Holding Company Valuations: More Than Simple Math
By Sadikshya Karki, Senior, Advisory Services
Owners of holding companies commonly assume that valuing an interest in a holding company is straightforward: its value is its pro-rata portion of the sum of its net assets. However, there is more to the story.
Let’s start with the basics. A holding company is an entity that is intended to invest in assets rather than focus on ongoing operations. A typical holding company may own marketable securities or other equity interests, real estate, timber, minerals, and/or equipment. Such assets represent a holding company’s primary value, whereas an operating company’s value is indicated by the earnings it generates.
Valuation of a holding company relies on the asset approach, which adjusts the recorded book value of the company’s assets and liabilities to their fair market values to reach a value indication. The value of the liabilities is subtracted from the value of the assets to derive the entity’s adjusted net asset value (NAV) — the value of its equity.
Digging deeper, here are some factors that play a significant role in determining the fair market value1 of an ownership interest in a holding company.
Control refers to a business owner’s ability to control the financial, operational, and legal aspects of the business, including a sale of the company or all of its assets. The NAV derived from the asset approach represents value on a controlling basis. Determining the value of a non-controlling interest, however, typically requires applying a discount for lack of control. The definition of fair market value assumes a transaction between a willing buyer and seller. A hypothetical buyer of a non-controlling interest cannot force the sale of assets, determine the timing and amount of distributions/dividends, or control the liquidation of the company. This is considered in the determination of a purchase price.
The magnitude of discounts applied for lack of control is asset-specific and it’s important to consider the nature of the individual assets. Various studies help determine the appropriate discount for lack of control for different asset types:
Real Estate Limited Partnerships (Partnership Profiles, Inc.)2
Partnership Profiles can help determine discounts for lack of control for interests in entities that hold real estate. Partnership Profiles is a database on limited partnerships that hold real estate and are traded on secondary markets, where bona fide offers are made by multiple bidders through registered broker-dealers. The data indicates that limited partner interests in real estate limited partnerships typically trade at a discount from their adjusted NAV. Financial data regarding these limited partnerships and transaction data about trades of limited partner interests can help determine the appropriate discount for lack of control for non-controlling interests in partnerships, limited liability companies, or corporations.
Closed-end funds are mutual funds that issue a fixed number of shares. They can help determine discounts for lack of control for interests in entities that hold cash, investments in marketable securities, stocks and bonds, and other similar investments. A minority interest holder in a closed-end fund cannot influence key decisions. As a result, the trading values of interests in these funds offer empirical evidence regarding discounts for lack of control. The discount (or premium) at which ownership interests in closed-end funds trade relative to the NAV of the fund can be determined by comparing the NAV of a closed-end fund with the freely traded price of a unit of the fund.
It is imperative to understand the difference between a minority interest and a non-controlling interest. For holding companies that are corporations, the level of control of a particular ownership interest depends on the percentage ownership and, usually, whether the subject interest represents a majority or a minority interest — more or less than 50%.
For holding companies that are limited partnerships, however, the concept of control works a little differently. Limited partnerships have general partners that possess certain control rights. In such a scenario, even a 99% limited partner interest might be subject to a discount for lack of control. Therefore, it is important to recognize that a particular interest might represent ownership of more than 50%, but may not have control.
Marketability is defined as the ability to quickly convert property to cash at minimal cost.3 This concept is important in valuation because a hypothetical owner cannot sell an equity interest in a privately held holding company as easily as they could sell shares of a public company.
Furthermore, a non-controlling interest in a holding company may be less marketable because it may be subject to restrictions on transfer and sale. Therefore, a discount for lack of marketability is applicable in determining the fair market value of a non-controlling interest. Various studies and court cases provide support and insight to determine an appropriate discount for lack of marketability.
The liquidity of individual assets also affects the extent of the discount for lack of marketability. Liquidity is asset-specific, and it’s important to consider the cost and time that would be incurred in the sale of each individual asset.
For example, marketable securities are significantly more liquid than investments in real estate because the sale of land and buildings requires more time and incurs higher selling costs, such as brokerage, legal, and inspection fees. A hypothetical buyer would assess the value of a holding company based in part on the net proceeds they would receive from the sale of assets if the company were to go through a liquidation process. Thus, liquidity of individual assets is an inherent factor that determines the fair market value of an interest in a holding company.
Overall, determining the valuation of an ownership interest in a holding company requires more than a simple calculation. Control and marketability factors should be carefully considered.
- There are various definitions of fair market value. For tax-related purposes, most are similar to that from U.S. Treasury Regulation §25.2512-1, regarding the value of gifts, which defines fair market value as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.”
- Partnership Profiles, Inc. provides information in its Minority Interest Discount Database as well as in its annual publication, Executive Summary Report on Re-Sale Discounts.
- International Glossary of Business Valuation Terms, as quoted in Appendix B of the American Institute of Certified Public Accountants’ Statement on Standards for Valuation Services No. 1.