What all valuation professionals need to know about IPCPL

In the valuation profession, there have been long-standing, unproductive arguments about how best to estimate something called the discount for lack of marketability (DLOM) for assets traded only in private capital markets.  In contrast, estimation of the analogous liquidity risk premium (LRP) for assets traded in public capital markets seems fairly well settled among securities analysts because—in short—they have the data.  There is a new, innovate theory and method for estimating DLOM of private capital markets that is theoretically-sound and is quite consistent with preliminary empirical evidence: the Implied Private Company Pricing Line (IPCPL). Because IPCPL uses data from both public and private capital market transactions, it reconciles the views and data of valuation professionals and securities analysts. This is important.  Please read on!

Who developed IPCPL and when?

IPCPL theory and the related method was originally developed by Dohmeyer and Butler in 2012, and refined in Dohmeyer, Burkert, and Butler in 2013.[1] Igor Gorshunov provided preliminary private market capital market empirical evidence consistent with IPCPL in 2015.[2] David Goodman and Malcolm McLelland presented formal aspects of IPCPL theory in 2016 and direct empirical evidence consistent with IPCPL theory in 2018.[3] An applied IPCPL model with monthly data updates was developed by Dohmeyer, Butler, Burkert, and Toby Tatum, and is available from Business Valuation Resources.

Why was IPCPL developed?

IPCPL is based on the deep, original insights of Bob Dohmeyer and co-authors Pete Butler and Rod Burkert that (i) accurate private capital market valuation requires the no-arbitrage condition between the public and private capital market prices of risk, (ii) public and private capital markets naturally differ in liquidity risk characteristics, and (iii) although the no-arbitrage price of liquidity risk across public and private capital markets is unobservable it can be estimated directly from the differential associated with selling equity in private capital markets relative to public markets.

So, IPCPL was fundamentally developed to estimate the no-arbitrage market price of liquidity risk in private capital markets based on the idea that equity sales transaction cost differentials represent the no-arbitrage market shadow price of liquidity risk. The IPCPL method can potentially be used to estimate the no-arbitrage market prices of other types of risk as well, but such aspects of the theory have not yet been fully developed.

What is the relevance of IPCPL in practice?

Because IPCPL represents a theoretically sound and empirically tested method of estimating the no-arbitrage market prices of private capital market liquidity risk, it represents a meaningful solution to the long-criticized and -contested methods for estimating “discounts for lack of marketability” (DLOM).  Subject to the caveat that equity control-related discounts must be considered jointly with DLOM in practice, DLOM is equivalent to equity liquidity (risk) discounts. Because the IPCPL method approaches private capital market pricing in a unique way, it generally avoids several problematic valuation issues (e.g., small company and idiosyncratic risk premiums). Although empirical testing and the development of applied IPCPL methods are incomplete, IPCPL theory has withstood theoretical criticisms and empirical testing quite well.

So, because IPCPL provides a theoretically sound and empirically tested method for estimating the market price of liquidity risk, it largely solves the long-existing DLOM estimation problem. Accordingly, all valuation professionals should have at least a basic understanding of IPCPL methods; particularly because such IPCPL-based methods are likely to be used more frequently in future valuation practice.

How can IPCPL be understood intuitively?

At the simplest level, IPCPL explains and predicts how observed equity prices and related implied expected returns vary due to equity sale transaction costs; and, thereby, estimates the unobservable market price of liquidity risk. Consider, for example, a single discounted equity cash flow and the related expression showing the expected return depends on equity sale transaction costs:

Where to learn more about IPCPL?

Read materials available on the IPCPL Tools webpage at Business Valuation Resources. If needed, the developers of IPCPL theory and methods can be contacted as necessary at their e-mail addresses available on the IPCPL tools webpage at Business Valuation Resources. ::

Malcolm McLelland Ph.D.
São Paulo, Brazil

Caveats.  Please note: (i) views presented above are my own and do not reflect those of others; (ii) like anyone, I’m not infallible and am responsible for any errors; (iii) I greatly appreciate being informed of any significant errors in facts, logic, or inferences and am happy to give credit to anyone doing so; (iv) the above article is subject to revision and correction; and, (v) the article cannot be construed as investment or financial advice and is intended merely for educational purposes.  MMc

[1]     Dohmeyer, Robert, and Peter Butler, 2012, “The Implied Private Company Pricing Line” Business Valuation Review 31(1), pp. 35-47; and, Dohmeyer, Robert, Rod Burkert, and Peter Butler, 2013, “The Implied Private Company Pricing Line 2.0 K0 = (FCFF1 / P) + g” Business Valuation Update 19(9), September 2013, pp. 1-9.

[2]    Igor Gorshunov, 2015, “IPCPL and Margin Reversion: Implications for the Valuation of Small Privately Held Companies” Business Valuation Review 34(2), pp. 70-73.

[3]   Goodman, David, and Malcolm McLelland, 2016, “The Implied Private Company Pricing Line (IPCPL): On the Nature, Scope, and Assumptions of IPCPL Theory” Business Valuation Review 35(1), Spring, pp. 18-29; and, Goodman, David, and Malcolm McLelland, 2018, “Private market equity prices and transactions costs: Generalized IPCPL theory and private market empirical tests” Business Valuation Review (forthcoming 2018).