Modern Financial Engineering and Discounts: The Collar Message

Abstract

An abundance of literature addresses the appropriate marketability discount to be applied to a block of publicly traded securities that cannot be immediately liquidated. Typically, the discounts are based upon inferences drawn from measuring discounts indirectly. Here, we take a different approach. We ask the specific question: What is the direct cost of providing full marketability to a less than liquid financial asset? Our findings indicate that marketability discounts for restricted stock and stock option grants, as well as large blocks of publicly traded securities that can be converted to publicly traded securities at some future date, can be determined with reasonable accuracy. This direct approach is superior to that of relying on observed discounts of restricted stock prices in private placements relative to their publicly traded counterparts. Liquidity or marketability is comprised of two components. The elimination of price risk is the first component. Price risk represents the risk that one may not receive the current market value of the underlying freely traded asset due to price fluctuations in the marketplace. The second component of marketability is the ability to convert an asset to cash in a timely fashion. Restricted stock units received as part of a compensation package may not convert to a freely traded stock for periods ranging from a few months to several years. The cost of restoring liquidity to an illiquid asset represents the appropriate marketability discount. We show that an at-the-money equity collar, engineered by buying and selling options on the underlying publicly traded stock creates a perfect hedge that removes all price risk at a point in time. In addition, borrowing against this hedged position will provide funds and restore full liquidity. In the absence of transaction costs, the return on the collar portfolio will be equal to the risk free rate. In practice this return is reduced by transactions costs and interest costs that are incurred. Therefore, the net transaction cost and net interest cost in creating the equity collar represents an appropriate marketability discount. This direct cost approach is the best tool available for calculating the size of the marketability discount. We demonstrate the application of this strategy to blockage discounts and discounts applied to restricted stock units. This approach cannot be directly applied to situations where an equity collar cannot be engineered. However, even where a perfect hedge cannot be directly created we can develop a sense of the appropriate marketability discount that should be applied in a given situation. We begin by looking at previous work dealing with the measurement of liquidity discounts for blockage and restricted stock. Next we apply the collar strategy to determine the appropriate discount to both restricted stock and stock subject to blockage discounts. Blockage Discount Literature Moore (1992) presents a checklist of 22 factors to consider when determining the appropriate blockage discount. The weighting of the factors is based upon the judgment of the valuation professional. Several of the factors he suggests are useful for determining whether a blockage discount is warranted. For example, The share size of the block – especially as compared to the number of shares outstanding of that