Emerging Market Finance

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 points between designated benchmark
  bond and less liquid government bonds in Japan.

5
Chinas 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 Bs worth is only 21 of firm As,
  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 private transfers
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.
• Lets look at two types of models.

19
Longstaffs (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
Longstaffs (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 is d 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
Control Blocks to SOEs
Non-Control Blocks to SOEs
Non-Control Blocks to private firms
Control Blocks to private firms
31
Control Premium Relative to Floating A-Share
Prices
Control Blocks to SOEs
Non-Control Blocks to SOEs
Non-Control Blocks to private firms
Control Blocks to private firms
32
Control Premium Relative to Revenue Per Share
Control Blocks to SOEs
Non-Control Blocks to SOEs
Non-Control Blocks to private firms
Control Blocks to private firms
33
ROE Across Groups
Control Blocks to SOEs
Non-Control Blocks to SOEs
Non-Control Blocks to private firms
Control Blocks to private firms
34
ROA across Groups
Control Blocks to SOEs
Non-Control Blocks to SOEs
Non-Control Blocks to private firms
Control Blocks to private firms