Yale School of Management 1 Emerging Market Finance Lecture 11: Valuation of Illiquid Securities Challenge: shares and other securities are often illiquid in emerging markets! How much should you value them?

Yale School of Management 2 Evidence on Illiquidity Discounts Silber (1991): Rule 144 letter stocks: average discount of 34% (based on 69 private transactions, from )

Yale School of Management 3 Discount Size and Firm Characteristics: the U.S. Sample

Yale School of Management 4 Discounts on Illiquid Bonds Amihud and Mendelson (1991) and Kamara (1994): yield spread between illiquid notes and liquid Treasury bills = 35 basis points. Boudoukh and Whitelaw (1991), the yield spread = 50 basis points between designated benchmark bond and less liquid government bonds in Japan.

Yale School of Management 5 China’s Experience with Illiquid Stocks State Shares: owned by the state and not publicly tradable Restricted Institutional Shares (RIS): held only by institutions (financial and otherwise), and never publicly tradable Floating common shares: A-shares and B-shares

Yale School of Management 6 The Rules State shares can only be transferred to other institutions privately RIS shares are officially only transferable via private search and negotiations. But, since Dec. 1998, auction houses have been selling RIS shares in semi-public auctions Regardless of share type, no short-selling is allowed.

Yale School of Management 7 Typical Ownership Pie

Yale School of Management 8 To first examine price discounts, we use two sets of data: the auction data 2,577 RIS auction transactions from August 2000 to June 2001, on 18 auction houses mostly in Shanghai. Total stocks auctioned: 258 Auctions take place on weekends and evenings Participants have to be “institutions” (mostly, private-fund management firms) Auction houses advertise in advance

Yale School of Management 9 Private-Placement Sample 242 transactions Aug to July 2001 Much larger blocks

Yale School of Management 10 Summary Statistics for Auctions RIS Auction Transactions Price Discount Trans. Value ( in 1,000 yuan) Trans. Size ( in 1,000 shares) Auction B/P Auction E/P Avg.77.93% (Std. Dev.) (6.65%)(674)(242)(0.42)(0.08) Med78.90% Max97.22%28,80012, Min36.98%

Yale School of Management 11 What Does the Discount Mean? Suppose you have two firms with identical future cashflow and operating under identical environments But, firm A is publicly traded, while firm B is privately owned. Then, firm B’s worth is only 21% of firm A’s, simply because firm B is private!

Yale School of Management 12 Summary Statistics for Private Placements Price Discount Trans. Value ( in 1,000 yuan) Trans. Size ( in 1,000 shares) B/P E/P Avg.85.59%76,34031, (Std. Dev.) (8.32%)(72,940)(26,870)(1.74)(0.02) Med87.03%52,57024, Max99.40%494,810326, Min56.28%

Yale School of Management 13 Discounts across B/M Groups Blue: auctions Red: private-trans.

Yale School of Management 14 Discounts by Auction Quantity Blue: auctions Red: private-trans.

Yale School of Management 15 Discounts by Fraction of RIS Shares in Ownership Structure Blue: auctions Red: private-trans.

Yale School of Management 16 Discounts by Age (since IPO) Blue: auctions & Red: private transfers

Yale School of Management 17 Future Investment Returns in RIS Assume the trading restriction is lifted in T years (uncertainty). Share price at time of lifting is unknown. Adopt “buy & hold”

Yale School of Management 18 Are the RIS Auction Prices Reasonable? The answer lies in the rules. Three rules are binding, each causing a distortion:  RIS shares not tradable, but transferable  No short-selling allowed (binding for floating shares)  RIS shares only for institutions, not for the public. Let’s look at two types of models.

Yale School of Management 19 Longstaff’s (1995) Model Assumption: the illiquid stock is locked up for some T years (not tradable at all). Then, the upper bound on the price discount:

Yale School of Management 20 Longstaff’s (1995) Model

Yale School of Management 21 Upper Bounds on Illiquidity Discounts: Longstaff (1995) Model

Yale School of Management 22 Amihud and Mendelson (1986) Model Liquid stock: no trading costs RIS transferable “privately”, but not tradable publicly, means it is MORE costly to exchange ownership  Let c be the % search/transaction cost for RIS (whenever there is a buy or sell).  Put aside the no-short-selling aspect for now. Then, relative to the fair value of a floating share, the discount for RIS is d = PV(all future transaction costs)

Yale School of Management 23 Table for Fair Non-Marketability Discount (without short-selling constraint) Assume c = 5%. T = # of yrs before lifting, t = # of yrs in a typical RIS holding period. Cost of capital = 10% per year Years before lifting restriction

Yale School of Management 24 Discount due to No-Short-Selling With No-Short-Selling, stock prices can be far above fundamentals, yet no one can do anything about it. Due to its emerging-market status, suppose the right P/E for China is 30. Relative to the floating-share price, a reasonable discount should be No-Short-Selling discount + Non-Marketability discount

Yale School of Management 25 Illiquidity Discounts based on Amihud & Mendelson (1985)

Yale School of Management 26 Restricted vs Floating Shares: a cause for other things Everyone wants to go IPO! No one wants to stay private, even if it means they have to take risk and make up the numbers! With relatively few shares floating, easy to manipulate common share prices! leading to “pyramid corporate family empire”.

Yale School of Management 27 With such discounts, every public corp. will be run like a “hedge fund” With the RIS shares priced so low, takes only little capital to acquire a “controlling shareholder” position The price discount for RIS shares relative to floating A-shares is so high (84% avg.) that every firm wants to be a “hedge fund”: Long RIS (or, state shares) and get the right to short floating A-shares.

Yale School of Management 28 “Hedge Fund” Strategy Public Company ABC Pay $0.16 to acquire an RIS or state share, to become “controlling shareholder” Sell floating A- shares to public at $1 per share. Transfer cash through “related- party” transactions

Yale School of Management 29 Sample for the Control Premium 154 private transfers of state-owned shares (SOS) to other state-owned enterprises (SOE) (with 91 transfers involving controlling blocks and the other 63 transfers non-controlling blocks) 17 transfers of controlling SOS share blocks to private firms, and 3 non-controlling SOS share blocks to private firms.

Yale School of Management 30 Control Premium Size % SOS price premium relative to book value of equity per share Control Blocks to private firms Non-Control Blocks to private firms Control Blocks to SOEs Non-Control Blocks to SOEs

Yale School of Management 31 Control Premium Relative to Floating A-Share Prices Control Blocks to private firms Non-Control Blocks to private firms Control Blocks to SOEs Non-Control Blocks to SOEs

Yale School of Management 32 Control Premium Relative to Revenue Per Share Control Blocks to private firms Non-Control Blocks to private firms Control Blocks to SOEs Non-Control Blocks to SOEs

Yale School of Management 33 ROE Across Groups Control Blocks to private firms Non-Control Blocks to private firms Control Blocks to SOEs Non-Control Blocks to SOEs

Yale School of Management 34 ROA across Groups Control Blocks to private firms Non-Control Blocks to private firms Control Blocks to SOEs Non-Control Blocks to SOEs