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Control Premiums in Business Valuation

A Scrutton Bland Guide

September 2015

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CONTROL PREMIUMS IN BUSINESS VALUATION A Scrutton Bland Guide

CONTENTS Foreword .................................................................................................................... 3 1 The Justification for the Control Premium ............................................................ 5 2 The Control Premium in UK Court Cases ............................................................ 6

3 The Challenge to the Classic View ...................................................................... 7

4 What Is the Market Price? ................................................................................. 10 5 What is the Value of Control? ............................................................................ 13

6 UK Investment Trusts and the Closed Funds Puzzle ........................................ 18

7 The Pricing of Real Estate Investment Trusts: The UK and the USA Experience ...................................................................... 26

8 Voting and Non-Voting Shares .......................................................................... 30 9 The Control Premium as a Guide to the Minority Discount? .............................. 30 10 Some Conclusions ............................................................................................. 31


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Foreword

This paper explores the current and developing thinking in the UK with regard to the concept of a premium for control of a company, when carrying out valuation exercises on private companies using listed companies as guideline companies. It has long been recognised in business valuation circles that the market prices of most listed company stocks and shares are set by a large number of trades on a daily basis. The parcels of shares that are bought and sold in such trading activity are normally insignificant minority holdings. It is but the shortest of steps to state that the market prices and market capitalisations are therefore minority valuations. Logic then leads by a further brief step to the concept that a premium should be applied when considering control holdings. This is on the basis that there is value in control. This logic has then seemingly been confirmed by empirical data: a great many studies into bid premiums offered in takeovers of listed companies have led to the conclusion that the value of control is some 30% or 40% above the listed price. Valuers have for many years run along such comfortable grooves of intellectual certainties; those certainties have been reinforced by frequent repetition. The concepts above have been one of the fixed points of reference for many in the UK business valuation community for many years. Under the system of common law the findings in valuation cases set precedents: it is a brave soul who then turns against the received wisdom of the great and the good of past years and gives a contrary view. The concept of legal precedent can make it difficult to gain acceptance for a view which is at variance with all that has gone before. It takes a special type of intellect to challenge received wisdom. This is especially the case when that received wisdom is deeply embedded. Eric Nath of the USA has demonstrated such an intellect and strong thought leadership. He has demonstrated the passion of his conviction that the above concepts are both illogical and deeply flawed. I would like to acknowledge the leadership that Eric Nath has shown since 1990 in challenging these comfortable conventions. This Guide summarises the traditional views in respect of the Control Premium. It then looks at some of the decided UK cases on the question. The Guide then moves on to set out some of the arguments put forward by the revisionists which challenge the traditional views. In order to do this it sets out a hypothesis of the qualities of the shareholder population: the nature of the bid premium is open to a different interpretation if it is accepted that the population of shareholders is heterogeneous. The Guide then considers the five different reasons for takeovers which have been identified and the theoretical position of the control premium in each of these circumstances. In the UK the concept of the control premium has been supported by three kinds of empirical evidence in various cases:

The bid premiums that are offered on takeovers as noted above;

The discounts from net asset value that can apply on the market capitalisations of investment trusts, otherwise known as closed end funds;


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The discounts from net asset value that can apply on the market capitalisations of property investment companies and, latterly, Real Estate Investment Trusts

The empirical data in respect of bid premiums has been exhaustively researched. However it is the interpretation of this data which is changing rather than the data itself. The evidence in respect of closed end funds and REITs has been subject to rather less scrutiny as evidence for the control premium. This Guide therefore looks at both of these sources of evidence. In addition to the above factors which have been mentioned in various UK cases, there is an additional factor which is worthy of exploration: this is the premium which applies to voting shares when compared to nonvoting shares in those cases in which all other rights are the same. The traditional view in the UK has generally been that nonvoting shares have a value which is some 85% to 90% of that of voting shares. There have been various paired studies in various markets which suggest average premiums of 2% to 6% for voting over nonvoting shares. This point addresses the kernel of the debate: does control have value in itself, or does it only have value for the buyer by reference to synergy or to the greater cash flows or reduced risks which the buyer can obtain by implementing change? An extension of the logic of the control premium then leads to the doctrine that the bid premium, once inverted, provides guidance as to an appropriate minority discount: if control is worth some 130/100 of the market price, the clear implication is that a minority has a value which is 100/130 of the value of the whole. This then takes one automatically to the contrary thought: if there is no significant value in control per se in respect of the majority of listed companies, then there should be no material discount required in response to that absence of control. One of the fruits of the challenge to the concept of the control premium is a close focus on the cash flows of a business and their destination: if those cash flows are available for the benefit of all shareholders, and are not purloined in part by an avaricious controlling shareholder careless of minority rights, the valuation approach should reflect this fact. If on the other hand there is a majority shareholder operating with all of the democratic impulses of a mediaeval monarch, the valuation should be based on the cash flows available to the minority. There is then arguably no need for a further discount for a lack of control as this may represent a double discount. Andrew Strickland Colchester September 2015


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1 The Justification for the Control Premium

1.1 The concept that the Stock Markets of the World provide a minority valuation is one that is very well established:

The parcels of shares which are traded on a daily basis, and which determine the listed share prices, are generally insignificant minority holdings in listed plcs. It is the last trade of the day which determines the price of the shares;

The market price is therefore, by definition, a minority holding valuation;

There is a difference between a minority valuation and a majority valuation: a minority shareholder has no ability to control an enterprise;

When companies leave the relevant Stock Market due to takeover, the acquirer has, in most cases, to pay a premium above the pre-bid share price in order to gain control;

This bid premium varies over time and according to the relative pricing of the Markets but can amount to 30% or more of the pre-bid price;

This is the manifestation of the control or bid premium; it is also taken as a clear demonstration that the markets normally reflect minority values;

The market capitalisations of investment trusts and property companies generally trade at a discount to the underlying net asset values. This is further demonstration, in the eyes of some, that the market prices are minority valuations.

1.2 When undertaking valuations of majority holdings in private companies, using listed

companies as guidelines, it has been considered necessary, both in North America and in the UK, to make appropriate adjustments:

As minority shareholders have no ability to control an enterprise, majority holdings are therefore worth more than minority holdings;

The metrics used for valuing listed companies (normally the Price-Earnings Ratio or P/E) should therefore be uplifted to reflect the difference between a minority and a majority holding;

The level of the bid premium evident in the markets is a good source for this adjustment;

If the PE ratio of the guideline listed companies is say 15, the starting point for the valuation of a control holding in a private company should therefore be somewhere between 19 and 20, assuming that the premium for control is 30%;

It is then appropriate to make other adjustments, to account for the size and growth prospects of the company in question. However these adjustments are made to guideline companies whose metrics have been increased by some 30% or more above the values exhibited by the Stock Market.


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1.3 There is clearly significant force to this logic: that force is strengthened by frequent repetition and by the passage of time.

1.4 The logic leads the valuer in the expected direction: he is very conscious that UK

Company Law works on the basis of majority rule: with the exception of quasi-partnership structures control of a private company can bring with it enormous benefits.

2 The Control Premium in UK Court Cases

2.1 In the January 2015 fiscal valuation case before the Finance and Tax Tribunal of Mr

and Mrs Foulser v HM Revenue and Customs (UKFTT 0220) (TCO 4413) the Expert for HMRC used a bid premium of 40% as a core part of his calculations in respect of a November 1997 valuation of a holding of 51% in a private company.

2.2 The Expert noted that stock exchange P/E ratios are applicable to small parcels of

shares, and that the bid price for an entire company would include a bid premium to the ruling price per share in the normal range of premiums between 30% and 50%. Using data derived from the magazine Acquisitions Monthly, he noted that the average bid premium for 1996 was 31% and for 1995 it was 36%. For the first nine months of 2007 the average premiums ranged from 29% to 42%. The Expert eventually selected a bid premium of 40% as being the mid-point between 30% and 50%. (He had previously reduced the PE from guideline public companies by some 25% as the company was private and had various risks of concentration of the business on two main customers.)

2.3 The Tribunal clearly approved of the concept: “That was a logical step, and one we

consider appropriate to the valuation process employed by [the Expert].” However they considered that the bid premium should be reduced from 40% to 35%.

2.4 In the 2014 shareholder dispute case of Arbuthnott v Bonnyman & Ors (EWHC 1410), the valuation expert for Mr Arbuthnott added a 40% premium to the metrics of the guideline public companies. This was based on the transactions in the market spanning five quarters prior to the transaction. A “Big 4” firm had previously valued the business in 2009 and had applied a control premium of 39%. The other expert agreed that it was very important to include an uplift for control when valuing by reference to listed companies. Therefore, although the difference in values between the two sides in this case was a factor of more than ten (£225 million compared to £20 million), the two sides were agreed on the control premium concept. (The valuer for Mr Arbuthnott then made an adjustment of 35% in the opposite direction to account for the fact that the company in question was a private company.)

2.5 A relatively recent tax case was Stephen Marks v HMRC (2011). This was a fiscal valuation case heard at the First Tier Tribunal; it involved the business known as French Connection and the value of this business, and a related business, at 31 March 1982. A large part of the case centred upon whether the main company and the related business should be treated as one asset or two at 31 March 1982. However it was then also necessary to determine the values of the two businesses at that date.


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2.6 There were many differences between the valuer for the taxpayer and the valuer for HMRC. However the one area of agreement related to the level of the control premium. Both valuers assumed a control premium of 30% when comparing the main business to the listed guideline companies. The justification for this premium, both conceptually and in amount, was therefore not fully argued and explored in the written decision of this case.

2.7 The written decision states that the HMRC expert used a survey in the journal the

Investment Analyst of October 1981 which found an average 29% rise in the share price of target companies taken over and 31% rise where the bid lapsed. This was seemingly the basis for the control premium of 30%.

2.8 In the case of Ian Campbell McArthur deceased of 2008 there was a need to value

various holdings in several investment companies. The point was made in that case that it was normal for both investment companies and property companies to trade at a discount of from 10% to 30% from the underlying net asset values. It was stated that property companies would normally trade at a discount at the upper end of that range. The two valuers considered various discounts from net asset value which would apply to different sizes of shareholdings in such companies.

2.9 The case of Marks v Sherred in 2004 related to a company which imported

headphones into the UK: a majority holding of shares was involved. Although reference was made to the Price Earnings Ratios of guideline listed companies, it was also recognised that the company was far smaller than such guideline companies. A Price Earnings Ratio was set which recognised that this was a control holding but the level of the control premium in deriving this PE Ratio was not expressly stated.

2.10 The non-tax case of Re Cumana Limited of 1986 referred to control premiums of

15% and 20% being typical.

3 The Challenge to the Classic View

3.1 The classic view, as described above, has been challenged, with an increasing tempo, since the mid 1990’s. As previously noted, Eric Nath has provided much thought leadership in this area.

3.2 The challenge has taken several forms: it was recognised that only some 3% of the

listed companies in the market are subject to successful takeover activity in any year. With private equity houses and hedge funds scouring all parts of the economy for a financial gain, why do they not seize the benefits of the control premiums in some of the other 97% of cases, if this is a universal quality of listed companies?

3.3 As the number of companies taken over is normally a very small proportion of the

listed market each year, there is a major problem with sample selection bias: unless one follows the doctrine of efficient markets with a purity of thought as the most zealous disciple, it cannot reasonably be assumed that those companies taken over reflect a representative sample of all listed companies. It is far more compelling to hold the view that these companies will be largely represented at the under-valued end of a value spectrum: bids will not normally be made for companies that are over-valued by the markets. Bids will be made for a small number of companies which have special characteristics.


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3.4 The above view was elegantly expressed by Gil Matthews: “Use of the average acquisition premium in other transactions is a flawed approach. Since the average premium includes the prices paid for companies that buyers viewed as attractive undervalued targets and excludes companies that acquirers considered overpriced or fairly priced in the marketplace, the average premium paid in acquisitions is biased upward. Only a small portion of publicly traded companies are acquired in any particular year.”

3.5 It is very difficult for the efficient markets purists to argue that the companies taken

over each year are representative of the entire markets in any event: the control premium is an affront to the efficient markets hypothesis. (If markets were wholly efficient, the share prices would reflect the prospect of the relevant takeover transaction. The jolt to the share price on the announcement of a bid is a clear example of asymmetry of information and of inefficient markets.)

3.6 The next point is that takeovers of companies are singular events, specific to that

company, that acquirer, and that time. It is very possible that the acquirer may be a special purchaser who is prepared, at that relatively brief moment in time, to pay a premium price in order to gain control of that entity, with the peculiar benefits of synergy which may accrue to it.

3.7 This may be due to rational business reasons or it may be for reasons of hubris or

ego: however in either circumstance the acquirer assumes the position of a special purchaser. The activities of a special purchaser should not justify applying a premium to a group of guideline companies.

3.8 If the bid premium reflects an overarching presence hovering above the market

prices of all listed companies, then this must mean that control brings with it the ability to increase the cash flows of those companies. An assumed bid premium of 40% indicates that the cash flows of listed companies can all be increased by that amount. Rational investors would not pay such bid premiums unless they were of that view.

3.9 The premium that is payable is not a premium in order to acquire control, as there is

no benefit in having control per se. It represents normal market forces of supply and demand at work. An acquirer can accumulate a stake of only 30% in a public company in the UK before making a conditional bid for the entire share capital. This means that the price will be expected to increase at the point of making a general bid as the demand for the shares is likely to exceed the supply. Each shareholder will have his own opportunity cost, and the acquirer will have to make an offer which overcomes the resistance of shareholders until he has a holding of at least 90%, at which stage the offer goes unconditional. This is nothing more and nothing less than basic economics.

3.10 A rather more deeply argued explanation of the economic forces at work on the

announcement of a bid is that the premium recognised in the post-bid market price represents a probability-weighted expectation that the bid will be successful. The market price is normally expected to rise: its closeness of approach to the bid price reflects that probability weighted expectation. If the bid price contains an insufficient premium market participants may attach a low probability to it being successful. They will factor in their view of the probability of the bid being raised.


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3.11 Similar economic effects will be seen in reverse if an attempt is made to dispose of a large shareholding in the market place. Unless carefully managed, the supply will exceed the demand and the price of the shares will be expected to fall. These are relatively uncommon events, but they should not be used to support a hypothesis that larger holdings are worth less per share than smaller holdings.

3.12 Most of the time the bid will reflect the status of the bidder as a special purchaser. On

this interpretation, bid premiums are largely reflective of synergy benefits to acquirers. If this is not the case then, unless the acquirer is confident that he can manage the business better and generate greater profits from the same assets, there is no discernible benefit from control. This is a point that has been well made by Professor Aswath Damodaran.

3.13 The above points resulted in Eric Nath venting his frustration and making the

following comment in 2011: “… it is surprising that so many business valuers still cannot understand why public company shares do not trade as minority interests, and why it is bad practice to add a control premium when valuing a private company using public company data.”

3.14 Eric Nath also maintains that investors in the public markets have no regard to the fact that they do not control the business, as they have no desire for control. They have a desire to participate in very liquid markets. There is therefore no element in the market price related to the lack of control. The ownership of a minority stake in a listed company is not some form of second best investment position.

3.15 There has been an increasing recognition of these points in the mainstream: the International Private Equity and Venture Capital Valuation Guidelines (2012) have been endorsed by many national bodies, including the British Private Equity & Venture Capital Association (BVCA). The Guidelines express unease with the classic view by stating the following: “While there is an argument that the market capitalisation of a quoted company reflects not the value of the company but merely the price at which small parcels of shares are exchanged, the presumption in these Valuation Guidelines is that the market based multiples are indicative of the value of the company as a whole.”

3.16 The Appraisal Foundation has been recognised by Congress as a source of appraisal standards in the USA. It has created the Appraisal Practices Board as a vehicle for the production of such standards.

3.17 The Appraisal Practices Board issued in April 2013 an exposure draft of an advisory

note entitled “The Measurement and Application of Market Participant Acquisition Premiums”. The Advisory note recognised that the market price is by definition a minority price, as it is determined by trades in insignificant proportions of the equity. For reasons that are not being explained this exposure draft has not yet (September 2015) been issued as a Standard.

3.18 However, this exposure draft recognises that there is no value in control per se, and

that a premium is only justified if there is clear evidence that there will be either:

Increased cash flows; or

Reduced risks leading to a lower required return on capital.


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3.19 If these qualities are absent, then the continuing existence of the company as an independent listed entity may support the view that no potential buyer believes that there is a value within the entity above the publicly traded price.

3.20 The Advisory note dispenses with the phrase “Control Premium” due to it

incorporating the wrong connotations. It replaces it with the decidedly clumsy: “Market Participant Acquisition Premium” or MPAP. Practitioners should no longer rely on historic premiums in closed transactions. They should instead identify how the company might benefit from enhanced cash flows or reduced risks if a takeover were to take place. The question should be considered from the viewpoint of the Market Participants, not from the viewpoint of the entity.

3.21 The Advisory note recognises several situations in which valuers consider the value

of the entire equity. Two of the most common situations are tests for the impairment of goodwill and the valuation of controlling holdings held by private equity companies or funds. It recognises that many valuers have historically added a premium of 30% or more to the market capitalisation of the entity being valued, in order to increase the market price from a minority to a control holding. This has resulted in some disquiet in the halls of the SEC it seems.

3.22 Market capitalisations can be an unforgiving judge of balance sheet values, notably

those of intangibles. It seems that in the past the harshness of these judgements has been softened by the application of sizeable control premiums, based mainly on knowledge of past transactions. The advisory note anticipates that this will change with the use of MPAP and that the market capitalisation will only be moved upwards if improved cash flows or reduced costs of capital are demonstrable.

3.23 The Advisory note remains as an exposure draft. Various comments have been received and the final document is still awaited as at September 2015. As noted above, the reason for the considerable delay is not known.

3.24 The Sixth Edition of “Practical Share Valuation” by Eastaway and others, which is justifiably used by many as a fountain of knowledge for business valuations in the UK and which is frequently cited in cases, states that the valuer should familiarise himself or herself with up to date research in this area before deciding on the appropriateness of any control premium.

4 What Is the Market Price? 4.1 The market price has been described as the clearing price: it represents the price set

by the market makers as they balance the selling and buying pressures in the market. It is understandable that the shareholders and buyers are viewed as homogenous groups. Much share valuation is dealing with hypothetical transactions between hypothetical parties: it is quite understandable that the valuer therefore wants to simplify as many of the variables as possible in order to instil some rigidity into such an uncertain landscape. The reality is, unsurprisingly, rather more complex.


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4.2 The potential buyers of the shares in question can be represented as a normal distribution sitting on a line representing the price of the shares: the most optimistic buyers will be prepared to buy the shares at a rather higher price than the least optimistic. Therefore there is no single market price as far as the population of buyers is concerned. The bell curve of a normal distribution has been chosen, not on the basis of empirical data, but on the basis that this is how the world very often works and it therefore appears to be the most appropriate assumption. (It is clearly very difficult to observe the actual shape of the population empirically. If the population is skewed and is therefore not evenly distributed around a mean, this does not change the conclusions.)

4.3 The potential sellers also form a normal distribution but they are somewhat to the

right of the population of buyers on the pricing line. The most pessimistic of the sellers will sell at a rather lower price than the most optimistic of the sellers.

4.4 We can all recognise that the population of shareholders is very likely to be diverse: they will extend from those who are desperate to sell at almost any price, through market traders who will sell if there is an opportunity of a modest profit, and then onto the various tracker funds which will always hold the shares in question provided that they remain in the Index and the personal investor whose attachment to the shares in question may be entirely rational or may be driven by loyalty or sentiment. .

4.5 The market can then be portrayed as the overlap of the two populations: if that

overlap represents say 0.5% of the buyers and 0.5% of the sellers, this suggests that transactions involving 0.5% of the equity of company will take place on that day. If there is no overlap between the two populations then there can be no market.

4.6 The position of the buyers and the sellers is illustrated below:

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

-4 -3 -2 -1 0 1 2 3 4

Market price as clearing price

Buyers

Sellers


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4.7 Some of the sellers would have been willing to sell for a lower price than the clearing price; some of the buyers would have been prepared to pay somewhat more than the clearing price. However, the clearing price, as it moves during the day, determines the market price. This then in turn determines the market capitalisation. The market price therefore represents the views of the most pessimistic sellers and the most optimistic buyers.

4.8 Buyers seeking control in a takeover will normally need to be prepared to pay a

premium of some 30% or more above the market price in order to gain 90% acceptances. This is not a universal truth but it appears to be the case that some 80% of takeovers involve the payment of a bid premium. This therefore means that some 90% of the population of sellers will fall within that uplift of 30% or more.

4.9 This does then mean that the price inclusive of the bid premium may represent a discount from the value perceptions of up to 10% of the sellers.

4.10 In a successful bid, with a premium of 30%, this uplift will therefore capture the 50%

of the sellers’ population below the mean and rather more than 40/50 of the sellers above the mean.

4.11 We should consider why shareholders should represent a diverse, heterogeneous population rather than a homogenous whole: some sellers will have more optimistic assessments of the future prospects of the company; some will be determined not to book a loss and will hang on grimly until the price at least equals their entry point; others will be passive investors, not responding to short term ripples in the share price whilst others will be short-term margin traders.

4.12 There can be circumstances in which the shareholder population is far more homogenous: if a company is in financial distress it is possible that liquidity will have drained away from the market. In such circumstances a large number of the shareholders will be frustrated sellers, all crowding at the door but with no ready means of exit. In such circumstances it is very understandable that a bid may be at a price which does not represent any form of premium.

4.13 The market price is, by definition, the best price. If there are no market makers, it may be perceived that the best price is that which will be offered by the most optimistic buyer in the above illustration. However, he or she would then be met by a surfeit of sellers, and this would drive the price down to the clearing price.

4.14 A bid will normally be launched with the aim of succeeding and in acquiring the

target. Therefore, if the potential buyer considers that the target is under-priced by only say 10% or that the benefits of synergy are marginal, he will be unlikely to make a bid. In such a circumstance he will be unable to offer a price which will meet the minimum price requirements of a sufficiently large number of sellers.

4.15 This is therefore the demonstration of the marked selection bias in the population of companies which are subject to takeover bids. That population is unlikely to include those companies considered to be fairly valued or over-valued by the market. It will also exclude companies only moderately undervalued by the market. It will be far more likely to include those companies for which the buyer is a special purchaser together with those companies which the buyer considers are very materially undervalued by the market.


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5 What is the Value of Control? 5.1 There have been five rational economic justifications identified for a takeover of listed

companies, as set out by Cornell of Caltec:

There is a benefit from synergy perceived by the acquirer;

The company is undervalued by the market;

The company is overvalued by the acquirer;

The company suffers from poor management;

Self-interest of acquirer’s management.

5.1.1 In addition to the above five economically rational justifications for a takeover, there are a wide range of what might be considered as irrational motivations. (They are certainly irrational in the economic sense.) These include:

The management of the acquirer are dedicated followers of fashion. They are spurred on to undertake acquisitions as this is the current vogue;

The management of the acquirer are manipulated by their investment bankers to undertake a transaction. The investment bankers are motivated by a desire for fees or for other reasons;

The management of the acquirer may be consumed by hubris and have a desire to be seen to be amongst the movers and shakers in business circles.

5.1.2 Although they might be considered to be irrational, we can all probably identify

transactions which, with the benefit of hindsight, can be seen to include one or more of the above causes. (Hindsight is often required as such motivations would obviously not be paraded by management as the rationale for a transaction.)

5.1.3 Some of the rational economic justifications will have their roots in irrational

motivations: the above irrational motivations are likely to increase the number of transactions which take place in which the target is overvalued by the acquirer.

5.1.4 As well as considering why takeover bids are made, it is useful to consider why they

are not made, as this applies to most companies most of the time. 5.1.5 There are a large number of reasons why bids are not made:

The company is either fairly priced or over-priced in the market;

The company does not offer a compelling synergy benefit to any possible acquirer;

The company is under-priced, but only to the extent of 5% or 10%. In such a situation, the potential buyer realises that the bid premium likely to be required by the population of sellers will result in too high a price being paid in order to complete the acquisition;

The sellers’ expectations may increase on the announcement of a bid in any event, on the basis of a self-fulfilling prophecy, unless expectations are managed at a very early stage;


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The above reasons can also be applied in respect of the values to be gained from synergies, from the resolution of underperformance due to poor management and the over-pricing by the acquirer: these factors need to be very significant to justify the bid premium that is normally required by the market;

Hostile takeover bids can be bruising affairs and can do damage to the business of both the buyer and the target. They are therefore not lightly undertaken;

It is very likely that underperforming management will overestimate their ability to improve the performance of the entity. They may therefore not seek out a bid and may resist one which comes along

Management of plcs, across the range of abilities, are likely to be very conscious of their own position and this may be an unstated reason for opposing a bid and not seeking a buyer when this is the optimum course for the shareholders.

5.2 Synergies 5.2.1 The word “synergy” can be defined as the working together of a number of

individuals for greater effect. It can be used carelessly, to disguise a multitude of different justifications for a transaction.

5.2.2 An example where synergies might apply is:

Company A has a well developed distribution network in Asia and Australia for its products. Company B, a larger company in the same sector, with strong distribution networks in Europe and North America, can benefit by selling its products through the Company A distribution network. The products of Company A can also be distributed more effectively by use of Company B’s network in Europe and North America.

5.2.3 The efficient markets hypothesis is under assault from many quarters: however, for

the true believers in the hypothesis there should be no premium payable in a takeover transaction involving synergies unless these could only be identified by the acquirer. If there was general market awareness of the potential described above in respect of Company A and Company B then the share price of Company A should reflect this potential.

5.2.4 Control premiums in the observed markets can therefore only fairly be attributed to

the benefits of the synergy for a special purchaser if those benefits were not widely known in the market place.

5.2.5 Once a particular sector is identified as an area of the market for consolidation,

prices should rise in that sector as takeovers are anticipated. It would therefore be entirely inappropriate to add a control premium to a price which was already uplifted in anticipation of a bid. The greater the relevance of actual bid transactions in the market place, the more dangerous their use in application to guideline companies. This point is well made by the Appraisal Practices Board of the Appraisal Foundation in their April 2013 exposure draft “The Measurement and Application of Market Participant Acquisition Premiums”.


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5.2.6 The point has been forcefully made that many transactions involving special purchasers, such as Company B in the above example, are singular transactions which apply to a constrained set of circumstances in a narrow time frame. They are very often unique; they are almost always transactions which do not provide information of general application even to the narrowest sub-segments of a market, let alone to the wider market place.

5.2.7 When considering guideline companies a valuer would need significant evidence to

support the view that there were a number of special purchasers waiting in the wings and on the cusp of transactions in which they were prepared to pay prices in excess of those determined by the markets.

5.3 An Undervalued Company

5.3.1 If an acquirer identifies that a company is undervalued, then it has a view which is

different to that of the rest of the market. For those who are not wedded to the efficient market hypothesis in its purest form, this should not be a huge leap of faith. It is reasonable to assume that the comparison of market values and innate values will follow a normal distribution, with the majority of companies valued at close to the innate value but with a number of companies under-valued or over-valued.

5.3.2 In such circumstances there is logic in believing that the takeover activity will be

focussed on those companies which are under-priced. In this circumstance, companies may be acquired if the under-pricing by the markets is greater than the uplift which normally applies when a bid is made.

5.3.3 Logic also dictates that the buyer will be prepared to pay a price somewhat less than

its perception of the market value as reduced by an allowance for transaction and other costs.

5.3.4 Control premiums in the observed markets which are attributed to undervaluation by

the market place are therefore most likely to be singular transactions and events. 5.3.5 If this transaction leads to the general conclusion that a market sector is undervalued

then in those very narrow circumstances it may be appropriate to add a control premium to the market values in that sector. However the time period in which such an adjustment might be appropriate would be very short as it would only be until the market wakes up to the realisation. This would also require an unduly courageous or ill-advised valuer deciding that he had identified a quality in the market that the market had not itself yet seen.

5.3.6 Assuming that the valuer is neither unduly courageous nor ill-advised, he should not

add a premium to the market price of guideline companies to allow for the thought that they may be undervalued.

5.3.7 Supporters of the control premium may argue that all companies are undervalued by

the market in that they represent, by definition, minority values. However, if this is the case, this can only be sustained if it is believed that the cash flows of all companies in the market could be increased by 30% or more as a result of a change in management.


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5.4 A Company Overvalued by Acquirer 5.4.1 This has been described, with rather elegant alliteration, by Richard Roll as the

“hubris hypothesis” and is a situation to which we can all probably relate. 5.4.2 I am very mindful of the truly extravagant prices paid for the grubbiest and most

down-at-heel estate agency businesses in the late 1980’s. As banks and building societies became ever more convinced that the route to the market for the sale of financial products in the future would be through property transactions, a feeding frenzy led to a scramble to build estate agency chains from the most unpromising material, bought at ever more fabulous expense. The so-called “Lawson boom” ended extremely abruptly in August 1988, to be followed by a moribund residential property market. In the early 1990’s, tiring of their losses, the same banks and building societies sold these businesses back to their former owners at a tiny fraction of their cost. The shareholders counted the cost of this immense folly and licked their wounds.

5.4.3 Overvaluations can be identified by the values before and after the transaction: if the

share price of the acquirer is adversely affected by the transaction, then this gives support to the hubris hypothesis: any hopes for synergies have been outweighed by the costs of acquisition.

5.4.4 We can all recognise those transactions in which the share price of the target

increases at the news of a bid, whilst that of the acquirer falls. This should not occur if the market believes that the buyer will be making a good bargain.

5.4.5 It is therefore seemingly very common for the market to determine that the benefits of

synergy are more than counterbalanced by the premium that the buyer will be paying in order to gain those benefits.

5.4.6 Clearly such transactions provide very little support to the idea that values of

guideline companies should be increased to reflect the benefits of control. 5.5 Bad Management of Target 5.5.1 The main premise of the control premium is that there is some economic benefit to

be had from control. That benefit therefore needs to be determined. 5.5.2 Professor Aswath Damodaran has stated: “The value of control can be zero if a firm

is already optimally run.” 5.5.3 This is a quality of a target company which is generally very difficult to distil and

isolate from the broader concept of benefits of synergy. We can all recognise those companies which have failed, or which have come close to failing, largely due to poor decisions taken at the highest levels.

5.5.4 I suspect that there are a great many transactions in which the acquirer has a low

regard for the management of the target company; in such cases the buyer may anticipate some easy wins from better direction and control. If the views of the buyer are ill-founded and the easy wins do not exist, then it is very likely that the buyer will have overvalued the target company.


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5.5.5 It is possible to argue that many control premiums are occasioned by the improvement that the acquirer’s management considers that it is capable of making to the target. This improvement does not even need to be realised, it is sufficient for the acquirer’s management to have that belief.

5.5.6 It is only possible to apply this rationale for the control premium to the entire market if

one can maintain that:

the value of the whole market could be enhanced if all listed companies were better managed and such a prospect can be realised; or

all companies face the prospect of being acquired by other companies whose management carry very significant self-belief, regardless of whether this is reality or self-deception.

5.5.7 If the valuer believes that the market values of most companies reflect average

management (with the actual spread of abilities following a normal distribution from the world-class to the deeply inadequate), and he does not have compelling evidence that there is an excessive confidence in the management of possible acquirers, then this reason for the control premium cannot readily be applied. It would be most unwise for a valuer firstly to maintain that he can rank listed companies by reference to the quality of their management and secondly that the guideline companies which he has selected all have management which are in the lowest decile.

5.5.8 There is however an intriguing argument that control brings with it “step-in” rights in

the future. As noted above, we must assume that the abilities of the management of the listed company sector are average, with a normal distribution of skills around that average. We therefore cannot rely upon the ability to improve management as a general quality which justifies a control premium. However, we live in a fast-changing world and none of us know what challenges will be faced by different businesses over the next five to fifteen years. Equally, we do not know how the management of the various listed companies will respond to the changes that will doubtless take place.

5.5.9 The idea that there may be a failure of management at some point in the future; and

that the acquirer will be able to step in; and that he may be able to improve such a situation; is an attribute of general application which comes from having control.

5.5.10 Another possible, but more contentious attribute of control is the prospect of reducing

the cost of management: the agency problem in listed companies, with the separation of the objectives of management and shareholders, is well recognised. One of the justifications for the private equity sector is that the agency problem is significantly reduced through a greater symmetry of management and shareholder interests.

5.5.11 If one is prepared to support the view that the senior management teams of most

listed companies are, to a significant extent, self-serving and are being rewarded at greater than their market worth, then this can be used as a justification for a control premium. This then requires the view that such management can be replaced with people of at least equal ability but at materially reduced cost.


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5.6 Self Interest of Acquirer’s Management 5.6.1 We do not need reminding of the principal and agent problems that can exist in listed

companies or in any enterprise where the owners and managers are not one and the same.

5.6.2 An acquisition can increase dramatically the size of a listed entity. If the motivations

are not those of misplaced egos and excessive vanity, the base, economic self-interest of the senior management team can provide a powerful propellant. This is even the case in situations in which the shareholder group gains no material advantage from such a transaction.

5.6.3 These motivations are ones of intense self-interest for the management team, but

make no economic sense for the shareholders. Once again, the valuer can only recognise the prospect of such a control premium if he has very strong grounds for considering that these forces are very likely to be at work on the guideline companies that he has chosen.

6 UK Investment Trusts and the Closed Funds Puzzle 6.1 Or, are Markets Really Efficient? 6.1.1 As noted in the Foreword to this Guide, the discount of the market capitalisations of

investment funds has been one of the sources to support the concept of the control premium in the UK. This chapter therefore explores the evidence with regard to this part of the market.

6.1.2 Much economic thinking is based on the concept of efficient markets. Roger Bootle is

an iconoclast in this regard: in his book “The Trouble with Markets” he has expressed a compelling sentiment: the efficient markets theory can only work if there are many powerful participants in the markets who do not believe in it.

6.1.3 The concept of efficient markets is sorely tested by the market capitalisation of

investment trusts in the UK (known as closed end investment funds in the USA). In both countries the shares in these companies typically trade at a discount of 8% to 10% from the underlying Net Asset Values (“NAV”).

6.2 The Puzzle 6.2.1 At its most stark a unit trust and an investment trust could hold identical portfolios of

investments: the units in the unit trust would be traded at NAV; the shares in the investment trust would generally trade at a typical discount of 10% from NAV. This is an affront to the law of one price.

6.2.2 This is described in the literature as the closed end fund puzzle: this puzzle has

resulted in the outpouring of many papers by academics and financial analysts over the last 40 years. It has proved to be a fertile field for those in need of an area for their PhD research. This chapter seeks to describe some of that thinking as it may impact upon the control premium.


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6.3 Some of the Components of the Puzzle 6.3.1 There are considered to be several elements to the puzzle:

Why should investors participate in the IPOs of new investment trusts when part of the money invested will be absorbed by underwriters’ fees and set up costs?

Does the market pricing of such funds typically move from a modest premium to a discount of some 10% in the first 100 days following the IPO?

What is the justification for any discount from NAV?

Does the discount reflect a discomfort with the accuracy of the valuations of the underlying investments?

Alternatively is the discount reflective of some lack of liquidity in all or part of the investment portfolios?

What is the justification for some investment trusts trading at a premium above NAV?

Why does the discount applicable to the whole sector in aggregate increase and decrease over time?

Why does the aggregate discount tend to decrease in January of each year?

Are all of these anomalies caused by the irrational retail investor? If so, why does the rational investor not take advantage of the arbitrage opportunities presented?

Are the arbitrage and takeover opportunities limited according to the size of the block holdings of the fund managers?

6.3.2 Is the answer to the ten questions above given by the simple truth that the concept of

efficient markets is a convenient fiction, invented by economists? Does it instead provide evidence of the existence of that elusive sprite, the control premium? Alternatively, is it, as one commentator has sourly expressed it: “an expensive monument erected to the inertia and stupidity of stockholders”?

6.4 Historical Experience and the Noise Trader 6.4.1 As valuers we always run the danger of providing intellectual support to an irrational

market: in 1929 there was a rash of new closed funds created in the USA; such funds typically traded at significant premiums above the NAV. The reasoning provided for this was simple: the two main assets of the closed fund are its investment portfolio and the goodwill represented by the stock selection skills of its managers. For this reason premiums were to be expected as the default position. This was a valuation concept which fuelled itself, until it burnt out. Since 1930 discounts have been the default position.


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6.4.2 There were signs of similar irrational exuberance in the 1980s: during that decade there were funds created in the USA which specialised in various country markets, including Spain, Germany and Korea. Several of these funds traded for several years at very significant premiums above the values of the underlying investments. For those countries whose investment markets were open, these premiums have been a source of bemusement in the academic press.

6.4.3 In smaller markets such as Greece there have been similar examples of other

periods of prolonged premium trading in the 1990s. 6.4.4 These historical experiences appear to have assisted in the formation of the concept

of the “Noise Trader”. The Noise Trader is the small retail investor who is strongly driven by general market and economic sentiment.

6.4.5 This is a concept which many will consider takes the art of being patronising to new

heights: it assumes that there is a rational institutional investor who makes all decisions based on wisdom and sound judgement built up over the years. In his heroic but dispassionate endeavours, built on the foundations of scientific objectivity and self-denial, he creates the efficient market. However, scampering around within that market are also the Noise Traders: these are the foolish retail investors; they demonstrate irrational excess enthusiasm when the sun is shining and dark despondency in the slightest economic shower.

6.4.6 The concept of the Noise Trader is then developed further: it is believed that his

influence is strongest in two areas, namely closed end investment funds and companies with the smallest capitalisations. Erratic movements in both of these parts of the market can therefore be laid at the door of the silly Noise Trader. One reason to presuppose that the Noise Trader is prevalent in the closed investment trust market is that rational institutional investors would not delegate part of their portfolio selection to collective funds. If this were done, there would be two layers of investment management charges. This is a view that can be very readily challenged with empirical evidence.

6.4.7 The concept was then taken one step further by explaining that the rational investor

needed a higher return in order to compensate for the uncertainties and the volatility created by the Noise Trader. This was therefore one justification for the structural discount within closed end funds.

6.4.8 These concepts were holed beneath the water line in the eyes of some when it was

identified that the UK investment trust market, unlike the closed end fund market in the USA, was dominated by institutional investors. Despite this fact, UK investment trusts show very similar pricing patterns to the closed end funds of the US market.

6.4.9 It is understandable that the concept of the Noise Trader was developed: there are

parts of closed end fund pricing which appear to be wholly irrational. An irrational force in the market was therefore created as an explanation. The reality may be that there is a bit of the Noise Trader in all of us.


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6.5 Current Evidence in the UK 6.5.1 In order to provide some current empirical evidence I summarised the valuations and

NAVs of the 210 companies listed in the Financial Times for which there was a share price and a net asset value in late November 2012.

6.5.2 Of the sample, 4 out of 210 (1.9%) were trading at a discount of 30% or more from

net asset values. (These are the types of discounts normally expected in order to support the concept of a material control premium.) However, 166 out of 210 (79%) were trading at some sort of discount from net asset values. The remaining 21% were trading at the net asset value or at a premium to that value.

6.5.3 Of those trading at a premium, 3 of the companies were trading at a premium of 10%

or more, with the highest premium being 14.7%. 6.5.4 45% of the companies were trading at a discount of more than 10% from net asset

values. 6.5.5 The median discount was 8.8% and the mean discount was 8.45%. 6.5.6 I repeated this exercise on a number of occasions in December 2012 and January

and February 2013. The pattern of results was broadly consistent with those described above. The exercise involved some 1,400 data points in total.

6.5.7 This empirical evidence sets the current UK market firmly within the consistent

experience of the markets in the UK and USA. Despite differing tax treatments, the literature describes the overall discounts having a mean reversion within a relatively close range of 8% to 10%.

6.5.8 In the context of control premiums these are modest discounts and do not support

the idea of discounts in the range from 10% to 30% as sometimes stated. 6.6 The Initial Public Offering and the First 100 Days 6.6.1 The behaviour of the investors who participate in the IPO’s of closed end funds

causes some major difficulties for economists: why should any investor be prepared to invest in a closed end fund at a price which reflects a premium over the opening NAV? The mystery within this question deepens when we are told that the historical experience is that the shares will be likely to be trading at a discount of approximately 10% from NAV within 100 days of the initial issue. Part of the decline in value is due to the issuing costs of a new fund, including brokerage and underwriting fees.

6.6.2 One answer to this conundrum is that IPOs take place during periods of strong

market sentiment. As previously noted, it is believed in some quarters that Noise Traders have a very strong influence on the pricing of closed end funds: a strong faith that the markets will be moving upwards provides sufficient justification for participation in new IPOs. This however is seemingly contradicted if other funds are trading at a discount at that time.

6.6.3 Another answer which is likely to carry some weight is that small investors may be

subject to the marketing tactics of brokerage firms: using this argument, they are unaware of the pattern of value erosion in the first 100 days. In other words, the less knowledgeable investors are being bamboozled by the cynical.


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6.6.4 More recent research has stated that IPO’s take place in parts of the closed end funds market which are trading at a premium at the time of the IPO: the whole of the closed end funds market may be at a discount overall, but new launches happen in the sub-sectors which are trading at a premium. This further research has also challenged the view that premiums convert into discounts in as little as 100 days in the majority of cases.

6.6.5 Some of the research appears to be tainted by the ability to dip selectively into the

rich stream of data to support various hypotheses. 6.7 Are there Other Explanations for the Discount? 6.7.1 As noted above, in late November 2012, 79% of investment trusts’ shares listed in

the Financial Times in late 2012 were trading at a discount from net asset values. It is an established truth amongst independent financial advisers that some 80% of collective equity investment vehicles under-perform the market. This is, at first sight, surprising, as the use of rusty pins for stock selection should lead to 50% being above and 50% being below the market.

6.7.2 The reason for the 80% under-performance is considered to be the fees charged

within the collective funds. 6.7.3 The average expense ratio within investment trusts, according to the Association of

Investment Companies, is 1.7%, which is stated to be slightly lower than the rates within unit trusts and Open-ended investment companies. If the management fee causes the discount, a median discount of 8.8% is consistent with a cost of capital of 19.2%. This could support the view that the shares in the investment trusts have a market capitalisation which is less than the market values of their investment portfolios, due to the costs of management.

6.7.4 If this argument is sustainable, it merely means that the location of the puzzle has

been moved: instead of the closed end fund puzzle, it becomes the open end fund puzzle: why should investors buy units in unit trusts and shares in OEICs at underlying NAV when these make no allowance for the future costs of management within those funds?

6.8 Are there Concerns over the Net Asset Values? 6.8.1 Some of the larger discounts probably reflect either uncertainties over the valuations

of the underlying assets or concerns as to the liquidity of those assets. Some of the investment trusts with the highest discounts from the trusts that I reviewed were invested in illiquid assets such as life policies or other assets which might prove difficult to value. Concerns have been expressed that some of the closed funds in the USA may be heavily invested in illiquid assets such as letter stocks.

6.8.2 As a general concept a closed end fund can safely invest in less liquid assets than

open-ended funds, as there are no concerns over possible short term realisations. It is therefore arguable that the small investor can gain exposure to the premium returns that come from illiquid assets. The acquisition costs of such illiquid assets are also likely to be far lower for a closed end fund when compared to the small investor. Despite this, the small investor’s shareholding is very liquid, due to the secondary market, so there is at least one liquidity increment.


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6.8.3 A discount for illiquidity of the underlying investments seems to be an unlikely explanation as the illiquid nature of the underlying investments should have been reflected in their valuation. However we can all recognise that valuation uncertainties are extremely low with very liquid assets but can be very high with illiquid assets. A discount for uncertainty is something to which we can all relate.

6.8.4 It seems to be generally accepted that uncertainties as to portfolio valuations do not

suffice to explain aggregate discounts. If funds are liquidated, merged or converted into open-ended funds, research has shown that the market prices move up to the stated net asset values, rather than the net asset values declining to the market capitalisations.

6.8.5 The shape of the discounts over the life cycle of a closed fund therefore appears to

be broadly predictable: there is a period of premium, followed by a reduction to a discount of some 8% to 10%. That discount can then vary up and down, seemingly without regard to factors within the fund. The discount then does not usually crystallise, but largely disappears if the fund comes to an end in some way.

6.8.6 The lack of concern over the net asset values is evidenced by the involvement of

some activist investors in certain of the closed end funds in the USA. Their approach has been to take minority stakes in some of the higher discount funds and then to press for the fund to be “opened up”: they push for the funds to be liquidated, converted to an open-ended fund or shrunk by following a policy of share buybacks at 98% of underlying NAV. The justification that they give is that management is self-serving, and that they are in tune with the wishes of investors.

6.9 Can Premiums be Justified? 6.9.1 It is generally recognised that premiums should only exist if there is either a negative

agency cost or a recognition of the liquidity increment. 6.9.2 A negative agency cost occurs if the value added by the management of the fund in

terms of over-performance exceeds the total cost of that management. 6.9.3 The liquidity increment should exist if there is asymmetry between the liquidity of the

shares in the investment trust and the liquidity of the underlying investments. This situation means that investors can gain exposure to the premium returns from illiquid assets but within a liquid market structure.

6.9.4 However the true cost of the liquidity increment may be the greater volatility that

comes with liquid markets. The shares of both closed end funds and Real Estate Investment Funds (“REITs”) demonstrate greater volatility than those of the underlying assets.

6.9.5 In late 2012 21% of 210 investment trusts in my sample were trading at NAV or a

premium above NAV. It is not known whether this reflected historic over-performance or expectations of over-performance in the future, or some other factor.

6.9.6 The literature reviewed does not include any empirical evidence linking premiums

with historic or future over-performance. However, the research has identified that investing in discounted funds generates higher overall medium term returns.


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6.9.7 As expected, there is thought to be a link to the simple rule of supply and demand: the premiums in certain of the country funds fell from dizzy heights in the 1980’s as more and more such funds became available on the markets.

6.9.8 For whatever reason, the liquidity increment does not lead to the funds trading at a

premium overall. 6.10 Why do the Average Discounts Change over Time? 6.10.1 The oddities of pricing of the markets in January each year, whether in respect of

small stocks or in respect of closed end funds, appears to defy all attempts at analysis.

6.10.2 There appears to be a relatively strong positive correlation between the movements

in the discounts of various closed end funds. As might be expected, discounts have a tendency to reduce when markets are expected to move upwards and the opposite also applies.

6.10.3 The movements in the discount have unexpected consequences: the returns on

investment trusts are more volatile than the returns of the underlying investments. 6.10.4 There does however appear to be mean reversion at work: the aggregate discounts

have an uncanny ability to return to an overall level of some 8% to 10% in both the UK and the USA, when viewed over medium term time horizons.

6.11 Opportunities for Arbitrage 6.11.1 There is thought to be friction in the markets which takes away some of the

opportunities for arbitrage. 6.11.2 One possible mechanism would be to short-sell the funds trading at a premium and

to hedge the position by constructing a portfolio with identical components to that of the fund, if they were known.

6.11.3 Another strategy would be to invest in the funds trading at a discount, and to hedge

by shorting the components; the rational investor could then await merger, liquidation or the opening of the fund.

6.11.4 The stated difficulties in both of these devices are uncertainties as to the time scales

involved. This is despite the fact that studies have shown that such strategies could generate a strong over-performance or alpha of some 5% or 6% a year. The issue appears to be that arbitrage devices such as shorting need to generate relatively rapid returns to be justified by those with short term time horizons.

6.11.5 It has been shown that any attempt to acquire the entire closed fund at the

discounted market capitalisation is likely to be fraught: it has the tendency to lead to a rapid reduction in the level of the discount. One study demonstrated that successful takeovers took place in the range of 95% to 98% of NAV.


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6.11.6 Having cast the institutional investor as the hero and the Noise Trader as the inept bungler, there is then some difficulty in not being able to explain why the institutional investors do not exploit the market distortions created by retail investors. One reason given is that the Noise Trader’s activities cannot be predicted: a closed fund trading at a discount may, due to the irrational steps of the Noise Trader, trade at an even greater discount before sanity is restored.

6.12 The Impacts of Block Holdings 6.12.1 Studies have been undertaken which show that discounts tend to be greater when

the investment managers have sizeable holdings of the share of the funds. Despite the community of purpose indicated by such a situation, it appears, in the USA at least, that sizeable holdings of investment managers have a depressive impact on value.

6.13 Are there any Conclusions? 6.13.1 There is a compelling argument that the average discount which applies is not

related to a control premium: there is no stability in the discounts or premiums over time and between funds. Added to this argument is that investors seemingly have no regard to the control premium in respect of open ended funds.

6.13.2 In my opinion rational explanations for the discount from NAV in investment trusts

should focus on the differences between these trusts and open-ended funds such as unit trusts and OEICs.

6.13.3 There are some far more promising justifications for the discounts than the concept

of the absence of control:

As the agency cost is seldom neutral or negative, there is an economic argument that the costs of management mean that the total is not equal to the sum of the parts. The management fees, of an average of 1.7% a year, reduce the returns to ordinary shareholders. The shareholder therefore receives less income than he would if he held a portfolio directly. If this argument is valid, it supports the concept of a discount and it also provides a justification as to why institutional investors do not invest into the discounted funds: the arbitrage opportunities are very limited if the discount is the present value of the future management charges.

A possible variation on the above theme is that the overall discount is the net of two factors: there is firstly the discount for the management fees, as described above, but this is offset, at least in part, by the liquidity increment.

These arguments have some force: investors see that one of the main attributes of collective funds such as investment trusts, OEICs and unit trusts is the opportunity that they bring for diversification. The acceptance of an agency cost, as part of the means of obtaining an interest in a diverse range of investments, is a rational response. With the abolition of commissions to independent advisers and the increasing prevalence of various tracker funds and other exchange traded funds, there is significant downwards pressure on the management charges levied within units trusts and all collective investment vehicles.


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The other strong candidate is that the discount is an adjustment for volatility: the share prices of the funds are more volatile than their components, and the market exacts a price for volatile securities. This is explained in the literature in a way that we can all understand: the investor in the closed end fund is exposed to the movements in the market; however he then has a second layer of risk, namely the prospect of a widening of the discount, due to a possible movement in market sentiment. It is this which leads to the greater volatility and volatility equates to risk for many investors.

6.13.4 This then leaves the conundrum as to why open ended funds do not trade at a

discount as they have similar, or greater, management fees and there is no significant liquidity increment. One reason for this may be that they provide the investor with a comforting certainty: unlike the closed funds, he knows that he will sell his stake in the open fund at market value. He is therefore spared uncertainties as to the movements in the discounts arising from sentiment. He therefore has the second layer of risk stripped away.

7 The Pricing of Real Estate Investment Trusts: The UK and the USA Experience

7.1 The pricing of shares in Real Estate Investment Trusts or REITs (and other property

investment companies) can provide interesting insights into a number of valuation factors in liquid markets. UK REITs can be likened to investment trusts in many ways:

their portfolios of investments are stated at market value and the Net Asset Value or NAV is widely used as a valuation metric;

the shares trade in a secondary market at varying discounts from NAV (and sometimes at a premium);

there is a liquidity asymmetry as the shares are traded in very liquid markets: the investor therefore has a very liquid position but accesses the additional returns expected from illiquid assets;

the volatilities of the shares are greater than the volatility of the underlying assets;

both REITs and investment trusts experience the “agency cost”, that is the costs of management which may or may not be covered by the additional returns generated by that management.

7.2 REITs appeared in the UK markets in 2007, but they have a rather longer history in

the USA, being first established in 1960. There are some variations between the rules and restrictions on REITs between the two regimes, but these are outweighed by the similarities.

7.3 Due to the similarities between REITs, other property investment companies and

closed end funds and the similarities between the USA and UK regimes, studies of pricing in the two markets should offer insights. We can ask ourselves if the existence of discounts to NAV in REITs supports the concept of the control premium.


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7.4 Market Capitalisation and NAV 7.4.1 The closed end funds puzzle starts with the assumption that the market capitalisation

of an investment trust should be equivalent to the valuation of the underlying investments. If this is not so, then the theory of efficient markets is that this should present an opportunity for profitable arbitrage and equilibrium should be restored.

7.4.2 Such arbitrage is far more challenging with REITs as the underlying investment

portfolio cannot be readily replicated. However, it would be surprising if movements of 30% and more above and below NAV do not trigger some sort of market response.

7.4.3 The comparison of market capitalisations and NAV is a very common metric. On the

basis that markets are determined to some extent by their metrics, and become influenced by the way that they are measured, the comparison allows insights into aspects of market pricing.

7.4.4 For UK property, the comparison data provided by the European Public Real Estate

Association (“EPRA”) is entitled the “EPRA UK Index NAV Discount”. This shows that from 1 January 1990 to 28 December 2012 the market capitalisation of the UK property sector was an average discount of 18% from NAV. The range was from a discount of 45% to a premium of 10%. I recognise that REITs only appeared on the UK scene on 1 January 2007. However, this long term average of property securities is not greatly different from the short term averages: for the calendar year 2012 the average discount is 17% and for the three years ended 31 December 2012 the average discount is 18%. However these averages hide some savage volatility.

7.4.5 The US market trades at a rather lower average discount to NAV: the range, ignoring

outliers, appears to be from a discount of 20% to a premium of similar magnitude, with a long term average of a discount of some 7% from NAV.

7.4.6 It is a feature of the movements of market capitalisations and NAV from 1990 to 2012

that the volatility is very high, but seemingly with relatively rapid mean reversion. The EPRA property index has shown some stability in the last three years as noted below, but this is not matched by similar clean lines for the REITs market.

7.5 Foretelling Property Valuations 7.5.1 Some of the research in this area has identified that there appears to be a lag in

property values when compared to the shares of REITs. Put another way, the share prices of REITs move some 6 months to 2 years ahead of the commercial property markets.

7.5.2 These results appeal to the intuitive senses: the share markets react on a daily basis

to economic and other news; however, the values of properties will tend to be at a past date to the extent of at least 3 to 6 months in any event. They may also be based on a historic analysis of discrete transactions in sticky and thin markets.

7.5.3 On this basis, discounts may sometimes signal an anticipated downturn in property

prices, whereas premiums may herald a forthcoming improvement. 7.5.4 The empirical evidence is however far from compelling at the sector-wide level: from

January 2010 to October 2012 the EPRA property index has moved up in a relatively straight line from 3600 to 4800. There has been far more volatility in the EPRA NAV Discount chart than is suggested by this relatively smooth progression.


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7.6 The Noise Trader and Volatility 7.6.1 The irrational retail investor makes an appearance in the literature on REITs in the

same way as he does in respect of closed end investment funds. The Noise Trader is considered to be one of the causes of volatility in share prices which exceeds the movements in the fundamentals. He appears to be the perfect alibi, explaining various sorts of erratic market movements for some researchers.

7.6.2 The argument concerning the Noise Trader is that he is the creator of greater

volatility than would otherwise be present: this then means that the rational investor requires a higher return in order to compensate for his actions.

7.6.3 The academic literature has also devoted some significant pains to establishing

whether shares in REITs have the characteristics of freehold property or behave more like equities. The long–term returns show similarities to the property market, but with far greater volatility in the short term. Other factors, such as dividend yield, have an impact on valuation, in addition to property values.

7.6.4 There are various benefits detailed for investments in REITs compared to direct

investment in property:

the investment is extremely liquid but gives access to an illiquid asset class;

the transaction costs are far lower than with direct investment;

there will be well developed asset management skills within the REITs;

borrowing costs within the REIT are likely to be lower;

larger REITs can access the largest investment grade properties, which is a rarefied market with some buying opportunities;

larger REITs will provide diversification of risk through access to a range of different properties.

7.6.5 Morri, McAllister and Ward went so far as to say in 2005: “Perhaps the enigma is that

whilst real estate securities appear to be superior in terms of the qualities outlined above, they often trade at discounts rather than premiums.”

7.6.6 As noted above, it may be that part of the reason for the default position being a

discount in both the UK and US markets is due to the greatly increased volatility that is likely within a very liquid investment market.

7.6.7 Movements elsewhere in the equity markets may also be a cause of volatility. In one

example of the REITs market being affected by external equity fundamentals, there was thought to be a large flight away from the dull safety of REITs to the excitement of the dot.com boom in the late 1990s. This flight from safety is thought to have had a marked downwards impact on the US REITs stock prices which were not caused by any property fundamentals. The market then corrected itself strongly, giving average annual returns for REITs stocks of 22.6% from August 2000 to December 2006.


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7.7 Other Possible Reasons for Discounts 7.7.1 As with the closed end funds, the management costs of the REITs potentially

represent a reduction in the shareholders’ return. Whether that agency cost is negative or positive depends upon opinions as to the effectiveness of the management team in adding value and the cost of that value added.

7.7.2 If it is thought that management represents a net agency cost, then the default

position of a discount to NAV can be supported. 7.7.3 It has been pointed out that the difference between market capitalisation and NAV is

effectively the difference in pricing between public and private property: by this is meant the difference between the value seen in the daily stock market movements and the aggregate values of properties acquired in discrete transactions. The timing difference between these two markets has already been addressed. It is, of course, possible for there to be other differences between those markets.

7.7.4 If the cost of capital is relatively low there can be concerns that REITs will pay

unrealistic prices for property. If REITs shares are affected by movements in other parts of the equity markets, it is possible that the public value of the property portfolios will be understated or overstated.

7.7.5 It can be identified that there are four possible settings for these two markets apart

from that perfect state of equilibrium: both the public and private markets may be over-priced; they may both be under-priced; the public market may be priced above the private market; or the opposite may apply.

7.7.6 Based on the long term averages in both the UK and the USA , it appears that

investors spend longer periods thinking that the private market is overvalued than the opposite. Due to the difference in the average discount, this sentiment appears to be more prevalent in the UK than in the USA.

7.7.7 Another alternative explanation put forward for the discount differential is that the UK

REITs market is still developing and maturing: under this hypothesis, there may be several factors impacting the UK market in the near future:

greater consolidation into larger REITs

greater specialisation by REITs into different areas of real estate;

a narrowing of the average discount from 17%-18% to a figure closer to 7%. 7.7.8 Once again, it is the lack of stability that indicates that the control premium is an

unlikely candidate to explain the overall discount: when the difference from NAV is both positive and negative, and when it varies significantly between enterprises, it is difficult to argue that this is caused by a uniform control premium factor.

7.7.9 Far more likely candidates are the direction of travel of property values, the relative

success of different investment strategies, the abilities of individual management teams to add value and the liquidity/volatility asymmetry.


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8 Voting and Non-Voting Shares

8.1 We have previously identified that the market price is determined by trades in very

small parcels of shares, with the final trades of the day determining the market price. For such small holdings it appears, at first sight, odd that there should be any appreciable difference between voting and non-voting shares. This is on the assumption that the two classes of shares are identical in every way, except that one of the classes has no voting powers. For a shareholder with a fraction of 1% of the shares of a listed company the power that comes with the ability to vote will generally be a power with no immediate consequence.

8.2 Studies in various markets have shown premiums for voting shares in the range from

2% to 6% over non-voting shares. Do these premiums offer any insight into the enigmatic control premium?

8.3 The answer appears to be that the voting shares carry with them a rather greater

promise in the event of a takeover approach. Barring regulatory constraints, an acquirer will have a strong focus on obtaining 90% voting control.

8.4 Therefore, even though a takeover may be considered to be an unlikely event, there

is the potential value that may accrue to the holder of voting shares in the event that such a takeover approach is made.

8.5 The point has been made that even “out of the money” options have some value, no

matter how small. The voting rights that come with voting shares have been compared to a relatively remote option: for many years the dividends received by both classes of shares will be identical and the small shareholder will gain no benefit from his additional investment. However there will always be the contingent prospect of a higher price being offered to voting shares in the event of a takeover.

9 The Control Premium as a Guide to the Minority Discount? 9.1 Until relatively recently the takeover premiums paid in the markets were taken at face

value as evidence of the difference in pricing between minority and control holdings. 9.2 This thought process was then used in reverse: if there was a control premium paid

in takeovers of an average of 30%, then this suggested that the “standard” minority discount in the markets was 30/130, which is some 23%. The thought then ran that this could then be used to inform some of the decisions with regard to the valuation of minority interests in private companies.

9.3 The increasing challenge to the concept of the control premium has also had the

effect of questioning the usefulness of this secondary thought process. 9.4 It is recognised that the question of discounts for minority status must be driven by

the available cash flows and the way that those cash flows are used: if the cash flows are largely absorbed by high remuneration paid to the controlling shareholders, then these cash flows are not available to minority holders, outside an action under Section 994, Companies Act 2006. However if the shareholding structure is such that management do not have control, then it is possible that the majority cash flows are available to minority shareholders. Any discount should then focus on the probability of that happy circumstance changing.


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9.5 As it appears that the bid premium is not a control premium and that control, per se, brings very modest rewards, it is conceptually inappropriate to consider its inverse as providing any guidance relating to the minority discount. The nature and size of this discount must be based upon establishing whether the shareholder has access to majority or minority cash flows.

10 Some Conclusions 10.1 Long-held concepts are being overturned: it is becoming increasingly difficult to

support arguments that the metrics of guideline companies should be increased by 30% or 40% or more on the basis that the minority price is significantly less than the majority price. However this is an area in which change is taking place at a decidedly slow pace.

10.2 If a company is optimally run, the benefits from control are modest indeed: they

provide the ability to alter the timing of the cash flows to the shareholders, but only to a modest extent. They also give step-in rights in the deeply uncertain future. If the management operates in a sub-optimal manner as it wrestles with new challenges, the person with control can exercise his step-in rights in order to change the decision making.

10.3 If the valuer considers that the UK markets demonstrate a systemic problem of

excess rewards for the management of all listed companies, he can attribute some benefit for a control holding in changing that state of affairs. This does require the valuer to consider that such management can be replaced with management at significantly lower cost, but at least equal ability.

10.4 There is also the fundamental truth that, given the choice, someone will always

choose to have control rather than to be denied that control. These various reasons support, in my opinion, the idea of a relatively modest premium of 5% to 10% for control. However, there is little reason why large premiums should be paid for such marginal benefits.

10.5 The same point can be framed in the opposite way: an investor will be willing to

accept a moderately reduced return in exchange for the comfort of control.

10.6 There must be many companies which are not optimally run: it is however a strange listed sector in which there is a general ability to improve performance by 30% across all companies by changing the management.

10.7 There are three different justifications given for the existence of the control premium: the first and the most powerful, is the level of the observed bid premiums offered for control in the majority of takeovers; the other two justifications relate to the discounts from net asset values at which investment trusts and property companies and REITs generally trade.

10.8 In all three cases it appears increasingly trite to interpret these market observations

as evidence of a significant control premium. There are a number of other explanations which are rather more compelling.


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10.9 Investors in the listed company markets require the ability to receive returns on their investments and to realise those investments at a time of their choosing. They are not thirsting for control; their investments are not somehow inferior to a higher control level of value. If the management of the entity cannot be drastically improved, they are not losing any benefits by not having control.

10.10 It has been almost twenty years between the issue of the first paper by Eric Nath and the issue of the advisory draft by the Appraisal Standards Board: the established article of faith was a very deeply held belief and it is only now being overturned in the USA. Will it take a further lengthy period before such change is accepted in the UK? Will we continue to see cases going through Courts with both sides espousing the notion of the control premium?

Andrew Strickland September 2015

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