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Emerging Market Finance

Emerging Market Finance. Lecture 11: Valuation of Illiquid Securities Challenge: shares and other securities are often illiquid in emerging markets ! How much should you value them?. Evidence on Illiquidity Discounts.

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Emerging Market Finance

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

  2. Evidence on Illiquidity Discounts • Silber (1991): Rule 144 letter stocks: average discount of 34% (based on 69 private transactions, from 1981-88)

  3. Discount Size and Firm Characteristics: the U.S. Sample

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

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

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

  7. Typical Ownership Pie

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

  9. Private-Placement Sample • 242 transactions • Aug. 2000 to July 2001 • Much larger blocks

  10. Summary Statistics for Auctions

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

  12. Summary Statistics for Private Placements

  13. Discounts across B/M Groups Blue: auctions Red: private-trans.

  14. Discounts by Auction Quantity Blue: auctions Red: private-trans.

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

  16. Discounts by Age (since IPO) Blue: auctions & Red: privatetransfers

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

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

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

  20. Longstaff’s (1995) Model

  21. Upper Bounds on Illiquidity Discounts:Longstaff (1995) Model

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

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

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

  25. Illiquidity Discounts based on Amihud &Mendelson (1985)

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

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

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

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

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

  31. Control Premium Relative to Floating A-Share Prices Non-Control Blocks to SOEs Control Blocks to SOEs Non-Control Blocks to private firms Control Blocks to private firms

  32. Control Premium Relative to Revenue Per Share Non-Control Blocks to SOEs Control Blocks to SOEs Non-Control Blocks to private firms Control Blocks to private firms

  33. ROE Across Groups Non-Control Blocks to SOEs Control Blocks to SOEs Non-Control Blocks to private firms Control Blocks to private firms

  34. ROA across Groups Non-Control Blocks to SOEs Control Blocks to SOEs Non-Control Blocks to private firms Control Blocks to private firms

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