The Centre of Audit Quality (CAQ) white paper and the illiquid security valuation debate
The question is whether the prices of these illiquid securities in the market indicate an imbalance between supply or demand or whether they are considered as forced or distressed transactions; whether the quoted prices will be used in the calculation of the prices or whether the valuation should be based of model prices.
The paper highlights a case where the SEC objected to an entity’s practice of ignoring current prices quoted by external pricing sources using instead a valuation based on a longer, return-to-equilibrium view of the market.
Under FAS157 if orderly transactions are occurring between market participants in a manner that are usual and customary for transactions involving such assets, then those transactions are not “forced” sales. The fact that transaction volume in a market is significantly lower than in previous periods does not necessarily mean that these are forced or distressed sales. Moreover, decreased volumes in a market do not necessarily mean the market has become inactive. Persuasive evidence is required to establish that an observable transaction is a forced or distressed transaction. It is not appropriate to assume that all transactions in a relatively illiquid market are forced or distressed transactions. Because the objective of a fair value measurement is to determine the price that would be received to sell the asset at the measurement date (an exit price) – such a measurement, by definition, requires consideration of current market conditions, including the relative liquidity of the market. It would not be appropriate to disregard observable prices, even if that market is relatively thinner as compared to previous market volume. Even if the volume of observable transactions is not sufficient to conclude that the market is “active,” such observable transactions would still constitute Level 2 inputs that must be considered in the measurement of fair value.
Under FAS 157 the role of the market is never disregarded or ignored when measuring fair value, even if markets are very thin and market prices fluctuate widely, i.e. there is a very significant bias towards empirical market data.
Use of valuation models
When quoted market prices in an active market do not exist, entities often employ valuation techniques, typically discounted cash flow models that utilize Level 2 and Level 3 inputs. If a valuation model is used, the objective of the measurement is to obtain the exit price at the current measurement date from the perspective of the seller. If market data exists about the assumptions that marketplace participants would use in pricing the asset, including observable market prices for similar assets (whether or not in active markets), as well as other Level 2 inputs, that information must be incorporated into the entity’s assumptions.
The model must be calibrated to initial transaction prices (if these are fair value) or the model may be tested against similar securities for which price data is available. A model reflects current market data appropriately if the model’s prices adequately approximate the market prices of these similar securities. Alternatively the entity may back test the realized transactions by comparing the realized fair value with the fair value reported in the most recent financial reporting period
Finally, any significant unobservable assumptions, including significant adjustments to Level 2 inputs, likely render the entire measurement a Level 3 measurement.
Illiquid Securities and Illiquidity Discounts
For illiquid securities where a market may not exist, the entity must develop a fair value approach based upon a hypothetical market which incorporates assumptions potential market participants would use in purchasing the security.
Illiquid securities are usually worth less than liquid securities however the impact of illiquidity is usually difficult to model because most theoretical models make the simplifying assumption of full liquidity. The illiquidity in these securities are usually priced using an illiquidity discount, i.e. the difference between as-if-fully liquid price and the fair value of the illiquid security. These discounts are a function of the length or severity of the liquidity restrictions and the risk of illiquid securities. Given the scarcity of trade data another issue here is what would be an appropriate measure for this illiquidity risk- would it be volatility or would it be beta?
Indications of exit prices that have been used to determine illiquidity discounts for these securities have been:
- transaction data from secondary market sales of restricted securities (i.e. securities having restriction on resale)
- transaction data from private placements.