Investment Profiles and Valuation Discounts

Valuation Discounts, What the Interest Owners See, and What a Direct Owner Sees

What sort of discounts apply to pass-through entities? Rand Curtiss helps clarify, looking at investment characteristics, investment profiles, and the interaction of these elements. He draws four conclusions. Find out what they are here.

Two dangerous lines of thinking are floating around concerning fractional interest valuation discounts:

• The first comes from the Service and Tax Court, and culminates in statements like:

Discounts for pass-through entities holding marketable securities are no more than X%

• The second comes from us, when we ask each other:

What sort or size of discount applies to a pass-through entity holding asset type Y?

The reason both lines are dangerous is that they ignore three things:

1. The investment characteristics of the assets owned inside the entity.
2. The rights of and restrictions on interest owners created by the entity agreements.
3. The interaction of these two fact sets.

Investment Characteristics

We know the two primary investment characteristics of an asset: return and risk. For purposes of this analysis, return has two aspects: actual cash income and taxable income.  Risk involves the volatility or uncertainty of principal value.

We are very familiar with these characteristics and consider them when we make basic investment choices. For example, when my two daughters were very young, I started saving for their college educations. I invested in growth stocks, which offered the prospect of high, long- term appreciation with acceptable interim volatility. I got lucky, the stock market rose, and as my girls entered adolescence, I gradually shifted the investments into bonds to lock in value.

[Important financial planning note: I totally forgot about weddings, which, in my case, are going to cost the same as a third daughter’s college education!]

Investment Profiles

Asset investment characteristics cannot be considered by themselves when we value a minority interest in a pass-through entity.  This ignores the existence of the entity, and makes no distinction between outright asset ownership and ownership of an interest in the entity. Asset investment characteristics, coupled with the features of a pass-through entity agreement, may create an entity interest with very different investment characteristics than the underlying assets. I call the entity interest’s investment characteristics its “investment profile.”

As a first example, we are appraising a minority interest in a family limited partnership (FLP) that owns nothing but Treasury bonds. (Please ignore the legitimate questions that could be raised about the business purpose of such an entity.) Under the terms of the FLP agreement, there will be no distributions whatsoever until the entity liquidates, and there are no provisions for withdrawal or return of capital.

The investment characteristics of the T-Bonds (owned directly) are steady cash and taxable income (due to interest payments) and no uncertainty about ultimate capital return (when the bonds mature, we will get back our full principal. If we do not, the U.S. Government has defaulted, and all bets are off. We probably have much bigger concerns than getting our money back!)

But the investment profile of the limited partnership interest —what the limited partner sees or realizes—is very different: no cash income (there are no distributions) and high taxable income (because  partnership  interest  income  flows  through  to  the  partners),  although  there  is  no difference in the risk characteristics. The high taxable income means that there is going to be a carrying cost (income taxes) or a negative interim after-tax yield for the limited partnership interest owner. 

As you can see, this investment profile is very different from that of owning the bonds outright. In fact, this profile more closely resembles owning raw land (no cash income, in fact, annual carrying costs) and (probably) very low capital risk.  When benchmarking your  valuation discounts and/or using Chris Mercer’s Quantitative Marketability Discount Model (QMDM),  you should be looking  at the investment profile of the limited partnership interest, not that of the underlying assets.

As a second example, we are again appraising a minority interest in an FLP, but this one owns nothing but growth stocks (defined here as stocks which have high appreciation potential but will pay no dividends, and have some volatility associated with them).  Moreover, the FLP portfolio is actively traded, so we can expect to realize capital gains and losses on a yearly basis. In addition, the  partnership  agreement  requires  that  there be distributions  in  excess  of  partners’ annual  (capital gains) tax liabilities each year.

Again, the investment profile of this limited partnership interest differs dramatically from the investment characteristics of the underlying growth stocks. Partners can expect annual after-tax income, and capital value is uncertain because of the volatility of the asset prices and the potential drain imposed by the annual distributions. The valuation discount analysis should consider this.

The third and final example involves “tiered” discounts. Assume we are appraising the discount for an FLP that owns minority limited liability company (LLC) interests.   When analyzing the two levels of investment profile (one for each LLC and one for the FLP), we also have to consider the fact that as the underlying  LLC’s  approach  their termination   dates,  their discount for lack of marketability (DLOM)’s  will  decline  to zero. Appraisers often overlook this “synthetic appreciation”—a term coined by Tim Lee of Mercer Capital. If you use the QMDM, you must be sure to factor it into your rate of return analysis. 

Conclusion

There are four morals to this story:

1. When appraising valuation discounts, ask yourself what the interest owner sees or realizes in terms of cash and taxable income and expected capital appreciation.
2. This might be very different from what a direct owner of the entity assets might realize.
3. Do not be misled just by the nature of the entity’s assets; you must also consider the effects imposed by features of the entity agreement.
4. Even if you do not normally use the QMDM in your discount appraisals, consider its irrefutable logic as a means of guiding you in the right direction.

Rand M. Curtiss, MCBA, FIBA, ASA, CBA, is President of Loveman-Curtiss, Inc. in Cleveland, Ohio.

This piece was first published in Business Appraisal Practice (BAP), Third Quarter, 2008.  Visit www.go-iba.org.