Closed-End Funds Are Not a Proxy for Discounting
Reconsidering the Use of CEFs as a Proxy for DLOC
The market pricing of publicly traded closed-end funds based on net asset values is not a reliable proxy for estimating discounts for lack of control for closely held businesses having a portfolio of marketable securities. Despite the acceptance for decades by the highest courts of this valuation method, the author, in this article, sets forth the basis for questioning this established practice.
The market pricing of publicly traded closed-end funds (CEFs)1 based on net asset values (NAVs) is not a reliable proxy for estimating discounts for lack of control (DLOC) for closely held businesses (CHBs) having a portfolio of marketable securities. Despite the acceptance for decades by the highest courts of this valuation method, I have not found any published evidence supporting it as a valid metric. Significantly, not a single article or scholarly study cites lack of control (LOC) as having any bearing on the market values of CEFs. An additional problem arises from using the terms DLOC and âminority discountâ interchangeably.
Letâs quickly review the reasoning on which CEF pricing may be applied as a proxy for CHB minority discounts: (1) CEFs are priced by investors due to lack of control over managerial investment decisions; (2) private investment holding companies are comparable to CEFs having similar portfolios of marketable securities; and (3) CEF discounts from net asset value are a credible guide for estimating the minority discounts of CHBs. This line of reasoning is built on the faulty premise that CEFs discounts are valued based on LOC. Secondarily, one can easily argue that investors willingly surrender investment control to acquire the financial expertise of CEF managers and can safely do so because there is not the illiquidity issue inherent in CHBs.
Perhaps there is no better place to expose the CEF pricing fallacy than a 2017 Insights article by Messrs. Kirk and Masters, âDeriving a Discount for Lack of Control with Closed-End Fund Pricing.â The authors begin by stating that âClosed-end fund pricing has been regarded as one of the unsolved mysteries of finance,â ââŚ theorized by numerous studies âŚâ and concluding that ââŚ the share price of a closed-end fund is generally dependent on the supply and demand of investors.â They then report that published studies pertaining to CEF price premiums and price discounts produced a âmultitude of factorsâ and list seven, none of which included LOC. Similar conclusions come from the Closed-End Fund Association website, which has indicated that the prices of CEFs are âestablished by competitive markets which reflect âreal worldâ buying demand and selling supply of shares,â and provides eight causative factors, none of which includes LOC. The authors make the assertion that âthe value of a noncontrolling interest is not necessarily equivalent to the pro rata percent of the enterprise value or the underlying NAV, such as the case with closed-end fund pricing [emphasis added].â And then comes the unsupported leap of faith that CEFs trade at discounts off their NAVs because ââŚ a noncontrolling interest lacks unilateral control over a companyâs underlying assets.â One might very well ponder what part of a CEF pricing premium contains the LOC.
To illustrate how judges have been hoodwinked for decades, we highlight a recent case, Pierson M. Grieve v. Comm., T.C. Memo. 2020-28. 33 closed-end equity funds were used to support a DLOC. As the Court summarized, âAccording to Mr. Frazier [the taxpayerâs expert], closed-end funds have sold historically at a discount because of the noncontrolling nature of an investment in a closed-end fund. In his report, Mr. Frazier explains that the lack of control over day-to-day operations and investment decisions, and the inability to liquidate assets of the entity are investment characteristics shared by investors in publicly traded closed-end funds.â In no way has the expert provided evidence as to where CEF discounts actually come from. It is interesting that the judge seems to be stating (perhaps inaccurately) that this expert wrote in his appraisal that the illiquidity of CHBs is a characteristic of CEF pricing.
There may be some merit in drawing upon CEF market pricing data, but one cannot declare that the entire discountâlet alone any of it in my opinionâis due to LOC when no proof exists. To extricate ourselves from an improper valuation practice, I would propose that the CEF discount, specifically, be identified by a label other than LOC. How about something like âmarket pricing factorâ (abbreviated to MPF) where all pricing causes are lumped together? This solution is imperfect because we duck describing the causative factors, but at least we would no longer expose ourselves to basing a discount on a wrong assumption.
 Defined in the International Glossary of Business Valuation Terms as âAn amount or percentage deducted from the pro rata share of 100 percent of the value of an equity interest in a business to reflect the absence of some or all of the powers of control.â We need not recite the numerous drawbacks so familiar to business appraisers that one associates with LOC for CHBs.
 Judges have questioned the reliability of discounts based on CEFs. See, e.g., Estate of Frazier Jelke III v. Comm., T.C. Memo. 2005 131; Estate of Webster E. Kelley v. Comm., T.C. Memo. 2005-235; and Peter S. Peracchio v. Comm., T.C. Memo. 2003-280.
 At page 2 of an article entitled âA Rational Asset Pricing Model for Premiums and Discounts on Closed-End Funds: The Bubble Theory,â written by Robert Jarrow and Philip Proctor in 2017, is the summarizing finding that âno consensus has been reached regarding the source of discounts.â
Peter L. Becket, ASA, ARM-BV, graduated from Yale University in 1963, then served during the Vietnam era as an infantry captain in the U.S. Marine Corps. After graduating from the Columbia Graduate School of Business with an MBA in marketing and finance, he joined United States Trust Company of New York as a trust and estate administrator and became an officer while working in the bank’s closely held business section. Mr. Becket gained greater valuation expertise through courses offered by two national business appraisal societies. Specifically, he acquired the Accredited Senior Appraiser (ASA) designation from the American Society of Appraisers in 1986 and the certified business appraiser (CBA) designation from The Institute of Business Appraisers, Inc. (IBA), in 1990. (The IBA merged with the National Association of Certified Valuators and Analysts (NACVA) in 2012.) During 1991â1992, he served as the president of the Connecticut Chapter of the ASA. He worked as an independent contractor for two business appraisal firms before founding Becket Business Appraisals, LLC, in 1994. He has written and published a 28-page booklet entitled, “An Attorney’s Handbook for Business Appraising,” and has spoken at various training seminars. In 1999, the IBA awarded Mr. Becket with the designation Business Valuator Accredited in Litigation (BVAL); that designation was later changed by NACVA to Master Analyst in Financial Forensics (MAFF). Mr. Becket has testified a dozen times as an expert witness in superior courts throughout Connecticut and in Pittsfield, Massachusetts.
Mr. Becket may be contacted at (860) 435-0207 or by e-mail to Peter@BecketBusinessAppraisals.com.