conversely, if some parties know things that others do not, this may mean that a party to a transaction is not ‘acting knowledgeably’, which may be a reason to place less weight on the data.

What is liquidity and why does it matter?

Liquidity refers to how easily an asset can be converted into cash. It has been described as ‘a broad and elusive concept that generally denotes the ability to trade large quantities quickly, at low cost, and without moving the price’. ^[1] In practice, the liquidity of interests in businesses is observed across a spectrum. At the upper end of this spectrum are listed shares and bonds. These are frequently traded in an active market and can be traded in large quantities at the push of a button. At the lower end are uninfluential minority shareholdings in private companies controlled by their management, for which there may be few (or no) ready or willing buyers.

Cash provides advantages over less liquid assets – it can be spent, invested or saved for unforeseen consequences. ^[2] Liquidity preference theory posits that, all else equal, investors demand progressively higher expected rates of return on assets that they must hold for longer before they are free to sell them to another party. In other words, liquidity matters and can affect asset prices. From a valuation perspective, this means that metrics or returns observed for publicly traded but illiquid assets may incorporate a discount for illiquidity, rendering the metric or return less comparable to that of a liquid asset of otherwise equivalent risk.

For private companies, the lack of marketability (ie, the ability to market and sell an asset quickly) is often pronounced, compared to public companies. However, even in the case of shares in public companies – which this chapter focuses on – the liquidity of shares may differ significantly from one company to another or from one date to another. The liquidity of an entire market can also fluctuate over time. For example, during the global financial crisis, the liquidity of listed shares was on most measures markedly diminished.

Measures of liquidity: Easily measured, but difficult to judge

According to the Bank for International Settlements, ‘no single universally accepted measure exists which can capture all the dimensions of liquidity’. ^[3] Consistent with this, practitioners typically consider a range of measures. These include measures of:

• market breadth, which concerns the extent of activity and price volatility in the relevant market – this affects the spread that intermediaries demand, to compensate for risks associated with the likelihood of price changes during periods when stock is owned;
• market depth, which refers to the market’s ability to absorb relatively large orders without an effect on price; and
• immediacy, which relates to the period of time required to market and sell an asset.

Examples of common liquidity measures in each of these categories are set out below.

The measures in the table are readily identifiable for listed shares. However, there is little in the way of guidance to indicate when the measures indicate that a share should be considered ‘sufficiently liquid’ or what the measures mean for the position of a share on the liquidity spectrum.

Reports of the approaches taken in disputes provide some benchmarks. However, judgments are usually focused on establishing the liquidity or otherwise of a specific share or asset, rather than general benchmarks. ^[4]

Accounting standards, by contrast, tend to provide general information in respect of liquidity. For example, International Financial Reporting Standards (IFRS) establish that, in assessing ‘fair value’, valuers should have regard to matters of liquidity in the analysis of market data. This is observed in IFRS 13, which states: ‘if there is a quoted price in an active market [. . .] for an asset or a liability, an entity shall use that price without adjustment’. ^[5] However, an active market is defined only as a ‘market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis’. ^[6]

Accounting standards in the United States are more detailed, but similarly inconclusive. For example, Financial Accounting Standards (FAS) 157, identifies several factors to consider in an assessment of liquidity. However, it does not provide quantitative benchmarks. Rather, the standard advises that:

[t]he reporting entity shall evaluate the significance and relevance of the factors to determine whether, based on the weight of the evidence, there has been a significant decrease in the volume and level of activity for the asset or liability. ^[7]

Accounting standards therefore recognise that an analysis of liquidity can be relevant in a valuation analysis. They also set out various factors and measures of liquidity that a valuer should evaluate when considering liquidity. However, the standards do not help valuers form conclusions on when an asset is ‘sufficiently liquid’.

Accounting standards also emphasise that an absence (or reduction) of market activity does mean that the share price data is unreliable or should be disregarded. FAS 157 states that:

[e]ven if there has been a significant decrease in the volume and level of activity for the asset or liability, it is not appropriate to conclude that all transactions are not orderly (that is, distressed or forced).8

International valuation standards (IVSs) also state: ‘Low market activity for an instrument does not necessarily imply the instrument is illiquid’. ^[9]

How does the valuer reconcile these statements with the consensus view that that trades in a share needs to be ‘sufficiently liquid’ in order to be reliable? We suggest that an analysis of the cause of the illiquidity is required. The valuer can ask: ‘Notwithstanding the illiquidity, do the underlying trades satisfy the conditions of market value?’ We examine common causes of illiquidity, and their implications, below.

Causes of illiquidity

Amahid, Mendelson and Pederson identify the following factors as common causes of illiquidity: ^[10]

• demand pressure and inventory risk;
• asymmetric or private information; and
• search and bargaining costs and exogenous transaction costs.

Below, we consider the extent to which the first and second factors listed above may give rise to transactions that do not satisfy the conditions of market value and thus may be of limited (or less) relevance to a valuation analysis. We refer to the IVS definition of market value:

the estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction, after proper marketing and where the parties had each acted knowledgably, prudently and without compulsion.11

We do not consider the third factor. These relate to over-the-counter or privately traded securities and is outside of the scope of this chapter.

Demand pressure and inventory risk

Demand pressure arises because not all agents are present in the market at all times. This means that if an agent needs to sell an asset quickly, buyers may not be immediately on hand. As a result, the seller may sell to an intermediary who buys in anticipation of selling at a later date. The intermediary must be compensated for the risk of being exposed to price changes while they hold the asset in their inventory. This imposes a cost on the seller, such as a higher bid-ask spread.

Demand pressure may occur after prolonged periods of poor performance by a company, or alternatively, at times of increased uncertainty (relating either to the company, the industry it operates in, or the economy as a whole). In these circumstances, buyers often become wary of ‘catching a falling knife’ and choose to avoid entering into transactions.

If an asset’s illiquidity relative to the rest of the market is driven by demand pressure, it is possible that the low levels of activity simply reflect the actual market (ie, the balance of supply and demand) for the asset at that point in time. Consideration of the actual market for an asset – active or otherwise - is an important requirement of market value. Indeed, the IVS market value definition also defines a ‘willing buyer’ as one:

who purchases in accordance with the realities of the current market and with current market expectations, rather than in relation to an imaginary or hypothetical market that cannot be demonstrated or anticipated to exist.12

If this is the case, then it may still provide evidence of market value, with the caveat that the trade was entered into freely, between two knowledgeable parties, in spite of low volumes of trades. Indeed, if the low level of market activity is truly indicative of a lack of demand for the asset, it would be wrong to ignore it.

It is perhaps this logic that, when taken to its conclusion, means valuers may resolve to rely upon valuation metrics derived from a single, 100 per cent acquisition of a privately owned business involving just a single buyer and single seller, despite the fact that when considered against the standard measures of liquidity, the shares of that company would be considered highly illiquid.

Asymmetric or private information

Asymmetric or private information arises when market participants are concerned that the other party to a transaction may have access to pertinent information to which they do not. For example, the buyer may suspect that the seller has private information that the company is losing money, while the seller may be afraid that the buyer has private information that the company is about to announce positive news. Suspicions may be exacerbated in situations where there is poor analyst coverage or a controlling shareholder. In such situations, courts have suggested that share prices may not necessarily be determinative of market value. ^[13]

With respect to the market value definition, the existence of asymmetric or private information can indicate that a buyer and seller are not both ‘acting knowledgeably’, in which case a transaction would not meet the definition of market value. Where such a scenario results in illiquidity, the facts may give a valuer cause to place less weight on the data.

Conclusions: Reliability is a question of degree

Liquidity is not a binary construct and a valuer should consider the reliability of data based on an analysis of the overall situation in context. There are not concrete guidelines to inform an assessment of whether an asset is ‘sufficiently liquid’. The valuer must determine this on a case-by-case basis, in the context of their work and circumstances relevant to the asset under review. We suggest that the following factors are relevant in such a process.

• The relative liquidity of the assets in question, as compared to other comparable assets or the index on which it trades.
• The potential reasons for illiquidity. Do trades in the asset satisfy the relevant definition of market value? Is the sale an orderly sale? Are both buyer and seller in possession of sufficient information?
• The underlying purpose of the valuation exercise. Does the valuer require a liquid asset for his or her analysis?

The views expressed in this chapter are those of the author(s) and not necessarily the views of FTI Consulting, its management, its subsidiaries, its affiliates, or its other professionals