WFU Law School
Law & Valuation
5.4.2 Control Premia

5.4.3 Minority Discounts

How does one compute the minority discount? The computations vary with the context. Not having control and holding only a right to financial returns is sometimes a significant disadvantage, other times not.

Example

Example of minority discount Jung v. IRS.

Answer:


Real estate

For real estate companies a starting point is an analysis of of publicly traded real estate limited partnership and investment trusts. Partnership units, though fully marketable, typically trade for less than pro rata net asset value -- a discount reflecting lack of governance power.

For example, a 1993 study computed discounts for various kinds of publicly traded limited partnerships and found mean discounts varied according to the type of real estate held by the firm (see table to right). Karn, Smith & Schroeder, Discounts for Non-Publicly Traded Limited Partnerships (based on 146 limited partnerships).

Type
Mean
All real estate
46%
Apartments
48%
Commercial
55%
Mini-warehouses
25%
Mortgage loans
43%
Other real estate
50%
Cable TV
55%
Leased property
20%

Company shares

For company shares, many valuators compare the prices paid for minority shares in takeover bids for 100% of a target company's outstanding shares to the pre-bid trading price (control premia).

Source: Mergerstat Review / HLHZ Control Premium Studies (average of two studies)

Year
Average control premium
Average minority discount
1991
38.2%
-27.6%
1992
38.6%
-27.9%
1993
35.8%
-26.4%
1994
35.3%
-26.1%
1995
30.6%
-23.4%
1996
%
1997
%
1998
%

"The Short and Puzzling Life of the 'Implicit Minority Discount' in Delaware Appraisal Law"
University of Pennsylvania, Institute for Law & Economics Research Paper No. 07-01

Author: LAWRENCE A. HAMERMESH
Widener University School of Law
Email: lahamermesh@widener.edu
Auth-Page: http://ssrn.com/author=156312

Contact: MICHAEL L. WACHTER
University of Pennsylvania Law School
Email: mwachter@law.upenn.edu
Auth-Page: http://ssrn.com/author=44770

Full Text: http://ssrn.com/abstract=961022

ABSTRACT: The "implicit minority discount", or IMD, is a fairly new concept in Delaware appraisal law. A review of the case law discussing the concept, however, reveals that it has emerged haphazardly and has not been fully tested against principles that are generally accepted in the financial community. While control share blocks are valued at a premium because of the particular rights and opportunities associated with control, these are elements of value that cannot fairly be viewed as belonging either to the corporation or its shareholders. In corporations with widely dispersed share holdings, the firm is subject to agency costs that must be taken into consideration in determining going concern value. A control block-oriented valuation that fails to deduct such costs does not represent the going concern value of the firm. As a matter of generally accepted financial theory, on the other hand, share prices in liquid and informed markets do generally represent that going concern value, with attendant agency costs factored or priced in. There is no evidence that such prices systematically and continuously err on the low side, requiring upward adjustment based on an "implicit minority discount".

Given the lack of serious support for the IMD in finance literature, this Article suggests that the Delaware courts may be relying on the IMD as a means to avoid imposing upon squeezed-out minority shareholders the costs of fiduciary misconduct by the controller. Where either past or estimated future earnings or cash flows are found to be depressed as a result of fiduciary misconduct, however, or where such earnings or cash flows fail to include elements of value that belong to the corporation being valued, the appropriate way to address the corresponding reduction in the determination of "fair value" is by adjusting those subject company earnings or cash flows upward.

This approach to the problem of controller opportunism is more direct, more comprehensive in its application, and more in keeping with prevailing financial principles, than the implicit minority discount that the Delaware courts have applied in the limited context of comparable company analysis. The Delaware courts can therefore comfortably dispense with resort to the financially unsupported concept that liquid and informed share markets systematically understate going concern value.

Student paper

For an analysis of the Delaware Supreme Court's ruling in Cede & Co. v. Technicolor IV, see William Davis, Cede & Co. v. Technicolor IV.


Closed-end investments

Minority discounts also arise in closed-end mutual funds. These funds, which give investors an interest in a fixed set of financial assets, historically trade below NAV (net asset value).

Why is this? There are many theories:

  • Closed-end funds are mostly held by individual investors, who have a sense of powerlessness -- a so-called "small investor sentiment." J. Bradford De Long & Andrei Shleifer, "Closed-end fund discounts" Journal of Portfolio Management (Winter 1992)
  • Closed-end fund investors have limited control over fund managers, and they take into account the risk of future management and fee changes.
  • Closed-end funds holding a large block of assets are illiquid, and investors discount for this reason.
  • Investors must pay capital gains taxes if the fund liquidates its assets (such as stock), and investors discount for this possible tax liability. John Gasiorowski, Business Valuation Review (June 1993).

Whether these discounts can be used by analogy in valuing other closed-end type investments is in the air. The IRS, for example, takes the position that built-in capital gains are too speculative as a basis for discounting investment interests. TAM 9150001. Yet courts are split on whether built-in capital gains are relevant to valuations. Compare Gallun, 33 TCM 1316 (1974), Piper, 72 TC 1062 (1979), Andrews, 79 TC 938 (1982) with Clark, 75-1 USTC 13,076 (EDNC 1975).

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Closed-end large cap funds have discounts ranging from 18% to 26% (1982-1993) and closed-end small-cap funds have discounts ranging from 7% to 29% (1986-1993).


Swing blocks

Sometimes a minority interest may have a strategic position - such as a 2% shareholder in a closely-held firm with two 49% shareholders. THe IRS has take the position that when a minority interest in a family business can have governance power this power should be taken into account. For example, if a parent gifts three 30% interests to each child, the IRS has said that each child received a "swing block" since each could join another to form a 60% control block. TAM 9436005. Perhaps this ruling undermines the IRS position allowing minority discounts and abandoning tits previous "attribution" approach? . [Banister - Exhibit 13]

Minority discounts are an important element in estate planning, where taxpayers desire to pass low-valued property to family members and avoid gift and estate taxes. Revenue Ruling 93-12. IRS "swing block" position.

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"IF YOU CAN'T COME THROUGH THE FAMILY ATTRIBUTION..."

FAIR VALUE FALL/WINTER 1996

5.4.2 Control Premia

©2003 Professor Alan R. Palmiter

This page was last updated on: March 8, 2007